Say your prayers. We no longer have a lender of last resort fully standing behind the global financial system. The US Federal Reserve is prohibited by law from carrying out precisely those emergency actions that halted contagion and a worldwide collapse in October 2008.

The Dodd-Frank Act and the post-Lehman culture of righteousness on Capitol Hill have tied the hands of the Fed. In the America First mood in Trumpian Washington it is unclear whether the US will continue to uphold its responsibilities as issuer of the paramount reserve currency and how far it will go to help foreign institutions facing trouble.

The tougher new rules will make it much harder - and slower - for the Fed to halt fire-sale liquidation in a crisis. It is true that the repression has made US banks "safer" than any time in the last 40 years: common equity capital ratios have doubled since 2008. Lenders have big enough cash reserves to withstand a 30-day liquidity seizure. But this is to celebrate a financial Maginot Line.

The rules themselves have pushed ever larger parts of the money nexus into the shadows or into untested new instruments - "outside the perimeter" - and that is where the nitroglycerine now sits. As we have learnt over the last two weeks, acrobatics in the brave new world of exchange traded funds are a sight to behold. The structure is arguably more dangerous today than it was on the eve of the Great Recession.


The Dodd-Frank Act, rushed through in 2010, prevents the Fed from rescuing individual companies in trouble (there must be at least five, and they must be solvent) or lending to non-banks in a panic.

It can lend only to "insured depository institutions" through its discount window with the Treasury's permission.

Fed chieftains Ben Bernanke and Don Kohn warned that these curbs were ill-advised.
They were overruled.

What saved capitalism in 2008 was epic action by the Fed to shore up the commercial paper and the asset-backed securities markets, and to head off an implosion of the money market industry.

It took US$1.5 trillion ($2t) of emergency loans to stop the vicious cycle. Events moved with lightning speed, in chaos, with zero visibility.

"The Federal Reserve lent to individual non-bank institutions whose default would have been extremely damaging for the financial system and the state of the economy," said Stanley Fischer, the Fed's former vice-president in a speech in 2016.

"The facilities were many and varied, and developed as needed, because the US financial system is complex and, as the crisis unfolded, the nature of the next phase was largely unforeseeable. Had that flow of credit ceased, the severe recession that resulted would have been far more serious," he said.

The US Federal Reserve saved the European financial system, preventing a chain-reaction of defaults, during the global financial crisis. Picture / Getty Images
The US Federal Reserve saved the European financial system, preventing a chain-reaction of defaults, during the global financial crisis. Picture / Getty Images

New York Fed chief Bill Dudley has made much the same argument, describing how the institution had to step in with "funding backstops" when panic caused counterparties to shut off credit to rock-solid companies.

He lamented that the Fed cannot easily provide such a circuit-breaker today. It can act only in extremis, with a delay, and under severe constraints.

Financial crises do not wait for bureaucracies to catch up. Bear Stearns informed the Fed on a Thursday that it would default that Friday. When US Treasury secretary Hank Paulson pulled the plug on Lehman Brothers, and its US$660b book of liabilities, he thought the shock could be contained. Within days the collapse had engulfed the world's biggest insurance firm AIG, and threatened to engulf all else.

Once the bomb had exploded, it went global instantly. It was the Fed that then saved the European financial system, preventing a chain-reaction of defaults when the offshore dollar funding markets froze and it became nigh impossible to roll over three-month dollar credits. The European Central Bank and its peers could not create the dollars desperately needed to buttress Europe's interbank markets.

The Fed responded by advancing liquidity swap lines in US dollars to central bank peers, removing all limits over the wild weekend of October 14, 2008. Total swaps surged to US$580b.

The Fed can in principle still do this today, subject to approval by the US Treasury secretary, and therefore the Trump White House. My question is whether the Fed would hesitate - and for how long - under the implicit political constraints of Trumpian Washington.

The situation would be comical if it were not so grave.


It is not hard to imagine a dark scenario where Donald Trump positively relishes a bout of dollar waterboarding for Europe's pious elites. That was the attitude that prompted the (nationalist) Chicago Fed to sweep aside requests for help from the (metropolitan) New York Fed in 1930 and 1931, causing the US banking crisis to metastasise.

It was the bloody-minded attitude of the Banque of France in the early Thirties when it refused to reflate under the etiquette of the inter-War Gold Standard.

I have long argued that the Achilles' heel of the international system is the edifice of offshore dollar debt outside US jurisdiction. This has mushroomed from US$2t to US$11t (BIS data) over the last 15 years, driven by global leakage from zero interest rates and quantitative easing. The world has a "short position" on the US dollar that it cannot cover in a liquidity crisis.

We are probably not at the end of this cycle.

Goldman's Lloyd Blankfein is right that Trump is throwing "lighter fuel on the fire" with his late-cycle stimulus and the biggest fiscal deficit in US history, outside war and recession. The policy is unconscionable and will backfire once the Fed hits the brakes. But for now it is elixir for asset markets. I will start to worry only if - and when - the dollar starts grinding higher and threatens to trigger the proverbial "short squeeze" on dollar credit.

The situation would be comical if it were not so grave. The Fed and fellow central banks have stimulated a titanic expansion of debt over the last quarter century: an asymmetric policy of letting booms run their course while always intervening to prevent busts, culminating in the final throw of QE.

This has driven down the natural Wicksellian rate of interest and led to grievous intertemporal distortions. It has lifted the world debt ratio by 51 per cent of GDP to 327 per cent since the pre-Lehman peak, and led to a synchronised "everything bubble", from bonds, equities, property, to art and Bitcoin.

While one branch of western governments has created this leviathan of leverage and interlinked global asset speculation, another branch has called into question whether there will be a lender-of-last resort when the moment of reckoning finally comes. Just brilliant.