Brilliant article, Prof. I would add one more point. Pre-crisis, the banks used their capital to build massive trading machines, which made banks information monopolies. They became the bid to all of their customers' offers and the offer to all their customers' bids. Over time, they became liquidity and information sinks. This allowed them to widen bid-ask spreads, and capture increasing rents on the flow business they conducted each day. Their residual risks were traded among each other or laid off on regulated exchanges.



The important thing CB policy failed to account for was that CBs were responding to information from markets -- interest rates, equity and commodity prices, etc. -- generated by the residual trading of the banks. In time, these signals increasingly reflected price manipulation by the banks' trading desks, many of which were found guilty of rigging these critical prices (although, as in every case of all the financial malfeasance that has come to light post-crisis, no one actually was found guilty of such actions. Paying the billions in fines is just another cost of doing business, ultimately borne by shareholders.)



The other interesting thing that happened as a result of the creation of these information monopolies was the banks (including the then-but-no-longer-existing investment banks) were able to create the impression the toxic securities they manufactured actually had a bid and were tradeable. Until they weren't. Then the entire edifice they created -- from the bond issuance that funded the mortgage brokers to the credit-rating agencies' fictions, and everything in between -- collapsed under its own weight.



The CBs and other key regulators didn't see it coming because they didn't know what they were looking at. They were impressing each other with financial-accelerator models and taking a victory lap on having ushered in "the great moderation." This required they spend their time endlessly refining their dynamic stochastic general equilibrium (DSGE) models so they could keep the great moderation going.



We know how this ended.



The crisis wiped out bank capital, forcing the Fed to become the "bad bank" and absorb all of the dreck generated by the heretofore unimaginable venality of the bank employees via the various Maiden Lane LLCs et al. In return the Fed flooded the banking system with liquidity, all of which, to this day, remains trapped in the system.



This says to me the level of bank-capital destruction must have been so enormous that the banks still are not able to effectively intermediate these reserve additions. Of course, as you say, the demand for credit also collapsed, mostly from the relentless drive to delever among households and firms. Most households and firms never again want to find themselves so levered that the loss of a job or customer could wipe them out -- as it did their neighbors and competitors, who were just a tad more over-levered than they were.



Because the CBs do not understand the intermediation process or the motivations of the bankers, they find themselves implementing policies that may be effective in another dimension -- literally, an entirely different set of facts that produces an entirely different reality. Their policies certainly do not have any utility in the dimension we all find ourselves occupying at present.



