Three banks have failed, and several more are on the docket for downgrades by credit rating agencies.
The post mortem of a bank failure always reveals idiosyncratic mistakes the bank made. In the case of the Silicon Valley Bank, it relied excessively on uninsured deposits on its liability side, and on Treasury bonds and Mortgage-Backed Securities on the asset side. Those deposits were mostly from Silicon Valley’s business tech sector, which needed a safe place to put the proceeds of IPOs.
But unlike what happened during the Global Financial Crisis, the bank didn’t go on a reckless lending spree. Instead, it took the safer route of buying securities either issued by the U.S. government or guaranteed by it (such as agency-backed mortgage-backed securities). While these securities had little-to-no default risk, they were subject to interest rate risk. If the Federal Reserve were to raise interest rates, the market value of these bonds would collapse, lowering the bank’s capital and potentially making it insolvent. But the Fed had kept rates low for a generation—and it seemed to have learned its lesson from the last three significant rate hikes: Paul Volcker in the early 1980s, Alan Greenspan in 1987, and Ben Bernanke in the early 2000s: rate hikes destroy financial markets and institutions. Indeed, the Fed initially showed remarkable patience, reiterating that inflation was transitory and signaling that rate hikes were not imminent.
Eventually, under immense pressure, especially from academic economists, the Fed embarked on a series of rate increases in an attempt to land the economy softly. The problem is that the Fed has never managed to engineer a soft landing. Jerome Powell all but admitted as much during a recent exchange with Sen. Elizabeth Warren (D-Mass.). The reason is simple: higher rates reduce inflation only by creating financial crises that crash the economy. After more than a decade of near zero interest rates, the Fed hiked rates extremely quickly — by 400 basis points (4 percentage points). All balance sheets that had been built during the period of low rates immediately became toxic.
The Volcker experiment in the 1970s is often used as evidence that the Fed has the tools to disinflate the economy. Indeed, the Fed has been tasked with little else since that experiment. Everyone acknowledges that the disinflation was not costless — we had two back-to-back recessions as a direct result of Volcker’s actions. What is less recognized is that the Fed caused a series of financial crises — from the demise of the Savings and Loan (S&L) industry in the U.S. to the collapse of bond markets in developing countries. Higher rates doomed the S&Ls that were holding fixed-rate mortgages on their balance sheets. Their cash inflows were fixed, while their cash outflows were increasing with increasing interest rates. Government attempts to rescue S&Ls through deregulation that eliminated interest rate ceilings on their deposits made things worse. To make up for the higher costs of their deposits S&Ls made riskier bets in search of higher returns, eventually engaging in outright fraud.
What is missing from the debates over monetary policy today is the understanding that the Fed was not established to control inflation. It was created to prevent financial crises by acting as a lender of last resort in times of distress. Indeed, that’s exactly what the Fed is doing now — opening up its lending facilities to banks in need. But rather than focus on maintaining financial stability, the Fed has become obsessed with controlling inflation, something it cannot really do without causing either a recession or a financial crisis (or both).
What the Fed needs to do is abandon misguided economic theories that have subverted its primary goal of financial stability to inflation targeting. Rather than change interest rates to control inflation it should pivot to a policy of stable interest rates with the goal of maintaining financial stability. The current experience is yet another stark example that unstable interest rates are inconsistent with financial stability. This approach is counterproductive and unnecessary since we have more effective tools for macroeconomic stabilization, such as fiscal policy.
It is true that the Silicon Valley Bank made mistakes. It sold underwater bonds at a loss and relied on Goldman Sachs to help recapitalize it. The first mistake was to sell the bonds before raising equity. The second mistake was doing business with Goldman Sachs. And there’s probably more to the story: maybe insider trading and lapses by regulators. There always is. But the whole scenario would have never played out without Powell’s rate hikes. Volcker killed thousands of Savings and Loans. He is Powell’s hero.
Put on the crash helmets. It’s going to be a bumpy landing.
Yeva Nersisyan is associate professor of economics at Franklin & Marshall College and L. Randall Wray is professor of economics and senior scholar at the Levy Economics Institute of Bard College.