March 24, 2023
By Ashley Rindsburg | Tablet Magazine
It should go without saying that we are now in a financial crisis. We have just witnessed the collapse or near-collapse of five banks, including Credit Suisse, an institution of systemic importance. And yet it still needs to be said in light of the glib reaction following the collapse of Silicon Valley Bank (SVB) earlier this month, which many pundits claimed was only a problem for rich “tech bros.” But SVB was the 16th-largest bank in the United States and its speed-of-social-media implosion left observers and regulators grasping for answers, which made it easy to blame the bank’s failure on corrupt venture capitalists trying to cheat the system. After SVB, the San Francisco-based First Republic bank also started to melt down, while the crypto-focused Signature and Silvergate banks went into closure, a pattern that reinforced the notion that this was a Silicon Valley phenomenon being hyped up by wealthy venture capitalists looking for a government bailout.
As New York University professor Scott Galloway wrote on March 19 in a sneering tweet (since deleted but still cached), “Hunger games on the way up, Denmark on the way down,” a reference to scathing commentary he’d made on Face the Nation. There he argued that venture capitalists seem to want less government when times are good but government intervention when things go south. This was a tidy, retweet-friendly way of packaging the disaster in an easy to digest narrative primed for social media’s us-versus-them binaries.
Then Credit Suisse happened. After rapid outflows of deposits and a nose dive in its stock, Credit Suisse was acquired at the polite but firm suggestion of Swiss regulators by rival UBS, a development that put to rest the narrative that this was a Silicon Valley phenomenon and exposed the global nature of the banking failure, while pointing to its underlying causes.
While the current crisis has echoes of the 2008 global financial crash, the reality is that it’s more a toxic byproduct of the government’s response to the ’08 crash. It also has the potential to be considerably worse. When the U.S. government bailed out banks that had taken outrageous risks in the housing market, it ignited an era of loose monetary policy. To fund the $800 million Emergency Economic Stabilization Act and similarly sized American Recovery and Reinvestment Act, as well as to stimulate the economy (though these two efforts were essentially one and the same) the Fed cut interest rates to 0% for the first time in history. While there was an expectation that interest rates would stay ultralow for some time, the Fed kept them under 1% for almost 10 years. By 2019, the Fed’s balance sheet had swollen to $4 trillion. But the public, which enjoyed soaring stock markets, low mortgages and car loans, and the lush fruits of easy money, was placated.
Of course, it didn’t hurt that the Obama administration, with the enthusiastic backing of the media, successfully messaged the idea that the government had recovered the funds used for the 2008 bailouts. “We got back every dime used to rescue the banks,” Obama said in a campaign speech in 2012. This was later shown to be false, since the actual taxpayer cost of the bailouts was around half a trillion dollars.
While the current crisis has echoes of the 2008 global financial crash, the reality is that it’s more a toxic byproduct of the government’s response to the ’08 crash. It also has the potential to be considerably worse.
Then COVID hit, and the Fed began printing money like it was going out of style—and now it might be. In 2020 alone, the Fed created $3 trillion in virgin money compared to 2019 when it injected $115 billion into the economy—a nearly thirtyfold increase. It would print another $2 trillion in the two years after that. As a result, the money supply has increased more in the past three years than in the preceding decade. Put another way, more dollars were put into circulation between 2014 and 2022 than in the entire recorded history of the dollar.
And where did the COVID trillions go? Into the banks, primarily, which invested some of that money in long duration Treasury bonds, since that is the sensible thing to do when you come into trillions of dollars. The catch, however, is that when banks began investing the money in those bonds, the Fed was forecasting the interest rate would remain unchanged into 2023, which meant the value of bank-held long-term bonds would hold steady. (When interest rates go up, bond prices go down and vice versa.) But interest rates didn’t stay low. They went up. And it wasn’t just that they “went” up, as if by some natural force of economic anti-gravity. They were driven up by the same institution that created the tidal wave of new money while forecasting low rates into 2023: the Fed. For its part, the Fed was doubly betrayed by reality when inflation, which it (along with many media and political figures) had dutifully labeled “transitory,” started to look a bit more permanent.
The Federal Open Market Committee is the key Federal Reserve committee responsible for setting the federal funds rate, which is the rate at which banks can loan each other money. In other words, it sets the benchmark interest rate for the economy, which also determines how much money flows through the system. Far from the 0.1% rate that was predicted by the Fed in 2020, rates have risen to 4.7%, which means the Fed missed its own estimate by 47 times. What this means is that banks behaving with the Fed’s projections in mind now have a Titanic-size hole in their books. The value of those long-duration bonds banks snapped up in 2020 (when it was the safe thing to do) has plummeted, worth up to 10%-50% less than they were supposed to be worth. Meanwhile, banks have incurred liabilities in the form of loans and investments predicated on 2020 bond prices. The banks are, in simple terms, underwater—and not just in Silicon Valley due to greedy tech bros but, as The Economist recently reported, across the country.
The Fed’s rate hike on Wednesday delivered a hybrid message, increasing the federal funds rate by 0.25% but also signaling this will be the last, or second to last, increase. “Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain. The Committee remains highly attentive to inflation risks,” the Fed Open Market Committee wrote. But with the banking sector in crisis mode, even this modest rate increase—coming in place of a pause in raising or a drop in rates—could inflame the debt crisis, putting more banks at risk.
Despite the expressions of public shock in the days after Silicon Valley Bank’s collapse, the writing was on the wall. The investor Ray Dalio argued in his newsletter that SVB’s collapse, far from being an unforeseeable “black swan,” represented “a very classic event in the very classic bubble-bursting part of the short-term debt cycle.” Describing the mechanics behind the breathtaking risk the economy is now facing, Dalio wrote: “Tight money [employed] to curtail credit growth and inflation leads to a self-reinforcing debt-credit contraction that takes place via a domino-falling-like contagion process.”
What Dalio means is that the Fed can no longer raise interest rates without causing the value of long-duration bonds held by hundreds (if not thousands) of banks to drop again. But if the Fed lowers rates and loosens the money supply it risks creating more demand, increasing wage growth, and sending inflation even higher, which, after 15 months of rising prices, could morph into the kind of runaway inflation that might trigger an even more severe economic crisis. The Fed has placed itself in a damned if you do, damned if you don’t scenario.
Dalio is not alone in his doomsaying. Nouriel Roubini, the economist who predicted the 2008 crash, told Bloomberg, “It’s an extremely dangerous moment, because there’s now significant stress in some parts of the U.S. banking system at a time when inflation is still too high.” In an interview earlier this month, Roubini—who called the current scenario a “debt trap” weeks before Silicon Valley Bank went under—described how the situation could realistically unfold:
The Fed will have to keep raising rates in spite of what happened with SVB. Then we will have a recession. That recession is going to cause more defaults, because as income falls, people who have too much debt are going to default. And then the increase in bond yields and market spreads is going to cause a recession [that’s] even more severe. So it will be a negative feedback between the real economy and the financial markets with an economic crash leading to a greater financial crash making an economic downturn more severe.
Roubini noted that the total equivalent of fixed-income long-duration assets (basically, long-term debt instruments, of which bonds and certificates of deposit are examples) in dollars is a staggering $20 trillion, of which, he says, $10 trillion could be wiped away by raising the interest rate by enough to bring inflation down. Moody’s has downgraded the entire U.S. banking system from stable to negative, citing a “rapidly deteriorating operating environment.”It’s this that led famed “black swan” investor, Mark Spitznagel, to say last year that we might witness “the greatest tinderbox-timebomb in financial history,” with repercussions not unlike what was experienced during the Great Depression. The reason for the extreme language is that in the globalized economy, the debt crisis is global. Foreigners hold $1 trillionin U.S. currency and around $12 trillion in long-term debt. With bond prices plummeting, this places foreign banks and other debt-holders in the same situation as American debt-holders. More importantly for the future of the U.S., it incentivizes foreigners to dump the dollar. With China, Russia, Iran—and other countries who have suffered the wrath of the U.S. Treasury acting as the pointy end of America’s geopolitical stick—banding together to create new methods of trading outside the dollar, this exigency is now turning into a reality.
This is where disaster could cascade into catastrophe. A flight from the dollar would soak the economy in even more currency as foreign investors sell their dollars in exchange for more stable options. In such a scenario, no amount of interest rate raising could contain the damage without creating even more destruction—higher unemployment and more bursting bubbles.
After 20 years of comforting ideas about infinite, easy money, the U.S. is now hoping that someone will be left to bail us out of a mess of our own making.
Ashley Rindsberg is the author of The Gray Lady Winked: How the New York Times’s Misreporting, Distortions and Fabrications Radically Alter History(2021).