This banking crisis won't wreck the economy

With the regulatory resolution of Silicon Valley Bank, the forced sale of Credit Suisse Group AG and reports of other troubles at regional US banks, the question arises whether America or perhaps the broader world will go through another major financial crisis and "Great Recession." Fortunately, the answer so far appears to be no.

One reason for (relative) optimism is simply that the world, and policymakers, have been preparing for this scenario for some time. Not only do memories of 2008-2009 remain fresh, but we are coming out of a pandemic that in macroeconomic terms induced unprecedented policy reactions in most countries. Before 2008, in contrast, macroeconomic peace had reigned and there was common talk of " the great moderation," meaning that the business cycle might be a thing of the past. We now know that view is absurdly wrong.

Circa 2023, we can plausibly expect further disruptions and macroeconomic problems. But this time around the element of surprise is going to be missing, and that should limit the potential for a true financial sector explosion.

The kinds of bank financial problems we are facing also lend themselves to relatively direct solutions. Higher interest rates do mean that the bonds and other assets that many banks hold have lower values, which in turn could imply liquidity and solvency problems. But those underlying financial assets usually are set to pay off their nominal values as expected, as with the government securities held by Silicon Valley Bank. That makes it easier for the Federal Reserve or government to arrange purchases of a failed institution, or to offer discount window borrowing. The losses are relatively transparent and easy to manage, at least compared to 2008-2009, and in most cases repayment is assured, even if those cash flows have lower expected values today, due to higher discount rates.

To the extent an economic slowdown does start, interest rates will fall again, which in turn boosts the values of those underlying securities, alleviating the problem. In contrast, the earlier Great Recession only pushed home prices down all the more. That in turn led to high numbers of foreclosures, which destroyed yet further value in real estate markets, worsening the cycle.

Another protective factor is that this time around household balance sheets are in decent shape. The sharp increase in pandemic-induced savings is now behind us, and balance sheets have been worsening for several quarters as consumers spend down their liquid surpluses, but still the overall situation appears acceptable. That limits the risk of economy-wide declines in consumption. Today's problems are more likely to remain localized in banks and other financial institutions, compared to, say, 2008-2009.

Better financial shape

After the financial crisis, households spent many years deleveraging.

Some of the current doomsayers are suggesting that further bailouts of insolvent banks will induce very high rates of inflation, due to the money creation required to implement such bailouts. Yet the net pressures of failing banks are deflationary, as an actual failure would result in the destruction of numerous bank deposits. Fed actions to rescue these financial institutions in fact forestall pending decreases in money supply growth. The Fed has been very active with its discount window activities as of late, but from that we should not expect any kind of hyperinflation.

Unprecedented contraction

The year-over-year growth in the US money supply has shrunk for first time since at least 1960.

The various bailouts we have been engaging in are not costless. For instance, they may induce greater moral hazard problems the next time around. But that does not mean we should expect a spectacular financial crash right now. More likely, we will see increases in deposit insurance premiums and also higher capital requirements for financial institutions. The former will fund the current bailouts, and the latter will aim to limit such bailouts in the future. The actual consequences will be a bleeding of funds from the banking system, tighter credit for regional and local lending, and slower rates of economic growth, especially for small and mid-sized firms. Those are reasons to worry, but they do not portend explosive problems right now.

In short, the rational expectation is that the US will muddle through its current problems and patch up the present at the expense of the future. For better or worse, that is how we deal with most of our crises. We hope that America's innovativeness and strong talent base will make those future problems manageable.

Part of our current mess is a higher risk of stagflation moving forward. Problems in the financial system may discourage the Fed from raising interest rates at the previously planned pace. That raises the risk of persistent price inflation of 4% to 5%, and America could end up with stagflation, at least if the financial sector troubles lower employment and economic growth.

In the post-recession years of the 1980s, we had major financial sector problems from the savings and loan crisis and what was then called "Third World debt," but no collapse. Today's details differ, but history shows that not all financial sector problems have to be explosive ones.