Latest Crisis to Hit U.S. Economy Illustrates the Costs of Complacency

The Washington Post / David J. Lynch

12:20 JST, March 27, 2023

Each of the last four U.S. presidents has confronted an economic crisis serious enough to warrant extraordinary government intervention in the workings of the free market. Once rare, such dramatic rescues have become the norm.

The authorities’ swift response this month to the collapse of Silicon Valley Bank, which until the day it failed had been regarded as of little importance beyond the technology sector, revealed a brittle system addicted to infusions of official support, according to some economists.

Now, fresh economic dangers loom, including in the largely unregulated private markets that provide more than half of all U.S. consumer and business credit.

Economic calamities in recent years have erupted in rapid succession. The SVB episode came three years after the pandemic sparked job losses and supply chain disruptions, which occurred little more than a decade after the 2008 financial crisis.

The three episodes that rocked Americans had little in common. Two originated in errors by captains of finance; one resulted from a once-in-a-century outbreak of disease. But they all emerged after periods of success had lulled investors and executives into assuming that favorable conditions would endure.

Years of ultralow interest rates preceded both the 2008 crash and the SVB affair, encouraging bankers to engage in riskier ventures. Likewise, in the years before the pandemic, a relatively placid geopolitical scene made the cost savings of ocean-spanning supply chains seem attractive.

In both finance and manufacturing, risks accumulated like kindling until an unexpected spark ignited a conflagration. Rising interest rates popped the 2008 housing bubble and this year led to big losses on SVB’s portfolio of government bonds, previously believed to be super-safe. In 2020, the pandemic showed that relying on Chinese factories to produce everything from personal protective equipment to semiconductors had been a bigger gamble than most executives and policymakers appreciated.

“There was this complacency about all the fault lines,” said Carmen Reinhart, a Harvard University professor and former chief economist for the World Bank. “That means that you are very vulnerable.”

It is no accident that the United States has been buffeted by larger and more frequent economic storms in recent decades, some economists said. For decades after World War II, restrictions on global capital flows and strict regulation of domestic finance kept instability risks in check.

But those rules were eventually weakened, and as barriers between nations fell with the end of the Cold War, cross-border financial and production links flourished.

In the United States, money became so readily available that long-term interest rates, adjusted for inflation, plunged below 1 percent in 2003 from more than 4 percent in the mid-1990s.

Between 2000 and 2008, bank loans to clients in other countries roughly tripled to more than $30 trillion, growing twice as fast as the global economy, according to data from the Bank for International Settlements in Basel, Switzerland.

At the same time, companies discovered they could slash costs and boost profits by locating factories in low-wage countries such as China. By 2008, the value of world trade topped 60 percent of global gross domestic product, up from about one-third in 1979, according to the World Bank.

Tighter cross-border links produced big profits on corporate income statements. But they also generated large risks that were less visible.

“It’s a function of increasing globalization and increasing global integration,” said Nathan Sheets, chief economist for Citigroup. “As a crisis originates in one place, it’s being transmitted around the world. Some of these crises, if they emerged in a less integrated world, they would have had less of an effect.”

When March began, there was no obvious relationship between a tech-focused bank in Silicon Valley and the heart of Swiss finance, almost 6,000 miles away. Yet by drawing scrutiny to the entire banking industry, SVB’s collapse set in motion events that culminated in the forced sale of Credit Suisse, which first opened its doors in 1856.

Global ties also were implicated in 2008, when the housing meltdown demonstrated the dangers of opaque investments held by interconnected banks. And the pandemic, which temporarily severed some of those cross-border linkages, showed how the U.S. had become overly dependent on China for essential goods. Russia’s invasion of Ukraine last year underscored the need for secure sources of vital goods and materials.

These serial economic shocks are less an aberration than a return to past patterns. Major financial panics and recessions have periodically swept the United States, starting in 1796 with the bursting of a bubble in land speculation.

Turbulence cannot be eliminated from the economy, according to finance experts. Banks must, by definition, manage the tension between their use of depositors’ short-term money to fund long-term residential or business investments. Getting that balance right can be difficult.

“It’s basically inherent in the system. It’s always a work in progress. You’re never going to have a totally safe financial system,” said Liaquat Ahamed, author of “Lords of Finance: The Bankers Who Broke the World,” a history of central bank decisions preceding the Great Depression.

Dean Baker, a senior economist with the Center for Economic and Policy Research, also sees little reason for concern. The economy is healthier today than during the technology and housing bubbles of the decade before 2008, he said. SVB’s problems paled in comparison.

“I think this was hyped. This is nothing like ’08,” he said. “On the whole, I think things look pretty healthy.”

Today, the immediate contagion danger appears to have eased. Federal Reserve Chair Jerome H. Powell and Treasury Secretary Janet L. Yellen both say the financial system is fundamentally sound. Regulations enacted after the 2008 meltdown made the biggest banks safer by requiring them to hold more capital in reserve and undergo periodic stress tests. And the outflow of deposits from midsize banks appears to have stabilized.

Still, on Friday, fears of weakness in European banks drove down shares of Deutsche Bank, Germany’s largest lender. Its stock has lost nearly one-quarter of its value this month.

The economic fallout from the struggles of the U.S. regional banks could yet prove significant. Banks had already begun to tighten lending standards before SVB failed. Further tightening could make it harder for consumers and businesses to obtain loans, which “could easily have a significant macroeconomic effect,” Powell said this week.

The frequency of system-shaking events – coupled with the emergence of new risks – has some analysts bracing for fresh tumult.

“The economic system on its own is not self-correcting, when it’s bombarded by all kinds of shocks,” said Joseph Stiglitz, once President Bill Clinton’s top economic adviser and the World Bank’s former chief economist. “We’ve made an economic system that is more fragile and therefore more likely to be bombarded by shocks. And the shocks that we experience have bigger effects.”

Indeed, presidents and central bankers in this century have felt it necessary to launch massive economic rescues that have taken the authorities far beyond their customary powers.

President George W. Bush kept General Motors and Chrysler afloat in December 2008 with government loans, temporarily guaranteed money market mutual funds and invested taxpayer funds in the nation’s largest banks.

President Barack Obama subsequently extended the automakers’ financing and shepherded them through bankruptcy while also unleashing what he called “the most sweeping economic recovery package in our history,” the $787 billion stimulus legislation.

When the pandemic hit, President Donald Trump used wartime powers under the Defense Production Act to direct private companies to produce specific goods such as medical masks and ventilators and secured a $2.2 trillion relief bill.

Throughout these episodes, the Federal Reserve lowered its benchmark lending rate to zero and held it there for years while purchasing trillions of dollars worth of government bonds and other securities. From less than $1 trillion in 2008, the Fed’s balance sheet ballooned to almost $9 trillion at its peak last spring.

The Fed’s response to SVB’s failure illustrates how hard it is to unwind emergency aid. For much of the past year, the Fed has been gradually reducing its balance sheet, withdrawing some of the extraordinary support it provided the economy during the pandemic.

Its new loan program for banks, however, is reversing that progress, adding almost $400 million to the central bank’s ledger.

The repeat crises also hint at the volatile environment that may await the U.S. economy as policymakers grapple with fresh challenges, including the growth of unregulated private markets, the widening divide between the United States and China, and the financial fallout from climate change.

The sharp increase in interest rates that blew a hole in SVB’s balance sheet has left other banks with $620 billion in unrealized losses, as bonds issued at lower rates lost value, according to the Federal Deposit Insurance Corporation. Those holdings should not be a problem – unless other banks, like SVB, need to raise cash quickly to cover depositor withdrawals and are forced to unload those assets at depressed prices.

But higher interest rates could cause problems elsewhere in the financial system that boomerang on the banks.

One area of worry involves the “shadow banking system.”

U.S. mutual funds, finance companies, hedge funds, insurance companies, pension funds and other so-called “shadow banks” hold more than $20 trillion in assets and are an increasingly important source of credit lines and financing for banks, according to a new report by the Federal Reserve Bank of New York.

In addition to those direct links, shadow banks also own many of the same assets that banks do. So if a major hedge fund needed to raise cash quickly and began dumping assets in a fire sale, the resulting price declines would “impair the net worth of banks that hold similar assets,” the report concluded.

Unlike banks, which are scrutinized by the Fed, the Comptroller of the Currency, the FDIC and state regulators, shadow banks are largely unregulated. In November, the Basel Committee on Banking Supervision warned that some banks were not adequately managing the risk of their exposure to institutions such as pension funds, investment companies and broker-dealers.

“These exposures are growing in size and have the potential to cause further financial stability concerns,” said the committee, which sets standards for global bank regulation.