“What is Going On With The Economy!?”
Silicon Valley Bank (SVB), Signature Bank, Silvergate Bank, and potentially more banks to follow…
What are these bank failures signaling about our economy? Using principles from the Austrian School of Economics we can gain a broader perspective to find the source of the current economic climate.
On a fundamental level, when banks want to increase the demand for deposits they raise interest rates. Rising interest rates encourage deposits (savings) and enable banks to lend money to make a profit. For example, (without considering fractional reserve banking or reserve requirements) Bank A is offering a 2% interest rate on a savings account. Customer X deposits $1M in Bank A to make 2%. Bank A takes the $1M from customer X and lends $1M to investor Y at a 4% interest rate. Bank A profits from the spread of 2%.
The sufficient amount of savings at a bank is determined when they can no longer lend money for projects that will yield a higher return than the rate they must pay depositors. At the same time, if consumers decide to save, it would signal they care more about the future than the present. When there are sufficient savings, interest rates would decline since banks don’t feel the pressure to take on more deposits and declining interest rates incentivize investments (due to cheaper debt) that produce the future goods and services that consumers care about.
It’s important to note that even though low-interest rates encourage the borrowing of money for investments as debt is cheaper, the banks wouldn't have enough money to lend (if interest rates were too low) because lower interest rates would discourage deposits and may even cause withdrawals. Hence, real supply and demand would determine the ideal interest rate.
So how is it possible in our economy that interest rates were so low for so long and the banks can still lend money? The Federal Reserve!
The Federal Reserve has a dual mandate to support maximum employment and stable prices. They accomplish this task by controlling all forms of interest rates through the Federal Funds Rate and the Discount Rate. Without going into too much detail about exactly how these instruments work, essentially, the Federal Reserve's dual mandate tries to get the best of both worlds.
The reason many economists support an inflationary Federal Reserve policy (to keep inflation at 2%) is that inflation increases consumer demand as consumers would rather buy something today if it will cost them more tomorrow. High consumer demand is good for the job market, but inflation disincentivizes savings. If there aren't sufficient savings, according to supply and demand interest rates would rise. High interest rates should lower inflation, increase savings, and disincentivize inefficient investments, and this is bad (short-term) for the job market. The Federal Reserve tries to fix this contradiction by artificially controlling interest rates and can keep them low even though the natural laws of supply and demand would force them to go up.
Rising rates create a deflationary environment (when things continuously get cheaper) and this would cause consumers to save their money which will be worth more in the future than if they were to spend it now. Many economists think deflation is a recipe for doomsday because the economy will grind to a halt as people stop spending money. However, long term, cheaper goods and services mean a higher standard of living for society and this would be a good thing. If there are businesses that would fail with a decrease in consumer spending, then those businesses must not be the most efficient use of resources in the economy. The free market is also referred to as the “invisible hand” because it is natural supply and demand that chooses which businesses are successful, rather than monetary or fiscal policy picking winners and losers.
Higher interest rates cause a reallocation of resources across the economy. Politicians (who control fiscal policy) and the Federal Reserve (which controls monetary policy) wouldn’t invoke a deflationary policy out of choice because this would cause a major reallocation of resources that would cause tremendous pain to many people in the economy. Even though on a theoretical level it is a good thing for interest rates to be determined by the free market, in our current financial system, this would mean a severe recession/depression.
What is happening now?
The Federal Reserve started to raise the Federal Funds Rate in March 2022 because it lost control of inflation. According to the theory explained above, rising rates encourage savings (decreases consumer spending), discourages all but the most efficient investments, and will therefore lower demand for goods and services throughout the economy, and prices should drop, which would lower inflation.
An artificially low-interest-rate environment for a significant period of time causes a misallocation of resources (inefficient use of capital or malinvestment). For example, a malinvestment can occur if the free market determines a 6% interest rate, but the Federal Reserve artificially set the interest rate to 2%. A lower interest rate would signal that consumers are increasing their savings to spend in the future, and investors/entrepreneurs will be incentivized to take on debt at low rates to fund ventures which these savers will eventually spend on. The problem is that consumer savings is not causing the low interest rate and artificially low rates would also simultaneously cause inflation.
Eventually, the Federal Reserve would have to raise interest rates to lower inflation causing less demand from consumers (due to an increase in savings) and those that took out the previous low interest rate loans will have to pay higher debt interest payments in the future. This would cause many of those artificially low debt funded businesses/investments to suffer. If those investors/entrepreneurs were faced with the real cost of debt, in our example at 6%, they would’ve had to allocate resources more efficiently.
When the Federal Reserve started raising interest rates to tame inflation, it inadvertently caused, or maybe exposed, exposed significant risk in our financial system, specifically to any institution or firm with malinvestments or that is not properly hedged for a rise in interest rates.
In the case of SVB, deposits skyrocketed in 2020, and they needed a place to invest that money. The bank decided to buy long-term fixed-rate bonds that were supposed to be safe, but they didn’t properly hedge for increasing interest rates. Because the bonds SVB bought had a fixed interest rate, when the Federal Reserve raised the Federal Funds Rate, the rates on new bonds went up, and the underlying value of the long-term fixed-rate bonds SVB owned went down.
Think of it like this: Would you rather buy a bond with a high-interest rate or a low-interest rate? Of course, a higher interest rate, and this is why the low-yield fixed-rate bonds that SVB bought decreased in value as new higher-yield bonds became available for purchase. So essentially, if SVB were to try and sell all their low-interest fixed-rate bonds for current market value, they would need to sell them at a significant loss.
Investors/depositors in SVB got wind that their banks' assets didn’t fully cover their liabilities (deposits) and the depositors at the bank were only thinking one thing: if I don’t take my money out now the bank may not be able to give me my money in the future and that’s not a risk I am willing to take. Hence, a bank run ensued because everyone was trying to be the first out the door before the bank ran out of assets to sell to pay everyone back.
To make matters worse, this doesn’t happen in isolation. When it happens in one bank, fear spreads across to depositors in all similar banks who may have improperly allocated their resources. Because our economy is heavily reliant on debt/credit, when customers across the financial system start to withdraw their deposits upon which these institutions depend, it puts tremendous strain and liquidity pressure on the whole financial system threatening another major financial crisis and recession.
It wasn’t long before every major news source in the country was reporting the massive SVB collapse. This is why the US Government decided to step in and ensure all depositors in SVB are made whole, even above the $250 thousand FDIC insurance maximum (the maximum amount of money the US Government will ensure you receive if your bank goes under), to restore faith in the US financial system. Only time will tell if the domino effect of a bank run and the significant pressure of rising interest rates on our financial system is contained, but I think this is just the beginning of a much larger event taking place.
In general, when profit is diminished with a higher cost of capital (in our context of monetary and fiscal policy), massive waves of layoffs follow. Layoffs lead to less consumer spending on goods and services (especially in an inflationary environment), which snowballs and decreases revenues for businesses, which leads to more layoffs as companies need to cut costs to stay afloat. The companies that were hurt badly can go out of business completely. Additionally, stocks, private companies, and real estate are devalued, and large amounts of investor equity get wiped out. This chain reaction grinds the economy to a halt and means a lower standard of living for most Americans.
In summary, markets can remain inefficient for a long time until they are corrected (and they tend to overcorrect). What we are seeing unfold is a major correction, but it's not about the deposits in any one bank, but rather the reallocation of resources (money, labor, and land) across the whole economy.
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Photo Caption: Silicon Valley Bank
Photo Credit: Forex news