Last week Federal Reserve Chairman Jerome Powell spent two days on Capitol Hill, fielding countless questions from members of Congress about monetary policy. Nowhere in that exercise in happy-talk and obfuscation did anyone mention the possibility of a banking collapse that in less than one week would delegitimize the entire exercise. There are some calamities that arise without warning, like tsunamis or World War I, but the sudden collapse of Silicon Valley Bank, and the government’s over-the-top reaction to it, should have been as predictable as February snow in Buffalo.
While many are arguing that the collapse of SVB is a unique occurrence based on the bank’s particular client base and business model, this is wishful thinking. SVB was not unique, it was just first. But it has already proven not to be the last.
Fifteen years ago the banking system was pushed to the brink by its overindulgence in collateralized subprime mortgage bonds. Risky assets were also the undoing at SVB. But this time the risk was found in plain vanilla, general obligation US Treasury bonds (ironically considered the world’s safest asset). All banks, insurance companies, and pension funds hold them, they just didn’t need to sell them as urgently as SVB. But if the Fed persists in raising rates to combat the highest inflation in two generations, it would only have been a matter of time before all financial institutions heavily invested in Treasury bonds would drop like flies.
The crisis did not begin last week, or last year, or with the response to the COVID-19 pandemic. The seeds were sown in 2002 and 2003 when the Fed cut interest rates to 1 percent in order to ease the economic hangover that followed the collapse of the dotcom bubble. These ultra low rates succeeded in igniting a housing bubble, which was inflated even further when the federal government enacted a slate of new programs that made it easier for less qualified buyers to get mortgages. But the resulting housing bubble eventually led the Fed to raise rates sharply in 2006 and 2007. When it did, home prices fell, financial risk was exposed, and bankruptcies and bank runs soon followed. That crash led the government to guarantee bank losses, and cut rates to zero. See the pattern?
While the Fed backstop “solved” the problem in the near term, it created much larger long-term problems, including the moral hazard of a “Fed Put” which is the idea that the Fed will always rush to the defense of a crashing market. This confidence removed the fear of loss that normally restricts excessive risk taking. The Fed held rates at nearly zero for the majority of the ensuing decade. In addition, the federal government ran four consecutive trillion dollar deficits, by far the largest in history.
These twin streams of monetary and fiscal stimuli led to nearly a decade of unprecedented gains in stocks, bonds, and real estate. Eventually the Fed had to raise rates from zero to counter the obvious distortions that had arisen. But the modest hikes in 2017 and 2018 were sufficient to spark a mini crisis in the stock and bond markets and forced the Fed to abandon further tightening.
In 2020 the COVID crisis caused Washington to unleash an even bigger wave of fiscal and monetary stimuli. The Fed put rates back at zero and injected $3 trillion of printed cash into the economy. This led to 2021, one of the most recklessly distorted years of market history where worthless companies and cryptocurrencies skyrocketed in value. But more ominously, the effects of inflation on consumer prices, which had been held in check for more than 15 years by a boom in cheap imports, finally arrived in earnest. By mid-2022, the Consumer Price Index rose by 9 percent year over year causing acute suffering for Americans, particularly the poor, who had to pay much more for the basic necessities of life.
In order to try to put this runaway inflation genie back in the bottle, the Fed had to raise rates at the fastest pace since the early 1980s. The problem of course is that higher rates on new bonds means that lower yielding older bonds and mortgages have lost tremendous value. Those losses could be hidden as long as no one has to sell. Silicon Valley Bank had no choice. Their depositors wanted the money now. But withdrawals are not a unique phenomenon. Eventually everybody needs their money.
Once the Federal Reserve and the federal government embarked on their campaign of serial bubble-blowing the endgame was a forgone conclusion, an economic roach motel where central bankers can check in but they can’t check out. There is no way out that does not involve severe losses for investors, businesses, consumers, depositors, and taxpayers. But if we keep taking the stimulus and bailout drugs for ever, just to avoid the pain of withdrawal, we will eventually feel the sting.
So with these cracks in the financial system now exposed, we can conclude that the era of monetary tightening is over. There probably won’t be another rate hike. But inflation is still running out of control, and the Fed is now powerless to stop it. In the end, a banking and financial crisis will simply morph into a currency crisis, and we will all be poorer for it.
Peter Schiff is a founding partner of Euro Pacific Asset Management, the author of six books, and the host of the Peter Schiff Show podcast.