The shocks that occasionally batter the UK economy seem to be coming thicker and faster. The Global Financial Crisis (GFC) blew up in 2008. The Brexit vote followed eight year later. But we then only had to wait four years for Covid, and just two more for the cost-of-living crisis. At this rate we are already due another one.
A candidate has already emerged in the shape of a new financial crisis, again originating in the US. The GFC was prompted by a meltdown in the sub-prime mortgage market. This time the focus is on banks that mainly service the tech sector, notably the aptly-named Silicon Valley Bank.
The rosy view is that Silicon Valley Bank (SVB) was an outlier. There is something in this: the circumstances that led to its collapse may not have been unique, but they were at least relatively unusual.
In a nutshell, SVB took large deposits from cash-rich tech companies and parked them in long-term government bonds issued by the US Treasury. It was therefore operating more like a pooled investment vehicle than a normal bank.
These trades went sour when the US central bank raised interest rates aggressively last year, which simultaneously undermined confidence in the tech sector and caused large losses on SVB’s bond portfolio. This combination set off a death spiral of deposit outflows and the need to sell even more assets at ever lower prices. Fortunately, most banks do not have such concentrated customer bases, or such risky investment strategies.
It is also important to note that the latest crisis is centred on small and mid-sized banks in the US, who are not subject to the same liquidity rules and stress tests as bigger ones. In contrast, the larger US banks have been flooded with new deposits as nervous customers have moved funds to what should be a safer home. The run on some banks has therefore actually benefited many others.
Similarly, Credit Suisse had been exceptionally badly run for many years. It should survive, with better management and a huge injection of cash. In the meantime, won’t central banks ride to the rescue with more bailouts and interest rate cuts?
I would not ‘bank’ on it. For a start, history has taught us that banking failures are like London buses – you wait ages for one, and then three come along at once.
What’s more, Silicon Valley Bank (SVB) was not doing anything that was particularly disreputable. The bank made the classic mistake of mismatching the duration of its assets and its liabilities. But at first sight, the bank was doing no more than prudently reinvesting its customers’ money in government bonds.
Most worryingly, all it took to trigger the latest crisis was the return of official interest rates to what historically would be seen as normal levels. In real terms – after allowing for the pick up in inflation – they are still relatively low.
In the UK, for example, the Bank of England has raised its key rate to 4 per cent, which is the highest since the GFC. For most of this period, interest rates have been less than 1 per cent. But rates of 4 to 6 per cent were par for the course before the GFC.
And not only has money been cheap. Thanks to years of ‘quantitative easing’ by the world’s major central banks, there is also now a lot more of it. It is no surprise that many have become addicted.
This is the nub of the problem. Even if interest rates do not rise any further, the fallout from the unwinding of the long period of practically free money could drag on for years, and show through in many different ways.
The crisis headlined by the collapse of SVB is not even the first in what could be an extended series of unfortunate events. The Bank of England had, of course, to intervene in the gilt market last autumn when the rise in interest rates threatened to blow up the ‘liability-driven investment’ strategies which had been adopted by many UK pensions funds.
The obvious question is where the problem might pop up next. It is not difficult to think of candidates.
Starting big, how long can Italian government bonds be propped up by low interest rates in the euro area and the backstops provided by the European Central Bank? And what about Japan’s even higher mountain of debt, where the central bank is only just edging towards the exit from decades of ultra-loose monetary policy.
Outside the financial sector, significant parts of the UK economy have yet to feel the full impacts of last year’s interest rate increases and the tightening in financial conditions. For example, many smaller businesses are only just now coming off Covid support schemes and could soon find themselves paying much higher rates.
And closest to home, how about house prices? The rise in mortgage costs and increased economic uncertainty has already led to a sharp downturn in the housing market and in housebuilding, both in Europe and the US. But this could be the tip of the iceberg, as more homeowners come off their current low fixes and have to refinance. Bank of England analysis has suggested that a sustained 1 per cent increase in real interest rates could lower the equilibrium level of house prices by as much as 20 per cent.
The bigger picture is therefore that we need to readjust to normal interest rates, and this will be painful. Yes, weaker companies and those with riskier business models may struggle most – but they won’t be the only ones.
This poses two dilemmas for central banks. First, how far should they be willing to bail out failing institutions? If they do too little, the whole financial system might come crashing down. If they offer too much support, they may simply encourage more risky behaviour in future (the classic problem of ‘moral hazard’), or give the impression that the problems already run even deeper than anyone thought.
Second, on interest rates, how will central banks square their responsibility for financial stability with the commitment to monetary stability, that is getting inflation back down again? This is not an impossible choice. Central banks might argue that averting a financial crash would prevent inflation from falling too far. The authorities also have many different tools that they can use to achieve their different aims. But this is a difficult balancing act.
The European Central Bank (ECB) has already shown where its priorities lie. On Thursday it pressed ahead with another half-point increase in its key interest rates, despite the crisis engulfing European banks.
Admittedly, the hurdle for the ECB to pause (or to raise by just a quarter point) was higher than for other central banks, because the ECB had already committed to another half-point move.
It would therefore be wrong to read too much into this move ahead of the Bank of England’s own decision on UK interest rates next week. Our Monetary Policy Committee takes each meeting as it comes (rightly, in my view), which gives them more flexibility to respond to new events.
There were also already some pretty good reasons to pause, including signs that pipeline cost pressures are easing and that wage inflation has peaked. So at most I would expect a quarter-point hike on Thursday, and personally would vote for ‘no change’.
Nonetheless, it would be wrong to rely on central banks to fix problems that have been caused by an extended period of very low interest rates by keeping those same rates low for even longer, let alone to rush to cut them again. We need to go cold turkey!
In 1992 the great US investor Warren Buffett coined the phrase, “it’s only when the tide goes out that you learn who’s been swimming naked.” Now that the flood of cheap money has drained away, we should expect some more unpleasant revelations.
Plain-speaking Economics 