What is the importance of bank confusion? – 03/21/2023 – Paul Krugman

I’m on vacation, and I try to spend a few weeks without thinking about the usual things. But it turns out I can’t completely stay out of the debate about the sudden wave of banking crises and their effect on the economic outlook.

Then, as everyone knows, Silicon Valley Bank – not a huge institution, but an integral part of the technology industry’s financial ecosystem – was taken over by the Federal Deposit Insurance Corporation. [FDIC, Corporação Federal de Seguros de Depósitos] after facing a classic bank run. Signature Bank soon followed; First Republic Bank is under severe pressure. Swiss authorities arranged for the takeover of Credit Suisse, a large bank, by its rival UBS. And everyone is wondering what other land mines might be about to explode.

There will and should be many inquiries into how and why these banks managed to get into so much trouble. In the case of SVB, it appears that regulators have known for some time that the bank was a troubled case, but for some reason did not or could not control it.

But the most pressing issue is facing the future. To what extent does banking confusion alter economic conditions? How much should she change economic policy?

Some commentators – mostly, as far as I can tell, cryptocurrency enthusiasts – are issuing apocalyptic warnings about hyperinflation and the impending dollar collapse. But this is almost certainly the opposite of the truth. When depositors withdraw their money from banks, the effect is disinflationary, even deflationary. This was certainly what happened in the early years of the Great Depression.

The savings and loan crisis of the 1980s was not a Depression-level event, largely because depositors were generally insured, so they were reimbursed (at immense taxpayer expense) despite huge industry losses. Even so, the crisis may have constrained commercial lending, especially in commercial real estate, contributing to the 1990-91 recession.

And the 2008 financial crisis — which was functionally a bank run, even though the crisis focused on “shadow banks” rather than traditional depository institutions — was also disinflationary and helped trigger the worst economic crisis since the Great Depression.

So how does the current mess compare? It will definitely hurt the economy. But to what extent? And how much should that change policy, in particular the Federal Reserve’s interest rate decisions?

The answer is simple: nobody knows.

This is what we know: Depositors don’t seem to be demanding money and putting it under their mattress. They are, however, transferring funds from small and medium banks, to some extent to large banks and to some extent to money market funds.

Both types of institutions are likely to make fewer commercial loans than the smaller banks now under pressure. Large banks are more strictly regulated than smaller banks, required to have more capital (the excess of assets over liabilities) and more liquidity (a greater proportion of their assets invested in investments that can be easily converted into cash). Money market funds also face very stringent liquidity requirements. Add the likelihood that even banks that have not experienced a run on their deposits will become much more cautious, and we are likely to be seeing a serious reduction in credit. In fact, the banking turmoil will act a lot like a rate hike by the Fed.

But how big is an effective rate increase? I’m seeing smart, well-informed people produce numbers that are all over the place. Goldman Sachs says we will have the equivalent of a 0.25 to 0.5 percentage point rate hike; Torsten Slok of Apollo Global Management scores 1.5 points. I have no idea who is right.

However, the direction of the shock seems clear. I wrote a few weeks ago that the Fed is working its way through a dense fog of data, trying to navigate between the Scylla of inflation tightening too little and the Charybdis of recession tightening too much (or perhaps it’s the other way around; contributions from Homer scholars are welcome). Well, the fog got even thicker. But clearly the risk of recession has increased and the risk of inflation has decreased. So it makes sense for the Fed to swing a bit to the left.

What that probably means in practice is that the Fed should stop its rate hikes until there is more clarity on the inflation landscape and the effects of the banking mess — and it should be clear that that’s what it’s doing.

There doesn’t seem to be much danger that the Fed will lose its credibility in fighting inflation if it takes time to get its bearings. Inflation expectations seem very well anchored.

Should the Fed go further and actually cut rates? While I’m generally a money dove, I wouldn’t ask for a royal cut, at least not yet. Among other things, this can convey a sense of panic.

And even though the wave of banking problems has shocked almost everyone, panic doesn’t seem to be the right answer.

On the other hand, the fact that the Fed continues with rate hikes now may send the opposite signal: a sense of cluelessness. This seems to be the time to say, “Don’t just do something – stand still.”

For what it’s worth – and those may be the famous last words – I’m actually somewhat reassured by the way policymakers have responded to the current wave of banking problems. Some of us remember bitter debates in 2008-09 over how to stabilize the financial system: the troubled institutions were complex and opaque, and no one in power seemed willing to seize them so they could be rescued without also bailing out shareholders. This time, we’re talking about conventional banks that can be and have been taken over by the FDIC, protecting depositors without letting shareholders off the hook.

The result is that, so far at least, this doesn’t look like a full-blown financial crisis. But stay tuned.

Translated by Luiz Roberto M. Gonçalves

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