March 2023 Update
A possible memo on SVB from The Fed - wishful thinking?
In the light of the forced closure of Silicon Valley Bank (SVB) by the California Department of Financial Protection and Innovation, I thought I would respond to your memo dated March 2021 referenced here.
Following the arguments that were made by you in this memo in early 2021, the San Francisco Fed recently published a research paper which provided a theoretical basis for problems arising for the banking sector caused by our too loose monetary policy.
It transpires of course in the light of problems at SVB and Silvergate and other pseudo financials, that both were prescient warnings.
As you also know, monetary policy has been tightened quite significantly in the last few months and the market has driven the treasury yield curve to a degree of inversion not seen for about 40 years. This would indicate an expectation that economic activity and inflation will fall. We expected some stress from this gradual tightening especially in the more inflated and speculative parts of risk capital such as crypto, venture capital and private equity.
We now face the problem of contagion from SVB and how we deal with this will affect hard won ground with respect to Fed credibility and the essential removal of moral hazard from the system.
We have 3 options. All of which involve pain.
- Do nothing more than invoke Bagehot and provide facilities for illiquid banks facing deposit runs to come to the Fed window and that we lend to them freely on the provision of SOUND collateral, BUT AT A PENALTY RATE. This would be a different approach by The Fed from the last 25 years and help reduce the moral hazard you argue has become embedded. Essentially, we adopt the maxim "never let a crisis go to waste". Weak banks will have their equity prices reduced and/or dilutive issuance, and net margin compression, as perhaps they should. Those without SOUND collateral should go to shareholders to repair their balance sheets. Some may not make it. We have a due process to close these down safely as we do with SVB.
- Cut interest rates aggressively and repeat the playbook of the last 20+ years, mopping up after an asset bubble has popped. We would still have to claim we didn't know it was a bubble and we were surprised. This is getting embarrassing. It can be described as allowing banks to privatise the profits and socialise the losses. It is, as you say, 'monetary policy for rich people'.
I believe option 2 portrays us as incompetent and is morally and politically difficult anyway.
- Do absolutely nothing but let the FDIC close SVB. Arguments abound that SVB and Silvergate Bank and their ilk are not traditional banks and only pose systemic risk to the PE VC and crypto markets, and NOT to the banking sector. Such a stance is the harshest and the most dangerous in so far as social media makes rumours and heresay potentially very powerful destabilising forces. We probably need to cauterise the problem and prevent unnecessary contagion. So option 3 is desirable but dangerous.
I will argue for 1. The banking system is stronger than it was in 2008 and thus able to weather this closure of some ill hedged 'banks'.
If we adopt 2 then we run the serious risk of reigniting and embedding inflation. We do not know really what the output gap in the US economy is currently since it appears that much of the capital 'investment' in the last decade has in fact gone to non-productive speculation - crypto, real estate, VC, alternative energy etc. It may well be therefore that our achievable trend growth rate is now much lower than it was, and lower than we think, and we will have to wait for productive capital investment to have an effect on raising the potential growth rate of the economy. This will take years. With a small or even negative output gap, the cutting of rates will typically spark inflation especially in the services sector which is already buoyant and represents a significant weight in the CPI basket. To embark on aggressive rate cutting may provide the appearance of stability but merely 'kicks the can down the road' with respect to returning to sound monetary policy and also further embeds inflationary expectations.
We also rely on foreign capital to finance our expanding budget deficit and interest rate differentials are an attractive lure. Cutting rates would put downward and inflationary pressure on the US$. Option 2 would represent a failure to learn from past mistakes.
We do anticipate serious lobbying from professional firms and DC for bail-outs and expect criticism that we are killing the next 'Google' or 'Facebook', through "abandoning the dynamic tech sector" in Silicon Valley. However, it is not the role of The Federal Reserve to involve itself in the fortunes of private enterprise. The tech sector grew successfully before The Fed became too involved in supporting risky ventures via monetary policy. Rest assured this gentleman is 'not for turning'.
Delft Partners March 2023
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