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The global banking crisis and world economy

March 28, 2023 - 09:13 By Korea Herald
Jeffrey D. Sachs

By Jeffrey D. Sachs

The banking crisis that hit Silicon Valley Bank at the beginning of March has now spread rapidly and widely. We recall with a shudder two recent financial contagions: the 1997 Asian Financial Crisis, which led to a deep Asian recession, and the 2008 Great Recession, which led to a global downturn. The new banking crisis hits a world economy already disrupted by the pandemic, the Ukraine War, Western sanctions on Russia, US-China tensions, and climate shocks.

At the root of the erupting banking crisis is the tightening of monetary policy by the Fed and the European Central Bank after years of expansionary monetary policy. In recent years, both the Fed and ECB held interest rates near zero and flooded the economy with liquidity, especially in response to the pandemic. Easy money resulted in inflation in 2022. Both central banks are now tightening monetary policy and raising interest rates to staunch inflation.

Banks like SVB take in short-term deposits and use the deposits to make long-term investments.

The banks pay interest on the deposits and aim for higher returns on the long-term investments. When the central banks raise short-term interest rates, rates paid on deposits may exceed the earnings on long-term investments. In that case, the banks’ earnings and capital fall. Banks may need to raise more capital to stay safe and in operation. In extreme cases, banks may fail.

Even a solvent bank may fail if depositors panic and suddenly try to withdraw their deposits, an event known as a bank run. Each depositor dashes to withdraw deposits ahead of the other depositors. Since the bank’s assets are tied up in long-term investments, the bank lacks the liquidity to provide ready cash to the panicked depositors. SVB succumbed to such a bank run and was quickly taken over by the US government.

Bank runs are a standard risk, but runs can be avoided in three ways. First, banks should keep enough capital to absorb losses. Second, in the event of a bank run, central banks should provide banks with emergency liquidity, thereby ending the panic. Third, government deposit insurance should calm depositors.

All three mechanisms may have failed with SVB. First, SVB apparently allowed its balance sheet to become seriously impaired, and regulators did not react in time. Second, for unclear reasons, US regulators closed SVB rather than provide emergency central bank liquidity. Third, US deposit insurance guaranteed deposits only up to $250,000, and so did not stop a run by large depositors. After the run, US regulators guaranteed all deposits.

The immediate question is whether SVB’s failure is the start of a wider bank crisis. The rise of market interest rates caused by Fed and ECB tightening has impaired other banks as well. With the bank run on SVB, other bank runs are more likely.

Credit Suisse is now the next major victim. Credit Suisse lost money in a variety of ways during the past decade, including poor investments and fines paid for misbehavior. In a financial environment of easy credit, Credit Suisse muddled along. In a financial environment of tight credit and bank panics, Credit Suisse succumbed to a loss of market confidence.

Nor will Credit Suisse be the last to succumb. The sale of Credit Suisse has not calmed the markets, but likely intensified the panic. One reason is that the Swiss regulators forced Credit Suisse to write down to zero part of its bond debts. This bond write-off is likely to provoke yet more runs on other vulnerable banks.

Future bank runs can be avoided or limited if the world’s central banks provide ample liquidity to banks facing runs. Emergency lending, however, partly offsets the central banks’ efforts to control inflation. Central banks are in a quandary. By pushing up interest rates, they make bank runs more likely. If they keep interest rates too low, inflationary pressures are likely to persist.

The central banks will try to have it both ways: higher interest rates plus emergency liquidity if needed. This is the basically the right approach, but will come with high costs. The US and European economies were already experiencing stagflation: high inflation and slowing growth. The banking crisis will worsen the stagflation and possibly tip the US and Europe into recession. With the failure of Credit Suisse, a hard landing in Europe and probably in the US as well, has become more likely.

Some of the stagflation pressure is the consequence of COVID, which induced the central banks to pump in massive liquidity in 2020, causing the rise of inflation in 2022. Some of the stagflation is the result of shocks caused by long-term climate change. Climate shocks could quickly become worse in the next few years if a new El Nino develops in the Pacific, as scientists say is increasingly likely.

Yet stagflation has also been intensified by economic disruptions caused by the Ukraine War, the US and EU sanctions against Russia, and rising geopolitical tensions between the US and China. These geopolitical factors have hit global supply chains, pushing up costs and prices while hindering output. The US attempt to stop China’s access to high-end semiconductors will almost surely fail as China rapidly upgrades its own cutting-edge technological capacities. Yet the US unilateral actions will severely disrupt trade in the coming years and hinder cost-saving investments.

We should therefore regard diplomacy as a key macroeconomic tool. If diplomacy is used to end the Ukraine War, phase out the costly sanctions on Russia, and reduce tensions between the US and China, not only will the world be much safer, but stagflation will also be eased. Peace and cooperation are the best remedies to rising economic risks. As the world economy is destabilized by a growing financial crisis, ending the geopolitical conflicts assumes an ever-more urgent global agenda. The G-20 should not only address the financial crisis but also push the US and Russia to end the conflict in Ukraine.

Jeffrey D. Sachs is a world-renowned economics professor, bestselling author, innovative educator and global leader in sustainable development. -- Ed.