The real world has a way of confounding textbook economics. Macroeconomics, the branch that deals with the big things like growth, inflation and interest rates, seems broken when used to implement policy. In medicine, a drug is not approved for use if it has potentially serious side-effects. Or, if it’s approved, it is administered with care, in the right doses. The collapse of Silicon Valley Bank (SVB) and the pressure on other US banks suggests that economists still don’t quite appreciate the side-effects of their actions.
In advanced economies, the macroeconomic policies followed since the Covid-19 outbreak have been broadly in line with the textbook. The response to the collapse in economic growth was met by expansionary fiscal policy and loose monetary policy to help vulnerable individuals and firms. What was not accounted for was that a slowdown induced by a pandemic is different from a more routine turn of the business cycle. The frequent lockdowns meant that real economic activity would be constrained even if the government pumped in large amounts of money into the economy. Inevitably, the money pumped in was diverted to assets like equities or even bank deposits, rather than being invested in expanding production or spent on consumption.
While some stimulus was necessary to protect individuals from destitution and firms from closure, the magnitude of stimulus undertaken in advanced economies was excessive. Unsurprisingly, the first-order side-effect was a reawakening of the beast of inflation. The Russia-Ukraine war put inflation on steroids.
The policy response to the spectre of inflation was also textbook. When inflation rises, the cure lies in raising interest rates to dampen inflationary expectations and demand. The US Federal Reserve responded aggressively by raising interest rates by 500 basis points in a year. Other central banks followed suit. But just like policymakers failed to account for the side-effects of the massive pandemic stimulus, they failed to fully grasp the side-effects of an aggressive response to contain those side-effects.
SVB, a mid-sized American bank, but hugely influential in the technology heart of the US, didn’t do anything atrocious of the kind that banks did during the crisis of 2008. As a result of the pandemic stimulus, all banks, including SVB, saw a rise in deposits. However, their loans portfolio did not quite expand by the same amount, because economic activity remained subdued due to the nature of the virus.
SVB invested a lot of their excess cash in what are globally considered the safest assets of all: US treasuries. There were no excessive risky bets like in 2008. However, what SVB did not account for was such a sharp rise in US interest rates, which sent the face value of the US treasuries they were invested in sharply downwards. Because US regulations require mark to market, SVB’s losses on account of the ‘safe assets’ became huge.
This may have happened in many other banks too. But the nature of the depositors may have precipitated SVB’s crash. A lot of them were VC funds and startups that held deposits above $250,000 (the level at which the federal government insures deposits fully) and there was a rush to withdraw deposits in light of SVB’s weakened balance sheet.
In the end, the government had to step in to contain this unexpected side-effect of such a steep rise in interest rates by guaranteeing all deposits of SVB. In a bid to contain contagion, the US authorities will also allow banks to take loans from the Fed against the US treasuries they hold (at the original face value, not the depreciated value) with a minimal penal interest.
Again, this seems like sensible policy because a run on more US banks could send the entire global economy into a downward spiral. However, it assumes that the interest-rate cycle will reverse in the next year and rates will move downwards. But if inflation is driven more by supply-side factors, this assumption could go wrong leading to more trouble 12 months from now.
India has been fortunate that the pandemic stimulus was within reasonable levels. The rise in inflation here was stoked primarily by the Russia-Ukraine war. But RBI has, nonetheless, had to raise interest rates mostly to keep up with the US Fed and prevent a sharp decline in the rupee. However, because of what has happened in the US, RBI may now like to take a lead and halt hikes in interest rates and begin a reversal of the cycle. Having got its post-Covid response right, India needs to chart its own path so that it does not suffer from high interest rates and retains its growth momentum.
This article was first published in The Economic Times as Bank Crisis: The side-effects of macroeconomic actions on March 21, 2023.
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