One by one, it may be worthwhile to recapitulate the events of the past week.
You could argue that smaller US banks – like Silicon Valley Bank (SVB) – are outliers because they are niche players and not subject to the same liquidity regulations and stress tests as larger banks.
Similarly, Credit Suisse is doing exceptionally bad for many years. It should survive with better management and a massive injection of cash.
In the meantime, Will central banks ride to the rescue With more bailouts and interest rate cuts?
I wouldn’t ‘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 at once.
SVB was not doing anything that was particularly infamous. The bank made the classic mistake of mismatching the duration of its assets and liabilities.
But at first glance, the bank was doing nothing more than judiciously reinvesting its customers’ money in government bonds.
All that happened to trigger the latest crisis was a return of official interest rates to what would historically be seen as normal levels. Worryingly, in real terms – after allowing for the rise in inflation – they are still relatively low.
In the UK, for example, the Bank of England raised its key rate to 4 per cent, the most since the Global Financial Crisis (GFC) broke out in 2008.
For most of this period, interest rates have been below 1 percent. The authorities launched an experiment that now looks like it will have disastrous consequences. In contrast, rates of 4 to 6 percent were about the same for the course before the GFC.
Not only this, money has become cheap. Thanks to years of quantitative easing by the world’s major central banks, there is now much more of it.
It is no wonder that many people have become addicted to it.
This is the crux of the problem. Even if interest rates don’t rise any further, the fallout of eliminating a long period of practically free money could drag on for years, and show up in a number of different ways.
The crisis highlighted by the collapse of SVB is not even the first in an extended series of unfortunate events. Bank of England, of course, had to intervene in the gilt market last autumn When rising interest rates threatened to blow up the “liability-driven investment” strategies adopted by many UK pension funds.
The obvious question is where the problem might lie next – and it’s not hard 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 backstop provided by the European Central Bank?
And what about Japan’s towering mountain of debt, where the central bank is on its way out of decades of ultra-loose monetary policy?
Outside the financial sector, significant parts of the UK economy have yet to feel the full impact of last year’s interest rate hike and tightening of financial conditions.
For example, many small businesses Just coming out of covid support plans And may soon find themselves paying much higher rates.
And closer to home, what about house prices? Rising mortgage costs and increased economic uncertainty have already led to a sharp downturn in the housing market and homebuilding in both Europe and the US.
But this may be the tip of the iceberg, as more homeowners move out of their existing low-cost improvements and have to refinance.
Bank of England analysis suggested that a sustained 1 per cent increase in real interest rates could reduce the equilibrium level of house prices by 20 per cent.
So the big picture is that we need to readjust general interest rates, and that will be painful. Weaker companies, and companies with riskier business models, may struggle the most, but they won’t be the only ones.
This creates two dilemmas for central banks.
First, how far should they be inclined to rescue failed institutions, If they do too little, the entire financial system can crumble.
If they offer too much support, they may encourage more risky behavior in the future (the classic problem of ‘moral hazard’), or give the impression that the problems are deeper than one might think.
Second, on interest rates, how will central banks reconcile their responsibility for financial stability with a commitment to monetary stability, that is, to bring down inflation again?
This is not an impossible option. Central banks can argue that averting a financial crash will prevent inflation from falling too far. Authorities also have many different tools at their disposal that they can use to achieve their various objectives.
But it is a difficult balancing act.
The European Central Bank (ECB) has already shown where its priorities lie. It went ahead with raising its key interest rates by half a point on Thursday, despite the crisis at European banks.
The hurdle for the ECB to pause (or raise just a quarter point) was believed to be higher than for other central banks, as the ECB had already committed to another half point move.
Therefore it would be wrong to pursue this step bank of englandIts decision on UK interest rates next week. Our Monetary Policy Committee takes each meeting at the same time (in my view), which gives them more flexibility to respond to new events.
There were already some very good reasons to pause, including signs that pipeline cost pressures are abating and wage inflation has peaked. So at most I would expect a quarter point increase on Thursday, and personally vote for ‘no change’.
However, it would be wrong to count on central banks to fix the problems that have been caused by extended periods of very low interest rates, let alone rush to cut them again, keeping those same rates low for even longer. It’s a distant thing.
The chickens have come to roost in the house. We need to take a tough stand and stop banking on free money.
Julian Jessup is an independent economist. He tweeted @julianhjessop.