There Will Be No Soft Landing

Column: The high cost of years of low interest rates

Let’s recap: Silicon Valley Bank Santa Clara, California announced its weak balance sheet on March 8. The bank had $175 billion in deposits. They needed capital to grow, but the bank’s management had too many long-term government bonds. They seemed safe in low-interest rates environments at the time these bonds were bought. Then inflation arrived. Rates increased. Silicon Valley Bank had to sell its treasuries for $1.8 billion.

Panic spread the next day, on March 9. Rating agencies downgraded Silicon Valley Bank’s credit. Its stock plunged. A run on the bank—with depositors demanding their money back—took off. Silicon Valley Bank collapsed on March 10.

Silicon Valley Bank was the largest financial institution to fail since the 2008 Global Financial Crisis. Investors were stunned by the sudden demise of Silicon Valley Bank. Capital cushions are a key component of large banks. Regional banks, what about you? These mid-sized banks were feared for their stability, so depositors fled. As did shareholders. Signature Bank of New York was caught up in the whirlpool. It drowned.

To prevent the contagion spreading further, Treasury Secretary Janet Yellen, Martin Gruenberg, Federal Deposit Insurance Corporation chairman, and Jerome Powell, Federal Reserve chairman, made the following announcement on Sunday, March 12: Federal government will guarantee deposits at Signature Bank and Silicon Valley Bank. The FDIC had insured deposits up to $250,000. The FDIC no longer guarantees deposits up to $250,000. The panic-cyclone swept away the ceiling.

Joe Biden, President, quickly made clear that the backstop differs from the Troubled Assets Recovery Program or TARP. This was the controversial 2008 bank bailout. The new Federal Reserve facility doesn’t support shareholders, creditors or executives. Only depositors will be supported by the Federal Reserve. And tax revenue won’t pay for the guarantee directly, an FDIC fee will—a fee levied on banks and passed on to consumers, who also happen to be taxpayers.

Biden and Yellen don’t believe it’s a bailout. It is a bailout. In some ways, this bailout is worse that 2008’s. Congress passed TARP. Congress is an observer here. TARP established economic-wide guidelines and qualifications. Biden’s intervention can be discretionary or selective. Yellen, when she appeared before Congress March 16, admitted that the unlimited bank deposit guarantee doesn’t apply to all banks. It only applies to banks with systemic importance. Who decides which bank should be considered systemically important? She does. As circumstances dictate.

Yellen tried soothing Congress. She tried to project her strength. “I can reassure the members of the committee that our banking system is sound, and that Americans can feel confident that their deposits will be there when they need them,” She spoke to Senate Finance. “This week’s actions demonstrate our resolute commitment to ensure that our financial system remains strong and depositors’ savings remain safe.”

Feel better?

Authorities have struck similar notes of confidence during previous emergencies—the pandemic, the crash of 2008, the first hours of September 11, 2001. The events that followed proved them wrong. Biden and Yellen may end up looking exactly the same foolish. They’re playing Whack-A-Mole and focusing on the financial varmints that pop up. They should address the root causes.

The result of decades of low interest rates, including zero or very low rates, and $6 trillion in fiscal stimulus funding since 2020 is what has caused the chaos in the banking sector. The worst inflation in 40 years was caused by the flood of money, credit, and tax. The Federal Reserve raised interest rates in 2022 to restore price stability. The Fed should have acted earlier. It waited because inflation was temporary.

This assumption was wrong. The Fed’s complacency only made matters worse. Inflation expectations had been fixed by the Fed’s decision to raise rates. The Fed’s recent hikes might have helped to slow inflation. But they haven’t stopped it.

Biden, Yellen and the Federal Reserve all want a “soft landing.” They seek a magic solution to inflation that will prevent a recession. They will be disappointed. Inflation is not something that anyone likes. It lowers our standard of living. But the Federal Reserve’s solution—a contraction of the money supply through higher interest rates—is nasty too. A recession can be caused by high interest rates. Or worse.

Now Biden and the Fed are caught in a stimulus trap: Higher interest rates increase the likelihood of financial instability, while keeping rates pat—or cutting them—will prolong the inflation. In a world of periodic chaos, doing nothing will only perpetuate the current mix that has led to a decline in standard of living and increasing inflation.

Biden has rejected all other options. Biden has ruled out other supply-side options like deregulating energy and reducing means tested income transfers. Legal immigration will not be easier. Trade barriers won’t be lowered.

America was blessed by Powell, Yellen, Biden. “emergency” Measures that can last even after the crisis recedes. Republicans are eager for a piece of the action—why do Gavin Newsom and Silicon Valley tech giants get this guarantee, while midsized banks in rural areas do not?

The same team that brought America the worst inflation in a generation is trying to entangle itself in another sector of the economy, rather than limit and sunset its deposit backstop, enforce market discipline, or reassert Fed’s commitment towards price stability. It would be foolish not to trust their judgment. See the record. In an administration filled with academics and partisan fixers, practical wisdom is rare.

Soft landing? Fear not. Be ready for impact.