It has been a tumultuous several weeks in the world of finance. Just when “soft landing” (i.e., the notion that Fed rate hikes would tame inflation without causing a nasty recession) was the meme, a string of banks went belly-up. We summarized the history and status of this dismal parade of corpses a week ago.
On Friday, Germany’s Deutsche Bank (DB) was added to the list of endangered financial species. Its share price plunged as the cost of insuring its credit swaps soared, a sign of lack of confidence in DB among other financial parties. As best I can discern, however, DB is a relatively poorly-managed bank, but not one teetering on insolvency like Credit Suisse or the smaller American banks that have collapsed.
Silicon Valley Bank Getting Sold Off, Finally
On this side of the pond, the big news is that Silicon Valley Bank (SVB), whose spectacular implosion was really what brought “crisis” to banking, will be taken over by another regional bank, First Citizens Bank of North Carolina. The first attempt to auction off SVB was a fizzle, so the feds tried again. They really, really wanted to get this kind of full takeover deal done (rather than breaking up SVB and selling off bits piecemeal), so First Citizens was able to drive a juicy bargain. First Citizens was a fairly modest-sized bank, about half the size of SVB at the end of last year. First Citizens will get SVB assets of $110 billion, deposits of $56 billion and loans of $72 billion, and will start operating the SVB branch offices again. They will pay only $55 billion for the nominal $72 billion in loans that SVB had made, a 29% mark-down. The cost to the FDIC for this deal is about $20 billion. (I don’t know how First Citizens is paying for this acquisition). First Citizens stock skyrocketed on this news, so the market sees this as a sweet deal for First Citizens.
Going forward, the FIDC has pledged to share any losses (or gains) on those loans in the future, which offers further protection to First Citizens. FDIC gets shares of First Citizens valued up to $500 million. First Citizens decided not to take an additional $90 billion in securities that the FDIC will now have to sell on its own. These are likely the long-term bonds which sunk SVB when their value cratered with rising interest rates this past year. I’m not sure how much further losses the FDIC will bear on these bonds.
Anyway, so far, so good, kind of; it is sobering to note that this $20 billion cost to the FDIC just chewed up 1/6 of its total $128 billion kitty for backstopping all qualifying deposits at all banks in America. So we can’t readily afford too many more meltdowns of this magnitude.
Bank Deposits Continue to Flee, But Slower
A worrisome trend in the past month or so has been for depositors to pull their funds from bank checking/savings accounts, and stash their money instead in higher yielding money market funds or CDs or Treasury bills. Banks have borrowed records amounts from the Fed in recent weeks, in order to have lots of cash on hand if they have to pay off departing clients. And within the banking system, about half a trillion dollars has been moved from smaller regional banks to large banks.
I can’t find the reference now, but in the past two days I read an article stating that rate of deposit withdrawals is slowing down, and will likely not of itself destabilize the system. I’m going with that narrative, for now.
An indirect fallout from all this bank turmoil is the reduced inclination of banks to extend loans to businesses. This will make for a slowdown in economic activity, which should cool off inflation – -which is exactly what Jay Powell was hoping would be the outcome of the Fed rate hikes.
Economist Writing Every Day 
Scott
Good email thank you.
Im always intrigued why pushing the economy towards recession and destabilising the banking system is seen as the only response to inflation by the Fed.
Recent articles notable Wray & Kelton point to the view in some quarters that Fed raising rates since the 70s in response to inflationary pressures (and we have some good data) really doesnt seem to tame them directly but does cause lots of collateral economic and social damage.
Maybe a future article from you guys on fiscal (always an option unless you are a money supply fanatic) versus monetary (lets test to destruction our economy through demand annihilation) would be a good topic.
Kind Regards
Eric
NB: Based in the UK
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Eric, I have read elsewhere of what you propose, that raising rates does not actually cure inflation. Correlation does not demonstrate causation. I have not studied this myself, so I don’t have an informed opinion.
I agree that the fiscal side is a powerful lever. As an engineer who worked more than 30 years in industry, I am pretty sure that actual supply chain constraints can get worked out in 2-3 years. Partly b/c there is SO MUCH capital sloshing around the globe in search of profitable investments.
My opinion is that this current bout of inflation is largely a hangover from the fiscal response to the pandemic in 2020-2021. In the US particularly, deficit money just gushed into people’s bank accounts, trillions and trillions, both from direct stimulus packages, and, more perniciously, extended enhanced unemployment benefits that paid people not to work even when jobs started opening up. Lots of productive 58-64 year-olds retired early, permanently lost to the workforce, leading to labor shortages and hence wage inflation. All that extra money households got has not yet been spent down.
A huge problem with fiscal policy is it is so politicized. Anyone who calls for cutting spending in most areas is viciously attacked by opponents. It is way more popular so spend than to cut, in most cases.
I think Jay Powell knows all this, but is too chicken (as a political appointee) to state the obvious, that (for instance) the most recent round of deficit spending on (purportedly) infrastructure only serves to exacerbate inflation.
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Scott,
Many thanks for your comments and I get your reasoning re the US use of helicopter money.
Understandable but as you say probably an issue.
This paper:
Money Supply and Inflation How and how much can the Money Supply affect the Inflation Rate?
Amedeo Strano
Abstract:
The relationship between inflation and money growth has been tested for the Iceland over the period 1972 – 2002 then using a sample of 11 countries over the same period we test for the quantity theory relationship between money and inflation. When analysing the full sample of countries, we find a strong positive relation between long[1]run inflation and the money growth rate. There is a strong link between inflation and money growth both in the high- (or hyper-) inflation and low-inflation countries in the sample (on average less than 10% per annum).
Shows there is a close mathematical relationship over the long term between money supply and inflation. However as interesting as the paper is the countries chosen I have issues with in that it might lead you to question the paper¡¯s results but nonetheless a interesting piece of work. Might be worth a read.
The UK is seeing on the political right of the spectrum supported by some economists a similar conversation regarding UK Govt Pandemic spending and BoE QE since 2008. On the Left its far more about Energy price shock, Brexit Terms of Trade shocks etc.
Inevitably both are somewhat critical of the current interest rate policy action by the BoE supported by the current govt.
It will be interesting politically to see what narrative eventually dominates and as usual I suspect mainstream economists will have a different understanding from the politicians and policymakers.
Eric
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Eric,
Without wanting to open up a new discussion thread, re your most recent response, it seems that QE (at least in the US) has had nearly zero effect on what I will call real economy inflation (CPI, wages, etc.). Our Fed QE’d and QE’d post 2008, and could not push inflation over 2%. All that “money” created by QE went into financial assets, bought by the (more or less) rich, sending stocks soaring up and up.
The fiscal deficits put cash into the pockets of the bottom 75%, who have proceeded to spend it merrily. When we were locked down in 2020, we bought tons of Chinese goods on Amazon. With opening of the economy, that spending has spilled into services.
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