Fri, Mar 24, 2023 page9

• The New World Economy: The global banking crisis and the world economy

  After stabilizing the banking sector, governments should work to ease geopolitical tensions that weigh on the economy

  • BY Jeffrey D. Sachs
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  The banking crisis that hit Silicon Valley Bank (SVB) last week has spread. We recall with a shudder two recent financial contagions: the 1997 Asian financial crisis, which led to a deep Asian recession, and the 2008 financial crisis, which led to a global downturn.

  The new banking crisis hits a world economy already disrupted by the COVID-19 pandemic, war, sanctions, geopolitical tensions and climate shocks.

  At the root of the current banking crisis is the tightening of monetary conditions by the US Federal Reserve and the European Central Bank (ECB) after years of expansionary monetary policy.

  In the past few years, the Fed and the ECB held interest rates near zero and flooded the economy with liquidity, especially in response to the pandemic. Easy money resulted in inflation last year, and the two central banks began tightening monetary policy and raising interest rates to staunch inflation.

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

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

  Even a solvent bank might 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 others. As the bank’s assets are tied up in long-term investments, it 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 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 might have failed in the case of 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 US$250,000, and so did not stop a run by large depositors.

  After the run, US regulators announced they would guarantee all deposits.

  The immediate question is whether SVB’s failure is the start of a more general bank crisis. The rise of market interest rates caused by Fed and ECB tightening has impaired other banks as well. Now that a banking crisis has occurred, panics by depositors are more likely.

  Future bank runs can be avoided if the world’s central banks provide ample liquidity to banks facing runs. The Swiss central bank provided a loan to Credit Suisse for exactly this reason, and the Fed has provided US$152 billion in new lending to US banks in the past few days.

  However, emergency lending 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, but if they keep interest rates too low, inflationary pressures are likely to persist.

  The central banks are likely to try to have it both ways: higher interest rates plus emergency liquidity, if needed. This is the right approach, but comes with costs. The US and European economies were already experiencing stagflation: high inflation and slowing growth.

  The crisis is likely to worsen the stagflation, and possibly tip the US and Europe into recession.

  Some of the stagflation was the consequence of the pandemic, which induced the central banks to pump in massive liquidity in 2020, causing inflation that materialized last year.

  Some of the stagflation is the result of shocks caused by long-term climate change. Climate shocks could become worse this year 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 Moscow’s invasion of Ukraine, US and EU sanctions against Russia, and rising tensions between the US and China. These geopolitical factors have disrupted the world economy by hitting supply chains, pushing up costs and prices while hindering output.

  We should 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 would the world be much safer, but stagflation would also be eased.

  Peace and cooperation are the best remedies to rising economic risks.

  Jeffrey D. Sachs is director of the Center for Sustainable Development at Columbia University and president of the UN Sustainable Development Solutions Network.
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