Too much liquidity from the Federal Reserve has led to a world of Whack-a-Mole problems
The writer is a philanthropist, investor and economist.
The recent failure of Silicon Valley Bank combined two ingredients: excess deposits and asset losses, even in securities like Treasuries that are normally considered “safe.”
SVB did not have adequate liquidity to tolerate a bank run and did not have adequate solvency to meet its obligations. However, emphatically, the failure did not occur because there was very little liquidity in the banking system as a whole. It happened because there was too much.
As of the end of 2022, the US banking system held $18 trillion in domestic deposits, including an estimated $10 trillion of deposits insured by the Federal Deposit Insurance Corporation. That meant there were $8 trillion of deposits that exceeded the FDIC insurance limit.
Those destabilizing deposit gluts are there because in more than a decade of “quantitative easing,” the Federal Reserve took $8 trillion of bonds out of the hands of the public and replaced them with bank reserves.
Conceptually, one might think of a customer deposit as being “backed” either by reserves the bank has with the Federal Reserve or by assets such as a promissory note the bank received in exchange for a loan it made.
By buying trillions of dollars in bonds under quantitative easing, the Fed also pushed trillions of dollars in deposits into the banking system, backed by newly created reserves instead of bank loans. Yet despite the most aggressive monetary expansion in history, the growth rate of US commercial bank loans (business, consumer, real estate) averaged just 3.4% per year between 2008 and 2022, easily the slowest growth rate recorded since 1947.
In 1852, Walter Bagehot wrote: “John Bull can bear many things, but he cannot bear 2 per cent.” For more than a decade, quantitative easing took that thesis to an extreme.
Once the Federal Reserve created $8 trillion in base money, it ensured that, in equilibrium, someone in the economy would have to hold it indirectly as bank deposits, indirectly in money market funds, or directly as physical currency.
All the increased reserves, and associated bank deposits, gained nothing. Someone had to hold them, and no one wanted to. The moment any holder tried to put money “in” a security, the seller of that security would immediately take the money out. Long-term securities, including Treasuries, were propelled to record valuations as yield-hungry investors, banks and pension funds could not tolerate the perpetual zero-interest rate world created by central banks. .
Having engineered a toxic combination of excess bank deposits and speculation in search of yield, the Fed ensured that instability would continue.
like me wrote in the Financial Times in January 2022By relentlessly depriving investors of risk-free return, the Federal Reserve has created an all-asset speculative bubble that can now leave investors with minimal risk but no return.
Investment losses have emerged since early 2022, both because inflationary pressures forced the Fed to normalize rates after 13 years of zero-rate financial repression and because extreme valuations never hold indefinitely. The Fed can no longer operate monetary policy without explicitly paying interest to the banks on the liquidity it created.
The sudden banking tensions in the US and Europe, the British pension crisis last year, the stock market losses – these are all simply symptoms of a collapsing bubble. The Fed itself would be technically insolvent if it marked its assets at market value.
In response to SVB’s insolvency, the FDIC took the bank into receivership, wiping out shareholders and unsecured bondholders. This was, and still is, the proper approach to bank insolvency. The largest bank failure in US history, the 2008 Washington Mutual bankruptcy, is unmemorable because it too was resolved this way. The FDIC took over receivership. Shareholders and unsecured creditors lost because they were supposed to lose in this situation. Depositors lost nothing.
While the FDIC’s decision to cover uninsured deposits remains controversial, enhanced deposit insurance, funded with higher rates, may be needed for a period of time. It is not savers’ fault that the banking system is drowning in excess deposits.
Savers, collectively, are captive victims of the Fed’s dogmatic “ample reserve regime.” Until this misguided experiment ends, global policymakers will continue their fight to create new special programs, acronyms, and emergency facilities to run the world of complications it has produced.
