Will the banking crisis trigger a recession?
Analysis by Labour Economist; Jim Stanford
Front Burner CBC
Transcript for March 21, 2023
Host: Jayme Poisson
JAYME POISSON: Hi, I'm Jayme Poisson.
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REPORTER 1: It's the largest bank meltdown since the Great Recession more than a decade ago. Silicon Valley Bank, a bank that caters largely to start-ups and venture capitalists in the tech world, collapsed this week.
REPORTER 2: Another bank just shut down. Regulators today abruptly closed Signature Bank.
REPORTER 3: A group of American banks now creating a $30-billion rescue package to save First Republic Bank.
REPORTER 4: The world's financial markets have reacted with unease following last night's emergency takeover of the troubled Swiss bank, Credit Suisse.
JAYME POISSON: So in the last two weeks-ish, four banks in the U.S. and one in Europe have either found themselves teetering on the brink or completely collapsed. The entire U.S. banking system was given a negative rating by this agency called Moody's.
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REPORTER 5: Moody's changing its rating on the U.S. financial system. Lowering its rating -- lowering its outlook, I should say -- to negative, from stable.
JAYME POISSON: In response, other private banks and governments all over the world have rushed to try to contain the fallout. Maybe you've heard the word "contagion" come up a lot.
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REPORTER 6: How concerned should people be? Not just, though, about Silicon Valley Bank itself, but whether we think there's a contagion?
REPORTER 7: There's some of that worry, I should say, about the contagion, what that could look like.
REPORTER 8: Because it's also about jobs, not just about the global contagion.
UNNAMED SPEAKER: There's always a risk of contagion.
JAYME POISSON: On Sunday, for example, the central banks of Canada, the U.S., Asia and Europe all agreed to increase money available, which in turn would help banks lend money to each other so they can stay afloat. This can all get pretty technical and complex really fast, so today we're going to try to get at some of the big-picture questions you may be worried about. Stuff like: Is this 2008-level bad? Are we headed for a recession? If it's not 2008, how bad could it get? What does it mean for this crazy-fast pace of rising interest rates we've seen in the last year? Basically, if you aren't a rich venture capitalist or a big-time bank shareholder, how could this affect people like you and me? Today, Canadian economist Jim Stanford is back. He's a director of the Centre for Future Work.
JAYME POISSON: Jim, hey. Always great to have you.
JIM STANFORD: Jayme, thank you. I'm glad to join you.
JAYME POISSON: So five banks in total so far. Silvergate, Signature, Silicon Valley Bank, all went bust. We talked about these U.S. banks last week. And since we did that episode, two more have been really teetering -- First Republic and Swiss bank Credit Suisse. What has been happening with those last two banks? Take me through that.
JIM STANFORD: Well, Credit Suisse is in a different category -- not just because it's in Europe and the other ones are in America. It's just a lot, lot bigger than the American banks that failed. There's a euphemism that the banking regulators use. It's called a "systemically important global bank," which is a fancy term for "too big to fail." It's been having problems for the last couple years. All kinds of problems. Not just losing money, but also questions about governance and corruption at the bank.
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REPORTER 9: Credit Suisse is facing allegations that it has been handling dirty money for decades. An investigation led by German daily the Süddeutsche Zeitung, has revealed that Switzerland's second-biggest lender knowingly managed hundreds of millions of dollars for suspected war criminals, corrupt autocrats, and drug dealers.
JIM STANFORD: They've just released a report that they may have to relook at some of their financial statements.
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REPORTER 10: The company saying it found "material weakness" in its financial reporting over the past two years, because of what it said were "ineffective internal controls."
JIM STANFORD: So in the current environment where people are just very much on edge in the banking industry, that was enough to send it over.
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REPORTER 11: Shares in Credit Suisse fell by more than 60% this morning after European markets opened. And the value of banking shares across Europe has dropped sharply.
JIM STANFORD: The Swiss government and the Swiss Central Bank over the weekend engineered basically a giveaway of the Credit Suisse Bank to another big Swiss bank called UBS. UBS will now take over Credit Suisse -- if this deal goes ahead. It's not a done deal yet. They would take it over and absorb it into their own operations. Interesting point: even though, you know, banking is supposed to be the highlight of capitalism, the pinnacle of private enterprise, the whole thing was financed by the government in just an enormous away. UBS is hardly paying anything for Credit Suisse. UBS basically gets a bank for free -- this is amazing. Backed up by the government and the central bank. And the hope is that this will calm people's nerves, put out the panic that's spreading like a bushfire around the world banking system, and everyone can get back to normal. It's very unlikely that that's going to happen.
JAYME POISSON: And is it fair for me to say the other bank in the U.S., First Republic, the government was also pretty heavily involved? In this attempt to basically rescue it. Like, a group of private banks are also trying to prop it up right now.
JIM STANFORD: The politicians in every country are very worried about another round of bank bailouts. We of course experienced this big time in the global financial crisis -- so this is 2008/2009. You had banks on both sides of the Atlantic falling like dominoes. And then you had governments stepping in, both with direct government money and with liquidity, which means temporary dollars pumped in from the central banks. And the banks for the most part survived. A couple of them went under and got restructured. But at the end of the day, taxpayers were holding the bill. And in some cases, like in Britain for example, it resulted in tremendous austerity on society as a whole as government tried to make up for the huge amount of money they'd given the banks. So any politician knows that going out there and saying "I'm going to bail them out again" is not going to be popular. So they're bending over backwards to try and call this not a bailout. And even with the first one -- Silicon Valley Bank -- politicians were going to great lengths to say "This isn't taxpayers’ money. The average person won't be paying for it." And it's all nonsense. It absolutely is government footing the bill behind the scenes. Which particular account they draw it from and whether you call that taxpayers' money or not is ultimately a matter of semantics. But these businesses would have collapsed without government involvement. First Republic is another example of how they're kind of doing this charade.
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REPORTER 12: Eleven major banks jointly depositing $30 billion of their own money into First Republic Bank in an effort to stop another bank failure.
JIM STANFORD: A group of about a dozen big U.S. banks came together and said, you know, it's not good for any of us if one of our counterpart banks collapses, so we're going to put a bunch of money in as temporary aid. They're even calling the Credit Suisse takeover not a government bailout. "This is a purely commercial solution," which is [Unintelligible]. Without all that government money in the background, Credit Suisse would be dead today. And with First Republic it's not likely to work. You know, it's like one of those things where when somebody stands up and says, "Whatever you do, don't panic," it's usually a signal to panic.
JAYME POISSON: I do want to just talk about this bailout argument for a second. Because we talked about this last week with Felix Salmon at Axios, and his position was that at least what was happening at Silicon Valley Bank wasn't like a 2008-type bailout, where the government basically propped up these banks and there was no accountability and a bunch of bankers got really rich, right? That the money is largely coming from the FDIC, which is providing insurance, and that the only people who are really being bailed out here are the depositors -- the people that just had their money in these banks. Not the people that ran them.
JIM STANFORD: Yeah. I think that's a pretty fine line, frankly. It is true that Silicon Valley is going to be taken over and it won't exist anymore, and the CEOs and other top executives will lose their jobs. And the people who actually owned the bank -- the shareholders of the bank -- will lose the value of their equity. And individuals who were there already were guaranteed by the Federal Deposit Insurance Corporation in the U.S., to the tune of $250,000 each. These were, by and large, entrepreneurs in Silicon Valley, in the San Francisco area; the venture capital business. Some of the tech start-up companies. You know, we're not helping the poor depositors when we bail everyone out to the full tune of their accounts. And then the other thing to keep in mind is that the U.S. government just changed the rules. The rules in place for the deposit insurance system are you're guaranteed up to a quarter-million dollars in any one account. And they just said "Well, we're going to do it for everyone" for every dollar they had. Now, what does this mean? First of all, that they were able to protect those venture capitalist firms and tech start-ups that might have lost significant amounts of money. But secondly, you're sending an enormous signal to the world: We will change the rules as we go, when we need to. And in particular they have just implicitly said "We're going to guarantee everyone's deposit at any bank." And the FDIC doesn't have remotely enough money in its accounts. Ultimately the government is going to backstop this, and they're just playing an optics game to try and pretend that these are commercial solution [sic] to the crisis in private banking.
JAYME POISSON: If the alternative is, like, a complete, out-of-control, contagious run on banks across the United States, is this not the better of two evil options?
JIM STANFORD: Well, of course we do not want to see widespread bank collapses -- that's what causes a depression, never mind a recession. You know, when the financial system collapses widespread and people and companies lose most of their worth, then you're in a desperate situation. So you obviously don't want that. But we should at least be honest about what we're doing. And then we should be... We should have thought about this long and hard after 2008/2009. Why do we set up a private banking system which creates private businesses that literally have the power to create money out of thin air? That's what banks do -- private banks create money out of thin air when they issue new loans. And we could do banking in a very different way. Rather than the individual, for-profit private banks that have this unique power, we could either regulate them very, very closely so that the excesses of profit-taking and risk-taking are moderated, and/or we could create public banks that operate on a fundamentally different basis that use the power to create credit, to basically create money out of thin air. Again, that's what private banks do every day. But use it in a more responsible and ultimately accountable way. So there are big lessons to learn, and we clearly didn't learn them in 2009 because the same thing is happening again. I often think, Jayme, of the words of the great financial analyst Yogi Berra. I think he said "It's déjà vu all over again," and that's exactly what we're seeing today.
JAYME POISSON: Hold that thought, because I want to get to 2008 in one second. But you mentioned earlier that more banks are going to follow suit, it's going to get worse. And why?
JIM STANFORD: So to operate a private bank you get some shareholders together, you put up some money to start the business, you get a banking license, and then you go out and try to win business. And the old stereotype is that individuals, 50 individuals, will come along and deposit their hard-earned savings at that bank, and then the bank will lend it out to others. But in practice it works very, very differently. First of all, they make loans many, many times bigger than the actual money that was put in the bank in the first place. Secondly, in the modern banking system, they don't even have to have those deposits. It's possible to run a bank where nobody deposits in the bank, the bank just lends, and then the bank covers its own cash needs by borrowing from other banks through what's called the interbank lending system. So ultimately this is a very fragile, leveraged business model, where you take a little bit of money and transform it into a much bigger amount of money. And any moment that confidence starts to crumble, and all of the people who do business with the bank in various ways start to worry whether the bank's still going to be there next month or next week or even tomorrow, they all go and start to try and get their hands on the actual cash. But that panic, of course, is what causes the bank to fall. But ultimately every private bank, because they've taken $1 and turned it into $30 through this magic power they've been given, every one of those banks is vulnerable to a crisis in confidence.
JAYME POISSON: And just to kind of sum up that idea that the system is built on trust, right? So it actually probably doesn't take very much for people to lose confidence in that system and start to move their money out.
JIM STANFORD: The system is built on trust and confidence, but it's also built on, ultimately, the power of the government. And this is why some of the sort of crazy libertarian arguments that we heard -- that "You can't trust the government with money. We should create our own money." That was the thinking that went behind the whole crypto boom, which again is part of the current chaos. People thought cryptocurrency wouldn't have government involved and it would be more honest and more transparent, and more, you know, sort of market sensitive. And that was a disaster because there was nothing backing that up. So that was all a confidence game. Anything that's based on trust needs some kind of, sort of, reliable authority in the background. To first of all validate why this system is legitimate, and then to ride in to the rescue at semi-regular opportunities when private greed self-destructs. And that's what we're seeing now.
JAYME POISSON: I want to spend some time today talking about interest rates and how that plays into this whole crisis. So, when we were doing our episode last week on Silicon Valley Bank, largely we talked about how one of the things the bank does is they took these deposits and they put them in government treasury bonds. Which are generally a pretty safe investment, right, so long as you hold them to maturity. But because we've seen this historic rise in rates over the last year, the bonds lost their value. So when people started to pull their money out the bank had to sell them at a loss, and I think that led to people realizing that the bank wasn't solvent anymore. And so I actually don't know if interest rates played a role in all five of these banks, but maybe you could speak to that a little bit.
JIM STANFORD: This whole crisis is absolutely a consequence of the rapid increases in interest rates that we've seen around most of the world in the last year. In Canada, of course, we've seen the Bank of Canada raise interest rates eight times in a year from 0.25% to 4.5%. That 4.5% is not what you and I pay, of course, on mortgages and car loans and credit cards. We pay much more. That 4.5% is what banks pay when they're borrowing money from the central bank. And so other countries, the U.S., has also been aggressive. The Europeans have raised rates -- not as aggressively, but quite a bit. The impacts of high interest rates are felt in all kinds of ways, and many of them very unpredictable. On average consumers, of course, it means we pay more on our mortgage, which means we've got less money to spend on other stuff. For businesses it makes it more expensive to raise money to invest in a new factory or to hire new workers. But in the financial economy -- the paper economy, if you like -- interest rates have much quicker and, in a way, more devastating effects. The issue of bonds is an interesting one. A government bond is the safest asset you can buy if you think of it as lending money to the government, which is what the bond really is. It's a piece of paper that says the government will pay you back what you lend them, plus interest at a certain date. And those promises are still 100% valid. This is still the safest loan you can make. The problem is that the private financial industry has taken those pieces of paper, those IOUs called bonds, and developed a kind of a second game. Almost like a poker game going on at another table, where they're buying and selling the pieces of paper. Not so much the actual promise that the government will pay you back money at the end of the day, but they're speculating on how the value of each of those pieces of paper will go up or down each given day on the basis of trends in broader interest rate. And the reason that happens is the value of a bond. If the government has promised to pay you back at, say, 2%, but then the interest rate suddenly goes to 4%, well, people holding that IOU are going to say "This isn't quite so attractive anymore because I could go and buy a new IOU for 4% interest, so I'm going to sell the bond for less than it was actually worth." And this has created an enormous opportunity for, ultimately, gambling. That's what the speculation on bonds in the bond market is all about: big investors making bets on whether that piece of paper is going to be worth more tomorrow than it is today. And the bond market is enormous -- it's trillions of dollars every day around the world. So the promise of the government to pay back the money is absolutely secure, but what is not secure is what the speculative value of that piece of paper will be at any given point in time. Because of that rapid increase in interest rates, dramatic declines in the prices of many bond [sic]. And this is what's causing a repercussion. We got a hint of this actually several months ago. Last September, several of the big pension funds in the U.K. almost collapsed. They were bailed out by their central bank, the Bank of England, and the reason they were collapsing was they had put all kinds of money into what they thought were safe government bonds. And they are safe if what you're doing is waiting for the government to pay you back. But they are not safe if what you're doing is playing the market and hoping that this piece of paper will be worth more tomorrow than it is today. The shockwaves, if you like, of this rapid run-up in interest rates is causing financial chaos. And it was in the background for all of these banks. It raises fundamental questions about interest rate policy. Are central banks going to keep increasing the rates, you know? But if they are strict in saying "We have to do whatever it takes to bring inflation down," and that's what they have been saying, then I think more interest rate increases are in the cards which suggests this problem will get worse. It also, Jayme, raises a more fundamental question about how do we think we can manage inflation. Is using interest rates the only thing we can do to bring inflation down? Particularly when you see a cost of that strategy being absolute chaos in the banking system.
JAYME POISSON: OK, let's talk about that. If this is the cost of that strategy, and the banks keep raising interest rates -- this happened in Europe last week, and the Fed is going to make a decision on raising rates this Wednesday I believe -- what could happen?
JIM STANFORD: If the rates continue to go up and if the central bankers are true to what they've been saying, OK, and if you go and look at what Tiff Macklem, the Governor of the Bank of Canada, has been saying for the last year, and central bankers in other countries, they are saying "We will get inflation back to 2% no matter what." Now, if we take them at their word that means they should increase interest rates further. Because inflation is nowhere near the 2% target and it's not coming down the way they think it is. So, you know, until this breakout of the banking crisis, everyone thought that the U.S. Fed was going to raise their interest rate this week. Now I think it's in question. If we have a banking collapse and a financial panic, that probably will bring inflation down in a very, very painful way.
JAYME POISSON: All the money that they're throwing around -- could that contribute to inflation? Could that make inflation worse?
JIM STANFORD: It certainly does. It certainly does. And it would hasten the arrival of a recession that we might already be in, for all we know.
JAYME POISSON: Jim, I know you have been warning of a recession for a while. We've talked about this on the show. You've obviously not been a proponent of the bank's mission to fight inflation by raising interest rates. But what could happen here?
JIM STANFORD: In a worst-case scenario, Jayme, we would see a spreading of this financial contagion. You'll see other institutions come down. And either the governments step up that bailout effort to try and keep the system going or you could see major institutions just fail. And the impacts of that on the real economy would be severe. So you'll see average consumers, even if they didn't lose money directly in a bank collapse, saying, "You know what? We're not going to renovate the basement this year because I don't know where the economy is going." Or, "I'm not going to buy a new car this year because I don't know where the economy is going." And added up across the whole economy, all of those decisions can create the recession that everyone was afraid of. Again, it's another self-fulfilling prophecy. Which is part of the irrationality, if you like, of a decentralized market-based system like ours. Now, we had data in Canada that showed our economy has slowed down dramatically at the end of 2022, in large part because of the higher interest rates. In fact, by December, by the end of the year, the economy was actually shrinking. So it is possible -- we don't know yet. It's possible that the recession has already started. Which means GDP declines by 2 or 3%, maybe a little bit more. You could see 500, 600, 700,000 jobs lost. You could see the unemployment rate go to 8 or 9%, and just a lot of hardship and worry for at least a couple of years. And then the thing about recessions is they have lasting scars. It's not just, you know, "Well, we had a couple of years and then we're back to normal." People's lives are changed in that situation. For young people who graduate into a recession it means their whole career trajectory is put off. For many others it means their links to the labour market are broken and their social and economic well-being is damaged for decades. So this is a very serious risk, and it's one of the reasons I've been concerned about the reliance on high interest rates as the only recipe or the only solution for the inflation that we saw after COVID. The Bank of Canada is still hoping for what they call a "soft landing." In a soft-landing scenario growth would stop for a while, maybe for a year, and you'd see no real job creation. But you wouldn't see a wave of job losses. But I think this financial crisis makes that soft-landing scenario, which I think was always remote, I think it makes it very unlikely.
JAYME POISSON: What would it take for these central banks around the world, including the Bank of Canada, to reverse course?
JIM STANFORD: It is a very interesting question, Jayme. And a lot of financial investors are betting that that is going to happen. Again, remember, there are these large bond markets where people aren't lending money to the government, directly. What they're doing is buying and selling IOUs and placing bets on where interest rates are going. And by looking at the prices on those bond markets you can get a sense of investors' expectations. Not you and mine, but the people with big money guessing where they think the interest rate is going to go. And there's some signs now that they are expecting the interest rates to be cut. And this is what central banks would have done in the past. If you saw a banking crisis you would see cuts in interest rates and efforts to pump as much money into the system as you could. The problem right now is that goes completely against what the central banks have been telling us for the last year and a half. Which is "Inflation is the biggest enemy, and we're going to do whatever it takes to bring it down." So somebody is going to have a lot of egg on their face by the time this is over, and it could very well be the central banks. It could be that this financial crisis will show that it's impossible to bring down inflation that resulted from the supply shocks and uncertainty and disruptions of the pandemic. It's impossible to bring that down just through old-style monetary tightening. We either will have to put up with inflation for a little longer or we'll have to find other solutions for it. Such as price caps in certain markets, and excess profits taxes that redistribute some of the money from the companies that have profited from inflation, back to the rest of us. So it's going to be a very interesting time, very tricky time, and a very dangerous time in the next few weeks as central banks try to respond to this panic and see what it means for their self-proclaimed mission. Which is to defeat the dragon of inflation and defeat it quickly.
JAYME POISSON: OK. Jim, thank you so much for wading through this with me today. I would actually like to keep you here for another hour, but I know you're a busy guy. And also our producer Simi will kill me if I give her a longer interview than this, so thank you very much.
JIM STANFORD: It was my pleasure, Jayme. Thank you for digging in in this very accessible, conversational way.
JAYME POISSON: All right, that is all for today. I'm Jayme Poisson. Thanks so much for listening. We'll talk to you tomorrow.
