They’re All Wrong!

James K. Galbraith expresses his thoughts on the incipient banking crisis in a piece at The Nation. The TRL;DR version of his piece is that progressives are wrong about it:

The problem was not (as Larry Summers declared) that a bank should not convert short deposits into long loans and investments. That is—more or less—what banks do. Loans and bonds are their business. It was also not (as Elizabeth Warren declared, along with other progressives fighting the last war) that the bank took on too much risk. Its loans were risky—because it specialized in start-ups, which are inherently risky. But they were not failing. Its investments, in bonds, were not risky in the usual sense—they were not in danger of default.

In the same vein as Warren, Paul Krugman declared that tougher regulation (of loans) and larger capital requirements or liquidity cushions might have saved the day. Again, fighting the last war. SVB’s loans were all right so far. SVB’s bonds, of course, are liquid! Treasuries and high-quality mortgage-backed securities can be readily sold. SVB’s capital and liquidity would have passed tests until a few days before the crash. This is characteristic of bank failures: Capital looks ample until it disappears. In SVB’s case, the run drained $42 billion in one day—and that was that. The idea that capital requirements provide safety is an economists’ illusion.

This observation is interesting:

The business model of SVB consisted of an attractive return on deposits, adventurous loans mainly to young companies in the tech sector, perks for big clients to keep their funds in the bank, and large investments in government bonds and mortgage-backed securities. The safety of the bonds worked to offset the risk of the loans, while the bonds’ return covered the cost of deposits—which grew rapidly as client companies and some cash-rich individuals parked their funds at the bank.

He blames SVB’s problems on the Federal Reserve and, consistent with that, he thinks that the Fed’s actions to fight inflation are a fool’s errand. Basically, he still belongs to Team Transitory:

So why did the Federal Reserve invert the yield curve? To fight inflation? To kill jobs and stall wages? If so, the stupidity—or the economistic groupthink—is shocking. Most price increases have already faded from the economy (for now). Though job growth is strong, wage increases lag prices: Real wages have fallen. The Fed obviously operates in total disregard of its full-employment mandate—nothing new in that—and indifference even to the textbook logic of labor markets. Why is that? Among specialists, opinions differ on how smart top officers of the Federal Reserve actually are. Personally, I vote for dishonest over stupid.

He also predicts instability in the global banking system.

9 comments… add one
  • steve Link

    Have banks always crashed when the Fed raised rates?

    Steve

  • The short answer to that is yes. However, the Fed raising interest rates is just one of the reasons that banks fail so the failures/year is noisy.

  • Drew Link

    I just don’t see it. In fact, I think its horrible analysis.

    “That is—more or less—what banks do. Loans and bonds are their business.”

    This conflates loans, designed to be held to term (borrowers aren’t going to storm the bank to pay off early) with treasuries with inherent interest rate risk that get marked to market instantaneously every day. That’s just a glaring omission in his commentary.

    “Its investments, in bonds, were not risky in the usual sense—they were not in danger of default.”

    Of course not. See my comment above. But its an almost idiotic position to take. Runs are fueled by panic – “I can’t get my money out now or in any reasonable time frame.” Depositors aren’t interested in sitting idly by waiting for bonds to mature in 10-30 years.

    “Its loans were risky—because it specialized in start-ups, which are inherently risky.”

    Well, yeah. But as Tasty inquired. How much is too risky? Banks are not meant to be mezzanine debt or equity investors of capital…….disguised as “loans.” Contemporaneous default is a different issue from a high risk portfolio. They could have bought millions in Lotto tickets too, only worthless after the drawing and no winning ticket to be found.

    “SVB’s loans were all right so far. SVB’s bonds, of course, are liquid! Treasuries and high-quality mortgage-backed securities can be readily sold. SVB’s capital and liquidity would have passed tests until a few days before the crash.”

    Again. Arrant nonsense.

    “This observation is interesting:”

    And flat damned wrong. Did anyone think SVB was a mezzanine lender?

    “Basically, he still belongs to Team Transitory:”

    The Fed may have moved too quickly, but that destroys his transitory argument. Inflation has been horrid, and taken a great toll on the Average Joe. Real wages are lagging by some 2% at least. The Fed knows it and is desperate to get inflation under control. And if you include food and energy – and last time I looked people still eat and drive cars/heat or air condition their homes then they have clearly lost some 5-8% in buying power. How many years will that take for people to catch up? 4? 5? 6? And inflation is still 6% before food and energy. Transitory my ass.

    I don’t know who this character is. But I refuse to believe he is that stupid. He’s shilling for someone.

  • Son of John Kenneth Galbraith

    I thought you’d find his analysis interesting. I found it most interesting that he was singling out Lawrence Summers, Elizabeth Warren, and Paul Krugman for criticism in The Nation.

    BTW the decline in home prices (something that should be anticipated when the Fed raises rates) means that real home values are dropping sharply.

  • Drew Link

    I think Larry Summers has been as close as anyone to being technically correct and having his finger on the pulse the past couple years. About the only thing I agree with Sonny about is Krugman. You won’t reserve your way to safety; but you can shorten durations or hedge long term treasuries.

    As for housing. You bet, although, as always, its regional and dependent upon the kind of house. Cash buyers in hot markets (FL, Carolinas, TX) for upper end homes keep prices stable. First time buyers are screwed. And all those Covid driven buyers with work from home stars in their eyes, and mountain or lake getaway purchases? Go to Zillow or Redfin etc and look at prices. Going down fast.

  • Drew Link

    PS –

    Loan availability is tight, and things like bonding for construction projects is VERY tight. This is nothing but recessionary.

    As I’ve said: the Fed put itself into a box kowtowing to Congress (for many years) and more recently Biden/Yellen in their mad dash to spend on Covid, Green Energy, etc. Of course this years budget will fix things……….(snicker)

  • Andy Link

    Housing prices in my area have peaked but haven’t come down much. It’s a good thing we are planning to stay here and can keep our 2.24% mortgage.

  • Drew Link

    Andy –

    That mortgage is gold. Free money. Congrats.

  • Andy Link

    Yeah, we feel quite fortunate. It makes up somewhat for the shellacking we took trying to sell a house right after the bubble peaked in 2007.

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