A Simple Solution to the Banking Crisis That No Country Will Implement

by
Steve Keen
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Though Sil­i­con Val­ley Bank con­tributed to its own demise, the root cause of this cri­sis is the fact that pri­vate banks own gov­ern­ment bonds. If they did­n’t, then SVB would still be sol­vent.

Its bank­rupt­cy was the result of the price of Trea­sury bonds falling, because The Fed­er­al Reserve increased inter­est rates. As inter­est rates rise, the val­ue of Trea­sury Bonds falls. With the resale val­ue of its bonds plung­ing, the total val­ue of SVB’s assets (which were main­ly Bonds, Reserves, and Loans to house­holds and firms) fell below the val­ue of its Lia­bil­i­ties (which are main­ly the deposits of house­holds and firms), and it col­lapsed.

Why do banks own gov­ern­ment bonds? Large­ly, because of two laws: one that pre­vents the Trea­sury from hav­ing an over­draft at The Fed­er­al Reserve; and anoth­er that pre­vents The Fed­er­al Reserve buy­ing bonds direct­ly from the Trea­sury. If either of these laws did­n’t exist, then banks in gen­er­al would­n’t need to buy Trea­sury Bonds, and SVB would still be sol­vent.

Nei­ther of these laws are invi­o­lable. As Elon Musk once put it, the only invi­o­lable laws are those of physics—everything else is a rec­om­men­da­tion.

The UK equiv­a­lent of the for­mer law was bro­ken dur­ing Covid, with the Trea­sury and the Bank of Eng­land agree­ing to extend what they call the “Ways and Means Facil­i­ty” which is “the gov­ern­men­t’s pre-exist­ing over­draft at the Bank.” The use of an over­draft sped up the UK’s fis­cal response to Covid (such as it was).

The US law only came into force in 1935. Before then, The Fed­er­al Reserve reg­u­lar­ly pur­chased Trea­sury Bonds direct­ly from the Trea­sury. “The Bank­ing Act of 1935” banned this practice—though it too was ignored dur­ing WWII, and at var­i­ous times until 1981. Mar­riner Eccles, who was Chair­man of The Fed­er­al Reserve from 1934 till 1948, assert­ed that this law was draft­ed at the behest of bond deal­ers, who were cut out of a lucra­tive mar­ket when The Fed bought Trea­sury Bonds direct­ly from the Trea­sury, rather than on the sec­ondary mar­ket where bond traders made their for­tunes:

I think the real rea­sons for writ­ing the pro­hi­bi­tion into the [Bank­ing Act of 1935] … can be traced to cer­tain Gov­ern­ment bond deal­ers who quite nat­u­ral­ly had their eyes on busi­ness that might be lost to them if direct pur­chas­ing were per­mit­ted. (Gar­bade 2014, p. 5)

Call me cal­lous, but, giv­en a choice between bond traders los­ing a lucra­tive gig, or the finan­cial sys­tem col­laps­ing, I’d be hap­py to see bond traders become rather less wealthy.

So, a sim­ple solu­tion to the cur­rent crisis—which was caused by The Fed­er­al Reserve itself, as its “hike inter­est rates to fight infla­tion” pol­i­cy trashed the val­ue of Trea­sury Bonds—would be for:

• The Fed (and its equiv­a­lents) to buy all Trea­sury bonds held by banks, hedge funds pen­sion funds, etc., at face val­ue; and also,
• The Deposit guar­an­tee to be made lim­it­less, rather than capped at $250,000; then in future,
• The Fed should either allow the Trea­sury to run an over­draft, or it should buy Trea­sury Bonds direct­ly from the Trea­sury.

If even just the first of those rec­om­men­da­tions was act­ed upon, today’s cri­sis would be over. Banks would swap volatile Trea­sury Bonds at face val­ue for sta­ble Reserves—thus restor­ing the sol­ven­cy they had before The Fed start­ed to raise rates. Hedge funds, pen­sion funds, etc., would swap Trea­sury Bonds for deposits at pri­vate banks—and those deposits would be backed by Reserves, rather than Bonds.

The sec­ond rec­om­men­da­tion would mean that bank deposits—which can be huge, run­ning into the bil­lions of dol­lars for the largest companies—would be safe from any future bank­ing crises. If they were going to be lost, it would take idio­cy by the com­pa­ny or hedge fund boss­es them­selves, rather than idio­cy by The Fed­er­al Reserve, or any indi­vid­ual bank.

The third rec­om­men­da­tion would end the cha­rade of pre­tend­ing that the pri­vate sec­tor lends mon­ey to the gov­ern­ment when it runs a deficit. It would make obvi­ous the real­i­ty that the gov­ern­ment does­n’t bor­row mon­ey, it cre­ates mon­ey. Gov­ern­ments could focus on the impor­tant issue of how much mon­ey it cre­ates, and for what pur­pos­es, rather than pre­tend­ing that its spend­ing is con­strained by what it can bor­row from the pri­vate sec­tor.

So, why do I think that none of these easy solu­tions to the cur­rent cri­sis would be tak­en? Large­ly, because main­stream, “Neo­clas­si­cal” econ­o­mists are in con­trol of our cur­rent sys­tem. They know noth­ing about the mon­e­tary system—or noth­ing accu­rate. They’ll fight against pro­pos­als like this, even though they would fix a cri­sis that they cre­at­ed them­selves by not con­sid­er­ing what inter­est rate hikes would do to the resilience of the finan­cial sec­tor that they are sup­posed to safe­guard.

Gar­bade, Ken­neth D. 2014. ‘Direct Pur­chas­es of U.S. Trea­sury Secu­ri­ties by Fed­er­al Reserve Banks’, Fed­er­al Reserve Bank of New York Staff Reports, No. 684.