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

Summary:
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

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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.

Steve Keen
Steve Keen (born 28 March 1953) is an Australian-born, British-based economist and author. He considers himself a post-Keynesian, criticising neoclassical economics as inconsistent, unscientific and empirically unsupported. The major influences on Keen's thinking about economics include John Maynard Keynes, Karl Marx, Hyman Minsky, Piero Sraffa, Augusto Graziani, Joseph Alois Schumpeter, Thorstein Veblen, and François Quesnay.

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