The Dark Side of Financial Stability : The Forgotten Misery of a Major Depression
“ People are less happy about the state of affairs than they were when things were way tougher . It ’ s weird for somebody my age , because I was in the middle of the Great Depression when the hardship was unbelievable .”
Charlie Munger
The United States has experienced three Great Depression-level events in its 235-year history . The depression following the Panic of 1819 was the first , and the Great Depression in the 1930s was the last .
Fiscal and monetary policy innovations have prevented subsequent depressions , but a dangerous side effect is that many Americans fail to appreciate the stability . Not only does this negatively affect their happiness , but it also encourages behavior that invites future financial catastrophes . One example is the nation ’ s refusal to deal with its unsustainable spending . Armed with the world ’ s reserve currency and guided by a population that is increasingly insensitive to deprivation , Americans continue issuing debt to fund benefits they cannot afford .
The most severe consequences of America ’ s chronic budget deficits likely remain in the distant future , but they will emerge eventually . America ’ s debt capacity is not unlimited , and if the nation loses its ability to borrow on attractive terms , future citizens may be unable to avoid economic traumas from which their parents were spared . that few Americans can recite the lessons . But this knowledge gap is less excusable for financial executives and policymakers . A critical part of their job is detecting and mitigating risks early , and developing familiarity with past financial crises is essential to their success . During the COVID-19 pandemic , many financial leaders failed because they restricted their knowledge to the more recent past .
A Misplaced Faith in Low Rates
In Ernest Hemingway ’ s classic , The Sun Also Rises , when a character is asked how he went bankrupt , he responds , “ Two ways . Gradually and then suddenly .” Many bank failures follow a similar path . The set-up for the SVB run can be traced to the Global Financial Crisis ( GFC ) in 2008 . The Federal Reserve responded to the GFC by enacting monetary policies that were highly accommodative to economic growth . These policies contributed to low unemployment and low inflation that lasted for nearly a decade . Economic growth during this period remained relatively muted , but this is typical after the collapse of a debt-fueled asset bubble .
The extended period of low and stable interest rates anchored many investors ’ expectations regarding the future trajectory of rates . Few envisioned a scenario in which the Fed would suddenly reverse its long-standing dovish philosophy . In December 2015 , the Fed appeared to shift modestly when it initiated a series of nine , 25-basis point increases to the federal funds rate . The thesis was that the economy was more resilient , and it was important for the Fed to raise rates above the zero bound to restore its flexibility to respond to future financial shocks . But the economy proved more fragile than anticipated , and the Fed cut rates by a total of 75 basis points in the summer and fall of 2019 . The Fed ’ s reversal of its rate increases reinforced investors ’ perceptions that the Fed ’ s dovish bias would persist .
A Scared New World
On March 11 , 2020 , the World Health Organization ( WHO ) declared that the COVID-19 virus had metastasized into a global pandemic . Seemingly overnight , economies throughout the world came to a screeching halt . Absent government intervention , the US economy would have descended into a self-reinforcing deflationary spiral ending in depression . Drawing from the lessons of the GFC , the Fed quickly cut rates back to the zero bound and the federal government injected several trillion dollars of fiscal stimulus to support labor markets , distressed businesses and displaced individuals . In retrospect , many of these measures proved to be excessive . Heightened levels of inflation and speculation were the inevitable consequences .
The financial effects of the COVID-19 pandemic caught many Americans off guard , even though the United States had experienced similar events in the past . The closest comparable event occurred one hundred years ago when Americans suffered a similar spasm of inflation and speculation following the end of World War I and the Great Influenza . The Federal Reserve regional banks responded by raising rediscount rates by a total of 225 basis points in the first half of 1920 . This triggered a sharp recession and brief period of deflation in 1921 .
The Fed ’ s response to COVID-19 mirrored the one that occurred 100 years earlier . Americans were less surprised by the aggressive monetary stimulus in 2020 and 2021 because most had witnessed similar policy responses in 2008 and 2009 . But the sharp reversal of monetary policy in early 2022 caught many Americans off guard because they assumed that the dovish bias of the last 40 years was a permanent feature of Fed policy . There was a widespread failure to comprehend that conditions in 2022 were fundamentally different than they were over the prior 40 years , and a dovish bias was no longer feasible .
An Unanticipated Windfall in the Santa Clara Valley
Commercial banks are critical components of the US financial system , serving as essential liquidity sources for individuals and businesses . Prior to the pandemic , commercial bank deposits hovered around $ 13.4 trillion and changed little from month to month . But after the onset of the COVID-19 pandemic , commercial bank deposits suddenly increased rapidly , as businesses and individuals received large stimulus payments and were reluctant to spend them due to quarantinerelated restrictions and a desire to bolster their savings amid increased economic
14 FINANCIAL HISTORY | Summer 2023 | www . MoAF . org