For the past few days, I have been having flashbacks to 2008. I was certainly not as knowledgeable about the capital markets then, but I still recall the concern that I felt when Lehman Brothers collapsed. As the Federal Reserve began to slash interest rates and the Troubled Asset Relief Program was implemented to bail out troubled banks, I knew that there would be unintended consequences. The next several years would eventually prove me right. The Federal Reserve kept interest rates at near-zero levels for over a decade, long after the economy supposedly recovered. As a result, we saw the money supply grow much more rapidly than the economy. I have pointed this out several times before and regular readers are undoubtedly well aware of this.
The usual definition of the money supply available in a nation is the M2 money supply. This refers to all of the cash in circulation plus all the money that is stored in checking accounts, savings accounts, money market funds, and similar things. Although this is not the most comprehensive measure of the nation’s money supply as it excludes things such as time deposits, it provides a pretty good idea of how much money can theoretically be spent at any given period of time. Lehman Brothers collapsed in September 2008. This chart shows the M2 money supply from that time until today:
As is clearly shown, the M2 money supply was $7.8593 trillion at the start of the financial crisis. Today, it is $21.2671 trillion. That is a 170.60% increase in just over a decade. The actual productive capacity of the American economy certainly did not increase to that degree, however. We can see that quite clearly by looking at the nation’s gross domestic product over the same time period. Here is a chart that shows it:
The reported gross domestic product at the time of the Lehman Brothers collapse was $14.608208 trillion. As of today, the gross domestic product is $26.144956 trillion. That is only a 78.97% increase over the same time period. This is the basic cause of the incredible inflation that we have been seeing over the past year or two. That is because inflation is the natural result any time that the money supply increases because a larger money supply means that more money is attempting to purchase each unit of economic output in an economy.
There may be some that point out that there was very little inflation in the American economy prior to 2021, but that is not exactly correct. The incredible asset appreciation that we saw in the market and in home prices over the 2010 to 2020 period was inflation as it was not driven by economic growth. We just saw that the gross domestic product did not appreciate by nearly as much as the S&P 500 Index did! The difference between then and now is that the newly printed money was generally confined to the stock market prior to 2020. However, in 2020, the Federal Reserve printed an enormous amount of money to finance the government’s spending in response to the COVID-19 pandemic. Take a look at the M2 chart above if you do not believe me. This money was intended to go into the pockets of people that will spend it, rather than save or invest it. They did go out and spend it, and inflation was the natural result.
The Inflation Fight
The Federal Reserve, although initially dismissing complaints about inflation as “transitory” during 2021, finally decided to combat it in 2022 by rapidly raising interest rates. In February 2022, the effective federal funds rate was 0.08% but it was 4.57% by Februrary 2023:
Ordinarily, this would not be a problem. After all, even 4.57% is very low historically:
The problem arose because investors and companies became addicted to the “free money regime” that dominated from 2009 until 2022. There were numerous problems that arose during that time due to everyone desperately seeking any sort of return on their money. We saw, for example, businesses with no revenue and an unworkable business model receiving millions of dollars of funding. These are the same companies whose values collapsed when interest rates increased and people no longer had to take on high amounts of risk to generate a return. After all, why would someone throw millions of dollars into a long-shot technology start-up that will not even generate revenue for a decade when they could put that same money into a money market fund paying 4.5%? Naturally, this reduced the price of risky assets as people become more willing to simply hold cash.
The Impact Of Silicon Valley Bank
On Wednesday, we started to see banks impacted as Silicon Valley Bank collapsed. This caused panic throughout the banking system as many depositors started to fear that other regional banks were in danger. However, there is a lot of evidence that Silicon Valley Bank was an isolated case and that other banks should be reasonably safe. In particular, only about 7% of Silicon Valley Bank’s deposits were insured by the Federal Deposit Insurance Corporation (FDIC). Zero Hedge pointed this out in a few articles that ran over the weekend (such as this one). My question is, why is this the only bank that was being used by companies to store millions of dollars worth of money? Many of these companies do not make any profit and so they are dependent on their cash balances to keep their doors open. I somewhat doubt that a bank in Texas will have the same problems, considering that it will be serving the shale oil industry and those companies are definitely not dependent on drawing down their balances to keep their lights on.
With that said, the FDIC reported that the banking system as a whole had $620 billion of unrealized losses on its books as of December 31, 2022. Thus, there are likely many banks that would not be able to withstand a bank run should depositors begin to panic en masse. Thus, even though the problems that caused the run at Silicon Valley Bank do appear to be unique, it could still spark a crisis.
The real question though is why were the risk managers at the companies that deposited money at Silicon Valley Bank so ignorant of the risks? It is not exactly smart to park millions or tens of millions of dollars at a single bank. These companies should have spread their assets around to dozens of banks. That is only proper risk management, and it would have likely prevented a bank run from ever occurring.