Bank bailouts expose the limits of central banking, highlighting Bitcoin
The Federal Reserve’s bailout of Silicon Valley Bank last Sunday was a simple and universal announcement to the world: Oops. It provided yet another reminder that a predictable and unchanging monetary policy like Bitcoins can help avoid the schizophrenic ad-hoc policy coming out of the Federal Reserve.
What happened to the American economy? Following public pressure to deal with the economic effects of the coronavirus pandemic, the Fed cut its federal funds target in 2020, causing interest rates to collapse. When inflation inevitably followed, it sent interest rates soaring in the fastest rise since 1988.
What should a bank do? SVB, like almost all banks today, follows the standard manual of financing long-term assets (such as loans and securities) with short-term liabilities (such as deposits). So it bought US Treasuries with the large influx of deposits that followed during the pandemic. Since bond prices and interest rates move in opposite directions, the values of these bonds cratered when the Fed raised interest rates. So the book value of SVB’s assets slowly and steadily deteriorated until it faced a bank run late last week.
What SVB did wrong
The SVB management certainly made its share of mistakes. The banks deal with risk management, and SVB’s management should have secured its asset portfolio better. But there is no evidence that SVB engaged in the kind of risky financial innovation that characterized the great financial crisis. Rather, SVB was insufficiently naive in buying securities without adequately safeguarding the interest rate risk. But the rapid and unprecedented increase in interest rates will inevitably lead to certain banks in the economy suffering, and this bank was SVB. So the devaluation of SVB’s assets reveals as much the erratic nature of Fed policy as it does the risk mismanagement of SVB.
There are voices from various quarters, including government officials and even the president, who claim that this was not a bailout and that the taxpayers will not pay. Both are fake. The intervention took two forms: an extension of deposit insurance to uninsured depositors above the FDIC limit of $250,000, and an emergency lending facility that the Fed established for all banks. Both are rescue operations, although the details and consequences are different.
Make both insured and uninsured depositors of SVB all is a renegotiation after the fact of the deposit insurance conditions set by the FDIC. A bailout for depositors is still a bank bailout. Insurance everyone Depositors weaken incentives for customers to seek out banks with good risk management, removing the market discipline required for banks to manage risk well and serve their customers. Similarly, emergency loans allow banks to borrow from the Fed, using the bank’s devalued securities as collateral, which the Fed will value at par. It’s like pretending your old Chevy is a shiny new Cadillac. This will also cause banks to mismanage risk, knowing that any bad decisions that degrade their asset values will be covered by Papa Fed. All this will lead to future economic crises. In this twist of irony, bailouts create the very problems they were meant to solve.
Second, taxpayers will bear the costs of these bailouts in the long term. The Deposit Insurance Fund (DIF) of the FDIC will pay for the extended deposit insurance. At the end of last year, DIF had a balance sheet of $128.2 billion, which includes a 27% surplus of $27.2 billion over the amount of insured deposits in the banking system. At the end of last year, SVB’s held-to-maturity securities alone fell in value by $21 billion, which will eat up a large portion of this surplus, leaving little for other banks (such as Signature Bank). The FDIC funds the DIF through fees, called assessments, that the banks pay. When these fees rise tomorrow to pay for today’s bailouts, the banks will surely pass these higher fees on to consumers, either by raising interest rates on loans or lowering interest rates on deposits. In any case, all bank customers, i.e. taxpayers, will pay the price of the ad hoc extension of deposit insurance forced upon them by the authorities.
How the Fed got it wrong too
In the case of the Fed’s lending facility, someone has to bear the cost of the devalued assets that the Fed buys when it lends to these banks at well below market rates. Where do such losses go? As with all actions by the Fed, these losses will accrue to American citizens through inflation. The Fed will absorb the losses from the devalued securities the only way it can, by increasing the money supply. There is no free lunch, not now and not ever, and as always happens with inflation, those costs are borne by the poor, and those on fixed incomes with little access to capital markets.
It is tempting to ignore the moral hazard that bailouts inevitably create in times of crisis. I witnessed this myself during the 2007-2009 financial crisis, when I sat on the Council of Economic Advisers in the Bush White House and advocated limiting the TARP bailout. And many of the same arguments are reappearing now: “group X deserves special treatment” or “doing nothing will lead to widespread economic collapse”. Such statements are rarely supported with data or even reasoning. Like freedom of expression, a commitment to rescue operations is important precisely when it is difficult to do. Now is that time.
In the long term, we need a monetary system where central bankers can’t just tinker with the money supply as they wish. This would prevent the Fed from cutting interest rates to zero during a pandemic and then throwing them upward afterwards. Such a system would essentially tie the hands of central bankers, like Ulysses on his mast, so that the money supply expands in a predictable and unchanging manner. It may seem strange to want to limit our choices, but as the history of the Federal Reserve has shown, giving a central bank the power to control the money supply leads to an endless cycle of booms and busts. How many more times do we need to watch the same movie about easy money, bad bank management and ad hoc bailouts that transfer wealth from the poor to the rich?
Asking Congress to limit the operations of the Fed is unlikely to work, and asking the Fed to commit to a predetermined rule or formula for interest rates is even less likely. The Fed will never admit that it cannot fulfill its mission of price and financial stability, even in the face of the worst inflation in decades and its direct responsibility to supervise banks like SVB. No one wants to admit they can’t do their job.
Bitcoin can be a central part of the solution
Technology offers a solution, and it comes in the form of bitcoin. No individual or group controls Bitcoin. Instead, a network of thousands of nodes worldwide executes the rules of the Bitcoin protocol, which stipulates a predictable and immutable issuance of new money that no one can change on their own. All protocol changes require an open source development process, which takes years to coordinate a number of independent stakeholders. There is no central bank in Bitcoin, and therefore no group of people who can execute arbitrary bailouts.
Maybe the Fed shouldn’t have raised interest rates so quickly this year. Or maybe the Fed shouldn’t have lowered them so long during the pandemic. After all, hindsight is always 20/20. Or maybe it’s time to admit that monetary policy is just too important to be left in the hands of a committee of unelected officials who decide on their whim every six weeks. The political pressure to move interest rates in one direction or another is simply too strong for anyone to resist, regardless of their best intentions. Bitcoin offers an alternative to discretionary central bank management, with its predictable and immutable issuance of new money, which removes humans from the money supply decision. Although in a completely different circumstance, El Salvador has managed to recognize bitcoin as legal tender, and integrate bitcoin into the country’s monetary system, without losing the benefits of traditional banking. As Americans, perhaps it’s time to ask if our entire monetary system needs not a small update, but a major upgrade.
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