Unequilibrium monetary stimulation and the pumping of the economy with unproductive money has led to the inevitable: a depreciation of what is too much and a dramatic decline in the capacity of the holders of this surplus. Exchanges of goods are shrinking both in length and breadth – the range of exchanged goods is shrinking, and the transactions for these goods are shrinking in quantity. The cycle of monetary tightening that has begun is simply reinforcing this process, trying to forestall a recessive collapse that probably cannot be avoided. The problems with the banking sector are a precursor to possible cataclysms. But future events could be even darker, and this applies not just to banks, but to all major asset aggregates in the economy – insurers, pension funds, and investment companies alike.
Let’s try to simplify the underlying processes that led to the current situation and look at it all from the top down.
So, the government has created imbalances in the ratio of needs and opportunities by overstimulating needs by pouring tons of credit money into the economy. That is, a volume of demands has been created that prevails over the amount of capacity to meet them. This means that the credit goes beyond the possibility of its repayment in the foreseeable future, which creates a threat of credit default and depreciates the credit obligation and the value for its holder, or reduces it, if there is any possibility of repayment of the loan in the distant future. It is obvious that the further the term of possible repayment is, the cheaper the credit and the higher the premium from the repaying side.
How does this translate into the situation with the growing banking crisis?
In an attempt to redeem inflationary pressures, the regulator increases the cost of money, i.e. the actual claims on those who have to meet these claims – credit becomes more expensive and the speed of its creation decreases.
But an increase in the value of new credit means a drop in the value of old debts – claims created at a different, much lower price.
Now let’s look at this from a practical point of view. Banks, as you know, have two types of clients – those who lend to the bank, i.e. depositor-lenders, and those who borrow from the bank, i.e. borrowers. Those who lend, always want to lend for a short time and at maximum interest. At the same time, he who wants to borrow wants to borrow for as long as possible and pay as little as possible. The bank, acting in both capacities, earns money from the difference between the interest rate at which it borrows money from the creditor-donors and the rate at which it lends money to the borrower. Obviously, the bank borrows at a lower rate and lends at a higher rate.
When the cost of money as determined by the Regulator rises, there is what is called slippage: the cost of “short” money rises faster than the cost of “long” money, because the cost of credit is determined primarily by the rate at which money is received, not the rate at which it is then lent. The cost of borrowing is actually the cost of receiving the money plus a premium.
The source of money issue, that is, the source of funding in the national economy – the one who writes the confirmation of claims to fulfill certain obligations and confirms their binding nature – is the state. And under conditions of monetary dirigisme, it is the state that determines the value of money, rather than bringing (fixing) it in line with market processes. That is, the state sets the lending rate.
This means that the bank has to borrow more and lend cheaper. The bank’s margin decreases and so does the benefit of the bank’s donor lenders: now the rate at which they lend to the bank is less than the rate at which the bank borrows new money.
In addition, the bank’s donor creditors have an alternative in this situation – other fixed-income instruments, primarily government debt obligations. They are a tradable and liquid instrument, unlike bank deposits, which means that one can take advantage of the rising price of money and lend to the state at a higher interest rate than the bank offers. The bank’s existing subsidiary lenders are demanding their money back from the bank, and potential borrowers are deciding not to lend money to the bank, but to give it to other borrowers who offer a higher premium, primarily the state.
In addition, bank assets = are loans made to borrowers. As mentioned earlier, loans are inherently longer than loans. And this means that there is an imbalance – there are repayment claims on short loans to the bank, which have to be satisfied by the longer liabilities of the bank’s borrowers. In order to meet its loan repayment requirements, the bank has to repay the most liquid loans it has issued to its borrowers. These are primarily debt securities of the state, because it is the state that is considered the least risky borrower for the bank.
However, with the rising cost of money and loan premiums, the value of the bank’s previous loans to the government has declined – government bonds have fallen in price. The bank is forced to sell its assets – loans – at a lower price. Since both liabilities – a bank’s obligations to its creditor-donors and assets – the bank’s loans – were formed in an equilibrium environment, when the equilibrium is broken, when the value of money rises sharply, there are not enough assets to fulfill liabilities on the liabilities.
Thus banks are in total trouble. Rising rates encourage depositors to withdraw their deposits, and the realization that the increased value of money puts the bank in the risky position of being unable to meet its obligations due to asset depreciation: deposit withdrawals accelerate rapidly. A bank run arises and the snowball grows: deposits flow out, new ones do not arrive, depreciating assets are forced to sell off without the possibility of their retention and restoration in value.
The inversion of the yield curve is nothing but imbalance and a violation of the normal ratio: short term = low risk = small premium / long term = high risk = large premium. This is the ratio that banks make money on in a normal competitive environment, where flows of claims and liabilities are created and driven by market factors in a competitive environment.
Now short money is worth more than long money, which is a dangerous anomaly. Most importantly, it means that banks are not just losing a source of income – they are entering the zone of maximum risk when they lose the ability to meet their obligations.
In addition, the new liquidity, which the government is already providing and will provide to the drowning banking system, will cost close to the increased rates, which means it, in fact, puts another mine under the banks: new loans are expensive and obligations to service them further reduce the stability of balance sheets.
This situation is an obvious consequence of the policies of the government and the FED, which was simply impossible to avoid. The only question now is one of scale.
In fact, there are two options in what the government can do: either let go of the reins and let the system clean up, or – in every possible way to plug the leaks with new liquidity for the banks and start another cycle of credit expansion.
The first is the hardest surgery and change of the way of existence, akin to coming out of years of drug addiction, with withdrawal and a long recovery, but with the prospect of a healthy life.
The second is to buy the withdrawal with a new dose of the substance and keep the body in an unhealthy equilibrium until the next withdrawal.
As we know from the experience of the Government, and from the current situation in the world, nothing but the continuation of drug addiction awaits us.
Once again the old axiom is confirmed: wherever there is too much state, there is inefficiency, and if the state stays there for too long, disaster ensues.
