Kuttner on TAP: The Silver Lining in the Latest Bank Panic

The late Hyman Minsky was one of my favorite economists because of his warning that capitalist economies, absent stringent regulation, are chronically vulnerable to financial collapses. Old lessons are forgotten in the euphoria of new fads, which invariably end in crashes.

The lesson of the Crash of 1929 was so potent, and the New Deal’s cure so effective, that it took half of a century for the lesson to fall into the national memory hole. But beginning in the 1980s, new schemes such as leveraged buyouts, which had not been anticipated by New Dealers, were tolerated by Reagan’s anti-regulators.

In the 1990s, Bill Clinton gave a free pass to credit derivatives and subprime loans. It took until 2008 for the pyramid to come crashing down. In that crisis, the Fed was culpable for keeping money too cheap and regulation too light, a combustible combination. When the house of cards gets shaky, investors head for the exits and the crash feeds on itself.

The latest impending disaster is an instructive variation on the theme. It’s a different sort of bank run, one caused by a run not on bank deposits but on bank stocks.

The collapse of three badly mismanaged and poorly regulated regional banks, Silicon Valley Bank, Signature Bank, and First Republic Bank, caused financial speculators to bet against other regional banks whose balance sheets are basically sound. Last week, the value of the stocks of PacWest, Western Alliance, Zions, and Comerica swung wildly, as speculators bet on their collapse, then reversed their bets.

A collapse of regional banks could become a self-fulfilling prophecy caused by speculation. And the technique that the speculators used, short selling, is itself a plague that the Roosevelt administration tried and failed to ban.

In the run-up to the 2008 collapse, the Fed was culpable for keeping interest rates too low. This bout of financial instability has been exacerbated by the current Fed’s stubborn determination to keep rates much too high, which reduces the value of securities held by banks, and also weakens the real estate sector, adding to the stress on banks.

There are two silver linings to this mess.

First, Fed Chair Jay Powell is now rethinking his obsession with an inflation target of 2 percent, which led the Fed to raise interest rates to the point where they threatened the solvency of several banks and the economy. At the Fed’s most recent policy-setting meeting, the Open Market Committee signaled that it will soon cease raising rates.

Powell will have to live with inflation moderately higher than 2 percent. That will be good for both the banking system and for the economy.

Second, Fed Vice Chair Michael Barr’s April 28 report on the Fed’s grossly inadequate bank regulatory policies is a rebuke to the regime of his Republican predecessor Randy Quarles and to Quarles’s crony and partner in weak regulation, Chair Jay Powell. The report discredits and isolates Powell and gives Barr and other regulators a basis for much tougher bank regulation going forward.