The fatality of a new debt crisis

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Nouriel Roubini

Emeritus Professor of Economics at New York University Stern School of Business: Chief Economist at Atlas Capital Team and author of MegaThreats: Ten Dangerous Trends That Imperil Our Future, and How to Survive Them (Little, Brown and Company, 2022).

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In January 2022, when 10-year US Treasury yields were still hovering around 1% and German Bund yields were -0.5%, I made thewarning that inflation would hurt both stocks and bonds. Higher inflation would lead to higher bond yields, which in turn would hurt stocks as the discount factor for dividends increases. But, at the same time, higher yields on “safe” bonds would also imply a decline in their price, due to the inverse relationship between yields and bond prices.

This basic principle – known as “lifetime risk”– seems to have been forgotten by many bankers, fixed income investors and bank regulators. As rising inflation in 2022 led to higher government bond yields, 10-year Treasuries lost more value (-20%) than the S&P 500 (-15%) and all those with income assets remained fixed and long-term denominated in dollars or euros having to “carry the dead”. THE the consequences for these investors were severe. By the end of 2022, unrealized losses on securities of US banks had reached $620 billion, about 28% of their total capital ($2.2 trillion).

To make matters worse, the increase in interest rates reduced the market value of the banks’ other assets. If you took out a 10-year loan when interest rates were 1% and they rise to 3.5%, the real value of that loan (what someone else would pay in the market for it) will go down, implying that the loan unrealized losses of US banks are actually close to $1.75 trillion, or 80% of their capital.

The “unrealised” nature of these losses is simply an artifact of the current regulatory regime, which allows banks to price securities and loans at face value, rather than true market value. Indeed, judging by the quality of their capital, most US banks are technically close to insolvency, and hundreds of them are already completely insolvent.

There is no doubt that rising inflation reduces the real value of liabilities (deposits) by banks by increasing their “deposit allowance”, an asset that is not on their balance sheet. Since banks pay close to 0% on most of your deposits, even if overnight rates were to rise to 4% or more, the value of this asset increases as interest rates rise. In fact, some estimates suggest that rising interest rates have pushed the total value of U.S. bank franchise deposits by about $1.75 trillion.

But this asset exists only if deposits remain with banks when rates rise, and we now know from the failure of Silicon Valley Bank and other regional banks in the US that this is far from the case. If depositors flee, the deposit allowance vanishes and unrealized losses are realized on the securities as banks sell them to pay for withdrawals. Then failure becomes inevitable.

Furthermore, the “excess on deposit” argument assumes that most depositors are foolish and would rather hold their money in accounts with near 0% interest when they could be earning 4% or more entirely in market funds. . But then again today we know that depositors are not so accommodating. The current and seemingly persistent flight from uninsured – and even insured – deposits is likely driven as much by depositors’ quest for higher returns as concerns about the safety of their deposits.

In short, having not existed as a factor for the past 15 years – since interest rates and short-term policies fell to near zero after the 2008 global financial crisis – interest rate sensitivity on deposits has returned to the fore. Banks took on highly predictable term risk because they wanted to increase their net interest margins. They took advantage of the fact that as long as the principal charges on government and mortgage-backed securities were zero, losses on those assets did not have to be passed on to the market. To top it all off, regulators didn’t even stress test banks to see how they would fare in a scenario of sharply rising interest rates.

Now that the house of cards is crumbling, the credit crunch caused by the current banking stress will cause a harder landing for the real economy, due to the key role that regional banks play in financing small and medium-sized businesses and homes . Consequentially, central banks are faced not just with a dilemma, but with a trilemma. Due to recent shocks to the aggregate supply chain – such as the pandemic and the war in Ukraine – the attempt to stabilize prices through interest rate hikes was bound to increase the risk of a hard landing (a recession and a recovery from the arrest). But, as I’ve been arguing for more than a year, this bewildering balancing act comes with the added risk of serious financial instability.

Borrowers face rising rates – and consequently much higher capital costs – on new loans and existing liabilities that are past due and need to be renegotiated. But also the increase in long-term rates it is causing heavy losses for creditors with long-lived assets. As a result, the economy is falling into a “debt trap” in which high government deficits and debts cause “fiscal dominance” over monetary policy, and high private debts cause “financial dominance” over monetary and regulatory authorities.

As I have long warned, faced with this trilemma, central banks risk backing out (limiting the normalization of monetary policy) to avoid a feedback economic and financial collapse, and the stage will be set for a de-anchoring of inflationary expectations over time. Central banks should not delude themselves that they can still achieve both price and financial stability through some form of unbundling (raising rates to fight inflation and injecting liquidity to maintain financial stability). In a debt trap, rising rates will only fuel systemic debt crises that the liquidity injection will not be enough to resolve.

Not even central banks. they should assume that the looming credit crunch will kill inflation by curbing aggregate demand. After all, negative aggregate supply shocks persist and labor markets remain too tight. The only thing that can moderating wage and price inflation is a severe recession that will further exacerbate the debt crisis and, in turn, fuel a deeper economic slowdown. Since liquidity injection cannot prevent this cycle of systemic ruin, we should all prepare for the next stagflationary debt crisis.

Source: Clarin

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