Does a walk through the valley
reveal a shadow of the 2008
crash, asks James Meadway

The bubbling financial crisis unleashed barely two weeks ago by the failure of Silicon Valley Bank, the US tech specialist lender, shows no signs of dying down.

Credit Suisse, one of the oldest and largest banks on the planet, was forced last weekend into a shotgun wedding with close rival UBS by the Swiss government. Rumours continue to swirl around smaller US banks and, here in Britain, the Chancellor Jeremy Hunt has been offering assurances that our banking system remains “resilient” – mere days after a panic sale of Silicon Valley’s UK branch to global giant HSBC. Could we be looking at a repeat of the 2008 crash, when the world’s financial systems came within days of failure?

Banking systems are always unstable. To turn a profit, a bank must create more in loans than it has as capital in reserves. For this money-spinning operation to work, everyone must have confidence in the bank. They must believe it can continue to pay out the money it claims to have to its depositors when they demand it back.

If that confidence disappears, then the banks’ customers are likely to rush to get their money out. This is a bank run – since a bank will not have all the money at hand that it claims to have, it’s the classic way for a bank to fail. This is what killed Silicon Valley Bank – facing losses on its own investments, the bank’s managers tried to raise more capital by selling shares. The bank’s depositors, many of them involved in California’s tech industry and known to each other, took fright. WhatsApp groups and Signal messages spread the word that SVB was about to fail and $42 billion was withdrawn from the bank in a single day – at which point, the US government had to step in.

This could happen to any bank. Worse, one bank collapsing can cause panics and runs at other banks. Central banks emerged as a way to stop this happening. A single, usually government owned and controlled bank will act as “lender of last resort” to the system – offering money to other banks needing it in an emergency. This is what the Federal Reserve is now doing in the US, pumping billions of fresh, electronic dollars into the system over the last week or so.

The need to sustain confidence is why anybody in charge will insist, whatever else may be happening, that their country’s banking systems are stable and secure. But current tremors in the world’s financial systems threaten a more turbulent future, because although central banks were set up to preserve financial stability, in more recent decades they have also been asked to preserve price stability – in other words, to keep inflation under control.

The usual economists’ argument here is that by altering the interest rate it offers to other banks – in Britain, the Bank of England’s “base rate” – a central bank can change the price of borrowing and saving across the whole system. When inflation rises, the theory is that by increasing its own interest rate, a central bank can make borrowing in general more expensive. This can be direct, as with tracker mortgages pegged to the base rate. Usually it is more indirect, with banks and other lenders changing their own rates depending on the base rate.

This is where the problems start. Firstly, if borrowing is more expensive, businesses and households are likely to spend less. If they spend less, fewer people will need to be employed – unemployment will rise. The theory here is that rising unemployment will deter workers from asking for higher pay and so pressure for firms to increase prices will be reduced. It is a brutal mechanism but it is what is supposed to happen when the Bank of England puts up interest rates.

But when inflation is at 10.4 per cent and pay is rising only by 5.7 per cent, it can’t be pay that is pushing up prices. Allowing for inflation, pay for most people is actually falling sharply. Inflation is coming from rising food and energy prices.

We import about half of each, meaning it is events like war in Ukraine and bad tomato harvests in Morocco that create price rises. Cutting nurses’ pay in Britain won’t make natural gas from Qatar cheaper. Even if it wasn’t so cruel, the interest rate mechanism will have limited impact.

Second, for a decade after the crash, central banks worked to hold interest rates to very low levels. Silicon Valley Bank came to depend on this – its customers needed low interest rates to fuel high-risk tech investment, while the bank’s own investments depended on low interest rates to work. When rates rose, the bank failed.

A similar thing happened to pension funds in Britain after last year’s mini-Budget. Many less developed countries have built up debts over the last decade and now face ruin as interest rates rise. The whole world is heavily in debt and very sensitive to rates rises.

But if these interest rate increases won’t have much real impact on inflation, we’ll be trapped. Interest rates will stay high because inflation will stay high. And that increases the risk of financial failure over time – and, scared of risks, lenders will make fewer loans, worsening any recession. (Already loans to small businesses in the UK are falling.) It won’t be a short, sharp shock like 2008 – more like a long, drawn-out decline with added environmental disasters.

James Meadway is an economist and director of the Progressive Economy Forum, an independent thinktank (progressiveeconomyforum.com)