Four months before the Great Recession, in July 2007, economic data was reported as follows: the Federal Funds target interest rate was 5.26 percent; GDP adjusted for inflation had grown 1.9 percent in the previous four quarters; inflation was at a 3.6 percent rate for the preceding six months; non-farm employment had grown steadily for years; and home prices had fallen from double-digit growth to single-digit declines.
The above statistics match today’s data, virtually to the decimal point. Parallels between then and now extend to the precarious state of the U.S. banking system, albeit with different causes.
In 2007, debt was growing uncontrollably. Private nonfinancial debt more than doubled over the previous decade, to 165 percent of U.S. GDP. Banking system assets (net of cash holdings) also more than doubled, to 72 percent of GDP. There simply was too much debt for the economy to bear.
Now, for the last decade, total private nonfinancial debt has fallen to 149 percent of GDP while banks have grown from 69 percent to 75 percent of GDP. The biggest banking challenge is declining asset value as interest rates rise. Existing loans and securities with low rates must now equate to current higher rates by declining in value.
A study from leading finance professors found that banking system assets adjusted to their current fair market value are worth $2.2 trillion less than their value reported in bank financial statements. Since the banking system reports to the Fed a $2.2 trillion surplus of assets over liabilities, the system as a whole appears effectively worthless — not that every bank is worthless, but banks with positive value are offset by those with negative worth.
Comparable historical examples of worthless banking systems are not comforting. Japan’s banks after the 1990s property crash slowly rebuilt capital without a major recapitalization, and the country experienced decades of stagnation. The U.S.1980s saw double-digit inflation crushed with a steep recession. High interest rates and troubled developing country borrowers threatened the banking system, but vigorous growth began with dramatic interest rate cuts. The savings and loans sector of the financial system was completely restructured. The Great Financial Crisis also jeopardized the U.S. banking system, which was recapitalized while rates were radically reduced to zero. A painfully slow recovery ensued.
It is difficult for a worthless banking system to obtain funds to support its growth. Who would deposit or loan money to a system with no protection from an equity cushion? Deposit flight from banks has been widely reported, both for failures such as Silicon Valley Bank and First Republic and for the entire system. Over the last year, deposits at U.S. banks fell $924 billion. Banks borrowed $825 billion to offset the outflow, but this came entirely from government sources: $672 billion from Federal Home Loan Banks and $240 billion from the Fed. The private sector shows no confidence in the banking system.
The situation has worsened in the last few months. If banks can’t get financing from deposits or borrowing, they can’t grow their assets. Since February, banking assets declined $214 billion. Shrinking banks stifle economic growth. March 2023 saw declines in consumption, manufacturing output, and investment. In 31 years of these statistics, only 28 months had similarly grim declines, mostly coinciding with recessions.
Optimistic economic observers hope strong job growth will stave off recession; however, since 1959, every downturn has been entered into with good job growth. Recessions in 1960, 1969, 1973, 1980 and 1981 all were preceded with job growth around or above today’s 2.6 percent rate.
The U.S. banking system and economy need lower interest rates to regain growth. The Fed is hamstrung by high inflation, but since the real estate bubble burst in June 2022, inflation has been transformed. In the last six months, regular headline PCE inflation was 3.6 percent annualized compared to 8.0 percent in the six months before June. The Fed emphasizes the core PCE inflation measure excluding energy and food, which also made progress, but not as much: 4.3 percent vs. 5.2 percent. If official housing inflation statistics are adjusted for their inherent 12-month lag using Zillow rental inflation figures, core PCE inflation is 2.6 percent for the most recent six months compared with 9.0 percent for the period that ended in June.
The Fed adopted an extremely easy monetary policy to boost the disadvantaged in the United States — a worthy end. Few now doubt they overdid it, continuing maximum stimulus in the face of record-setting recovery with rising inflation. Nothing hurts these “last hired, first fired” more than a recession resulting from erratic policy. The Fed must be quicker to ease policy than it was to tighten for the pandemic inflation.
Douglas Carr is a financial markets and macroeconomics researcher. He has been a think tank fellow, professor, executive and investment banker. Follow him on Twitter @DougCarrMarkro.