Listening back to a podcast interview that I recorded in the fall of 2022, it occurred to me that I may have predicted the march 2023 banking crisis. I am not one to pat myself on the back very often, but this time I believe I had a good intuition about the looming problem of T-bills misevaluation. For context, I was talking with Nathalie Janson (a french economist that specializes in banking and finance) about the broader topic of the 2008 Great Financial Crisis. We went through the distant origins, the unfolding of the actual crisis, and the lessons learned from it, especially in terms of banking regulation.
Around 01h09mns into the discussion, I asked my guest about the potential problem caused treasury bonds, which I suspect of being artificially overvalued. She agreed. And yet I have never seen this issue raised in mainstream economic media or anywhere else that I know of. I am 99% sure the issue was discussed somewhere, but it was certainly not central in the global economic debate in recent years, which revolved largely around inflation and central bank’s response, supply chain disruptions, the war in Ukraine and its economic ramifications, etc.
In my understanding, sovereign bonds have long been considered very safe and liquid assets based on two premises :
- The belief that our governments will always remain solvent and cannot fail on their debt, almost by definition.
- The various financial and banking regulations that mandate financial institutions to hold a large portion of government bonds in order to ensure financial stability, as these bonds are regarded as historically safe and liquid.
I warned of the fragility of a system that relies increasingly on government bonds as its main safe asset, in a context of our soon-to-fail welfare states. Simply put, given our demography, growing reliance on state intervention, lack of resilience in the face of economic hardships and above all our decade-long policy of discouraging savings and sacrificing the future to the present, our finances will not hold for much longer. The weakest states will fail, especially given the hardships faced by some of the other states that usually come to the rescue (e.g. Germany in Europe). Inflation being back in the picture, it was obvious that interest rates would have to rise sooner or later. Central banks had unreasonable hopes that inflation was transitory and mainly the result of supply-chains disruptions during the COVID-19 pandemic. They eventually had to quickly raise interest rates, which automatically made refinancing harder. But had they not hiked those rates, the result would have been the same : either people would have lost their purchasing power and public finances would have suffered as a result, or – had inflation been given more slack – investors would have distanced themselves from the bond market as those fixed-income assets would have mechanically lost their real yield.
In short I was expecting the first large corporate or even sovereign defaults to trigger a crisis for the huge bond market that few people saw as a systemic threat. As it turns out, the system was even more fragile : it didn’t take more than liquidity problems in several small or mid-sized banks and the subsequent rapid sale of T-bonds to reveal the discrepancy between their book value (if held to maturity) and their real market value, much lower of course. But the fundamental cause was indeed the unreasonable faith in T-bonds, further maintained by financial regulations causing a self-entertained cycle resulting in considerable “mispricing”. This would be a problem in any financial and monetary system, but the problem is much more acute in a system of debt-money where smaller localized defaults or relative devaluations (due to more attractive present rates) can trigger a chain-reaction. The government-enforced labeling of T-bonds as the ultimate safe and liquid asset has predictably obscured its price discovery process, and made fair valuation impossible for anyone. Much to the satisfaction of governments of course, as we cannot forget that those regulations supposedly aimed at ensuring financial stability also had the collateral effect of making public spending easier than ever. But as in any bubble, the market eventually understands the error and adjusts with cold hard reality. We may be at the beginning of this process.
As always, many commentators pointed out that in the absence of a bank run, T-bonds could have been held to maturity and the crisis would have been avoided. This narrative also served as a basis for the historical decision that was made to retro-actively ensure all deposits above $250K at Silicon Valley Bank. Janet Yellen and Joe Biden insisted on the fact that this was not a taxpayers funded bailout, as the cost would fall on the FDIC, which is itself funded by ensured banks. In other words, the cost will be borne not by taxpayers but by customers in all banks that benefit from the FDIC’s deposit insurance. Big difference, right ?
Arguing that the system will hold if people just resist the urge to withdraw their cash to safety amounts to arguing that the Titanic had enough lifeboats for everyone if passengers had just been calm enough to evacuate in order. Technically, additional lifeboats did become available after the first survivors were rescued aboard other boats. It was just a matter of patience and cold-blood for the others.