May 10, 2023


Two-Price Economy

Minsky, First Republic Bank, and the paradox of contemporary monetary policy

The crisis affecting US and some European banks shows little sign of abatement. Following the collapse of Silicon Valley Bank earlier in the year, First Republic last week became the latest mid-size US bank to be bought up by a larger lender after investors withdrew more than $100 billion in deposits during the first quarter of the year. The Federal Reserve is now concerned about a “credit crunch” as mid-sized banks restrict their lending in the face of continued pressure on their balance sheets.

These developments have led to calls for rethinking the post-global financial crisis regulatory framework. Some have called for widening the “Too Big to Fail” regulations for larger banks to include smaller ones. Others have demanded a major expansion of deposit insurance. And still others have argued the opposite, citing fears of moral hazard and greater risk taking.

But these post-crisis reforms were based on dealing with the problem of credit risk. At the center of today’s crisis is interest rate risk. And that increased risk has been caused by central banks themselves. After a thirteen-year period of record low interest rates and plentiful liquidity in the aftermath of the global financial crisis, central banks’ suddenly reversed gear. To tackle persistent inflation, they have engaged in the fastest increase in interest rates in two decades, accompanied by “quantitative tightening” programs—the selling of government bonds and reversing of quantitative easing—that remove liquidity from the financial system. Last week the Federal Reserve raised interest rates for the tenth consecutive occasion to 5.25 percent, the highest rate since 2007, whilst the ECB ramped up rates to 3.25 percent.

This situation reflects a broader tension between monetary policy and financial stability. Current monetary policy involves destabilizing one set of prices—those of assets like government bonds—to try and stabilize another set: consumer prices. The collapse of confidence in the market value of the so-called safe assets of mid-sized US banks was largely caused by this trade-off. The failures reveal a fundamental feature of the modern monetary policy paradigm that financial regulators on their own can do little to address.

Capitalism is a two-price system

American economist Hyman Minsky described capitalism as a “two price” system. On one side are asset prices—both financial, like government or corporate bonds, and physical like residential or commercial property. On the other, there are consumer prices—goods and services that determine current output and consumer price inflation.  

In the contemporary global economy, asset prices are much more sensitive to interest rate adjustments than consumer prices. The present value of assets is determined by expected flows of future returns, which are in turn estimated using today’s interest rates: a five-year bond that pays a fixed 2 percent rate of interest would sell at a lower price than it was purchased for following interest rate hikes. In this way, the prices of fixed income assets and market interest rates are inversely related: tighter monetary policy necessarily results in lower asset values. 

This is exactly what happened to the government bonds and mortgage-backed securities held by Silicon Valley Bank and other mid-sized banks. The banks invested in these bonds thinking they were a safe and relatively liquid asset. Indeed, post-crisis regulation encouraged banks to hold more government debt for this reason. But the Federal Reserve’s rapid increases in interest rates led to drastic falls in their market value. This, in turn, caused investors to question the bank’s liquidity: its ability to raise sufficient funds by selling these assets to make good on deposit withdrawals. The result was a spectacular run on their—admittedly large and uninsured—deposit base that ultimately spelled doom. 

Investments in long-lived physical capital goods like residential or commercial real estate similarly grow less attractive as rates rise. Would-be homeowners are put off by the higher debt-servicing costs on a mortgage and would-be landlords are put off by the lower yield on rents relative to debt costs. House prices are falling in two-thirds of OECD economies according to the IMF. From the perspective of financial stability, falling house prices are bad news as houses serve as banks’ main source of collateral for mortgages.  

The commercial property market is even more vulnerable to interest rate rises as it is more highly leveraged than residential property. In part due to rising rates, commercial property prices have been falling rapidly in both the EU and the US, heightening concerns for regional banks that have large exposures to this asset class.

In contrast, the effect on output and consumer prices of interest rate rises is much more slow and indirect. It works through reducing demand in the economy. In theory, banks carry through the rise in their borrowing costs by charging higher rates to households and firms’, who then borrow less to consume and invest. 

But central banks themselves admit that this process can take up to two years to fully transmit to the real economy. Evidence suggests firms’ investment is relatively insensitive to interest rate shifts in either direction and more influenced by expectations about future profits. The impact on consumer spending will be mainly determined by whether households have mortgages and, if so, when they are due for renewal. In countries like the US where most people have longer-term fixed rate deals, the impact takes considerable time to filter through.

Furthermore, many other factors may affect the price of key consumption commodities more significantly that interest rates—most obviously supply-side shocks like those resulting from the conflict in Ukraine (energy prices), the Covid-19 pandemic (supply chains for manufactured goods), and volatile weather due to climate change (food prices). Interest rate hikes cannot address the supply-side causes of current inflation. They can only work indirectly through the mechanism of demand destruction.

In sum, we have a monetary policy regime that creates rapid and large movements in asset prices—often resulting in financial instability—in order to slowly and weakly effect its actual target: consumer prices. This is a serious design flaw. 

The systemic importance of asset prices

Central banks have tried to signal their intentions ahead of time in order to smooth the impact of interest rate shifts on market behavior. They have also tried to make small adjustments over longer periods. And since the global financial crisis, they have developed macroprudential policy to try and reduce systemic financial stability risks in certain sectors, including property. 

However, these efforts have been countered by other developments that have increased the sensitivity of economies to even small shifts in interest rates. 

Firstly, there has been an enormous growth in the size of financial and property assets, and corresponding debts, relative to the real economy. Financial asset values are now nearly 50 percent higher than the long-run average relative to income since 1977. House prices have doubled on average since 2000 in high-income economies as a combination of mortgage market deregulation and innovation, historically low rates, and quantitative easing have generated a huge expansion of investment in an inherently limited supply of residential real estate.

Secondly, the growth of market-based financing and repo-markets (“sale-and-repurchase” agreements) has meant that “safe assets” like government bonds have taken on much greater systemic importance in financial systems as forms of collateral. All kinds of financial institutions now deploy their holdings of government bonds as collateral to access to short-term funding.

The UK pension crisis in September 2022 was a classic case in point here. Pension funds engaging in liability driven investment invested in complex derivatives, using long-dated government bonds as collateral. The value of these bonds began to fall as the Bank of England began raising interest rates and engaging in quantitative tightening as inflation rose. In the market turmoil after former Prime Minister Liz Truss’s mini-budget, these bonds fell even more sharply, exposing pension funds to rolling margin calls from lenders as collateral values collapsed. The funds then moved to sell other long-dated bonds they held to cover the cash demands, which further exacerbated collapsing bond prices in a self-reinforcing downward spiral. The Bank of England was forced to take the extraordinary step of promising to buy up to £65 billion of government debt to calm the markets, despite otherwise having committed to shrinking its balance sheet as part of monetary tightening. 

In effect, monetary policy was trumped by concerns over financial stability. Indeed, the economist Daniela Gabor has argued that recent instances of quantitative easing had more to do with controlling the yield on government debt to prevent systemic macro-financial risks emerging in repo markets than with creating fiscal space for governments or stimulating demand in the real economy.

Alternatives to a one-price monetary policy regime

What reforms to monetary and macroeconomic policy are required to resolve the tension between price stability and financial stability? We can identify two big shifts. 

Firstly, fiscal policy should be given a much larger role in controlling consumer prices and asset prices. There is increasing evidence that the current inflationary dynamics are driven more by profit-driven inflation (or “greed-flation”) by larger firms than by more general increases in aggregate demand driven by rising wages. Price controls on strategic commodities like energy and food—or indeed public ownership of firms producing such commodities—will be more effective at controlling inflation than shifts in interest rates.  

Meanwhile, taxation can be an effective tool to dampen asset price volatility. Taxes on capital gains, both in financial assets and physical property (for example, through a land value tax), would reduce speculation in both sectors. Indeed, these types of returns are essentially economic rents. Taxing them more highly could increase the efficiency of the economy, especially if it allowed taxes to be reduced on income or productive investment.

Secondly, central banks need to acknowledge the collateral damage of rapid shifts in interest rates for the wider economy and consider alternative tools to reduce demand in the economy in a less destructive manner. One option would be to revisit credit guidance policies, which target lending in particular sectors by limiting the quantity of credit. These were widely and successfully used in the 1950-60s period of high growth and productivity. They included quantitative restrictions on consumer credit and mortgage credit that were seen to be inherently inflationary—for both asset and consumer prices—and could take resources away from strategically important sectors of the economy. The return of macroprudential policy to reduce systemic risks in the aftermath of the global financial crisis is a step in the direction here, but such policies have been used infrequently and with little bite. 

The need for a massive structural transition of the economy towards more sustainable forms of production and consumption further justifies the use of such an approach. Most obviously, central banks should work with other government agencies to limit credit and investment that supports unsustainable forms of activity (such as fossil fuel extraction and destruction of key ecosystems), while supporting lending for green energy, housing, and infrastructure. While the shocks caused by the war in Ukraine and the pandemic may be transient, climate change seems set to cause ongoing shocks to many sectors of the economy, and importantly food production. Achieving an effective and rapid green transition is the only way to hedge against such potential inflationary shocks. Perversely, raising interest rates across the board is likely to slow the green transition given the higher relative cost of capital for many green sectors like renewable energy.

The recent turmoil in financial markets has shown that the main tool central banks use to try to achieve price stability can destabilize the financial system. Monetary policy makers need to recognize that capitalist economies have two price systems which need different medicines. To marry modern-day price and financial stability requires greater coordination between fiscal, monetary, and wider industrial policy. Some examples of this could be seen in the response to the Covid-19 pandemic, where policies created fiscal space for massive investment in health care and the maintenance of jobs, and liquidity to support particular sectors. This more imaginative policymaking now needs to be scaled up to meet the multiple crises facing today’s world.

Silicon Valley Bank’s (SVB) short lifespan—from October 17, 1983 to March 10, 2023—has been witness to crucial transformations in the world of modern banking. The bank’s collapse has sparked wide…

Read the full article

An effective way to write the history of the last thirty years of the twentieth century,” economist Albert Hirschman wrote in 1985, “may well be to focus on the distinctive…

Read the full article

The 2008 crisis heralded a new age in central banking. The scale and nature of central bankers’ interventions was unprecedented. Traditionally, as lenders of last resort, central banks lend at…

Read the full article