We are living through a trillion-dollar rebalancing

The writer is an FT contributing editor and writes the Chartbook newsletter

Faced with a rash of banking crises it is tempting to declare, plus ça change. There is nothing more inevitable than death, taxes and bank failures. But what about the bailouts? The publicly subsidised takeover of Credit Suisse by UBS and the hasty extension of guarantees to all SVB’s depositors are just the latest in a recent series of such actions. They suggest that we have entered a new era, one in which thoroughgoing liquidation of financial bubbles is politically unthinkable and so moral hazard and zombie balance sheets pile up.

Both these interpretations are superficially plausible. Put them together and you have a vision of ever larger balance sheets, inevitable crisis and no less inevitable bailout, opening the path to even greater leverage and risk.

But in focusing on the morality play of bad bank managers and lax supervision, they mischaracterise the drama we are living through. What defines our current moment is neither the bank failures nor the relatively modest bailouts, but the astonishing macro-financial switchback of 2020-23. This began with mega-quantitative easing in response to the truly unprecedented shock of the Covid-19 lockdowns. The combination of stimulus, supply-chain disruption and Vladimir Putin’s war in Ukraine unleashed the biggest surge in inflation in half a century, which was met not with monetary easing, but with the most comprehensive tightening of monetary policy since the beginning of the fiat money era.

This is not a case of “plus ça change” but of polycrisis. We would not be here but for the pandemic. And the central bank response too is novel. They are doing what is necessary to stave off further contagion from SVB, but on rates they are sticking to their guns. Since early 2022, in the face of a market rout, the Federal Reserve has shown a resolve few people credited them with. Fed chair Jay Powell even half-hinted that a crisis or two might help to take the steam out of the economy. Certainly, those counting on the Fed to soothe their pain over huge losses on bond portfolios have had a rude awakening.

Containing the fallout from SVB and Credit Suisse does involve some element of public subsidy, but those transfers are tiny in comparison with the trillion-dollar balance sheet shift from bond investor to bond issuers triggered by the post-Covid pile-up of inflation and interest rate rises. As David Beckworth, of the Mercatus Center think-tank, has pointed out, in the US the ratio of public debt to gross domestic product has plummeted by more than 20 percentage points from its pandemic peak. This spectacular balance sheet shift between debtors and creditors is happening as a result of three forces: the rebound in real output following the Covid shock, the rise in prices and wages, which inflates nominal GDP, and the downward revaluation of the stock of bonds as a result of higher interest rates.

As recently as 2021, we were still worried about how we would cope with insuperable debt levels in a world of secular stagnation and chronic low inflation. Now the nominal GDP of debt-ridden Italy is increasing so fast that, to the third quarter of 2022, its debt-to-GDP ratio fell year on year by almost 7 per cent. Though no one wants to be seen to be celebrating the inflationary wave, we are, beneath a decent veil of silence, living through one of the most dramatic and powerful episodes of financial repression ever.

This is what lies behind the trillions of dollars in unrealised losses on the balance sheets of financial institutions around the world. The figure would be even greater were it not for the fact that central banks, thanks to QE, are also big holders of government debt and are thus sharing the paper losses. Beyond the narrative of feckless banks and bailout-happy regulators, the truly systemic question is how we see our financial institutions through this giant trillion-dollar rebalancing. That is what will define this historical episode.

Though debtors benefit from inflation and the revaluation of debts, they need to brace for the surging costs of debt service. Those who did not stretch the maturity of their obligations in the era of low rates now face an interest rate cliff.

But if we can adjust to higher debt service and avoid a rash of bank crises, the one-off shock to the price level opens up unexpected fiscal space. We must use this wisely. We need public investment so as to escape the reactive cycle we are locked in and to begin anticipating the challenges of the polycrisis, whether in public health, climate change or destabilising geopolitics.

We must also provide relief to that part of society which is least well equipped to handle these financially turbulent times. Those in the bottom half of income and wealth distribution are bystanders in the great balance-sheet reshuffle. They hold few, if any, financial assets and pay relatively little tax. They have lived the drama of Covid and its aftermath as a shock to jobs and a cost of living crisis. Unlike bondholders or investors, their interests are not represented by lobbyists. Their households are not too big to fail.

But if those who run the system imagine they can be ignored, that they are not systemically important, those elites should not be surprised by the strike waves and populist backlash coming their way.