It really might be different this time as the Fed puzzles over why high rates aren't hitting the economy harder
How significant is the role of government debt in U.S. GDP growth in 2023, and what are the implications of this financing method?
The role of government debt in U.S. GDP growth in 2023 is significant. Government spending and investment contributed its highest share to GDP growth in 2023 in more than a decade, and it has been financed with debt. Government debt is referred to as a risk-free asset because it is safer than a household or company, as federal authorities have the power to tax. This means leveraging up the federal balance sheet for growth is inherently less dangerous than a surge in borrowing by the private sector.
However, there are implications to this financing method. Rising interest rates are inflating U.S. borrowing requirements, and warnings have been made that the U.S. is on an unsustainable fiscal path. There is a limit to how much debt can be outstanding without the market driving yields up, and if there is a tipping point, it is hard to believe we are at it right now. The U.S. government's reliance on debt financing could lead to a fiscal crisis if investors become reluctant to lend money to the government because they fear the debt will not be repaid. In this case, government borrowing rates could rise suddenly and sharply, leading to a decrease in private investment in productive capital, lower future output, and national income.
What impact did the regional-bank failures in spring 2023 have on the U.S. economy and financial markets?
The regional-bank failures in spring 2023, specifically Silicon Valley Bank, Signature Bank, and First Republic Bank, caused some disruptions in the U.S. economy and financial markets. These failures were primarily due to liquidity issues stemming from unexpected and rapid loss of depository confidence4. However, the overall impact was relatively contained, and the economy and financial markets proved to be resilient.
The failures of these banks did not cause significant contagion within the financial system, thanks to swift regulatory intervention and the establishment of programs such as the Bank Term Funding Program (BTFP) to provide additional liquidity to banks. Credit spreads remained tight, even among riskier bonds, and volatility stayed low.
Regional banks experienced some decline in their stocks, and there was a temporary shift in deposits from smaller banks to larger ones perceived as safer. However, the impact on the broader economy was limited. The GDP growth forecast for 2023 was revised slightly downwards, but the labor market remained strong, and overall, the financial system continued to function well.
In conclusion, while the bank failures in spring 2023 caused some disruptions and raised concerns, their impact on the U.S. economy and financial markets was relatively contained and short-lived. The resilience demonstrated by the financial system and the economy reaffirms the notion that something different is afoot this time, with factors such as the privatization of risk and government debt powers playing a role in mitigating potential fallout.
How has the privatization of risk through non-bank lending affected the potential for financial contagion compared to past financial crises?
The privatization of risk through non-bank lending has had a significant impact on the potential for financial contagion compared to past financial crises. In the past, when financing was more publicly visible, problems in one area, such as tech stocks or subprime mortgages, would quickly spread, causing wider contagion and ultimately damaging the economy. However, with the growth of private lending outside of public markets, problems that arise have less chance of causing contagion.
Non-bank lenders, such as pension funds, endowments, family offices, and ultra-wealthy individuals, have become more involved in lending to mid-size firms and large corporations. This type of lending is less transparent and less likely to cause a panic among investors, as missed interest payments are not public news headlines that could startle investors into herd-like behavior. Additionally, pension funds and insurance companies investing in private credit funds are less likely to ask for their money back suddenly, reducing the risk of a sudden stop in funding3.
However, the IMF has expressed concerns about the growth of private credit and its potential to become "macro-critical" and amplify negative shocks. There is also the risk of "layers of leverage" in the chain of investors, funds, and companies, which could lead to problems if the market experiences a downturn. While the privatization of risk through non-bank lending has reduced the potential for financial contagion in some ways, it has also created new risks and challenges that must be carefully monitored.