Craig Alexander has served as chief economist at Deloitte Canada, the Conference Board of Canada and Toronto-Dominion Bank.
Given recent financial developments, it is worth remembering that history repeats but never exactly the same way. The failure of three U.S. banks and a crisis at a European bank are very reminiscent of the events in the early stages of the 2008 financial crisis and subsequent deep recession. The problems in 2008 were triggered by U.S. Federal Reserve interest rate hikes that, after some time, caused financial strains and a reassessment of risk that ultimately damaged the financial system. Sound familiar?
It is indeed important to take the right lessons from the prior crisis and understand the commonalities and differences between now and then because they will shape what is in store. However, this is not 2008, and the underlying financial vulnerabilities are not the same.
Financial shocks, such as the recent sharp increase in interest rates, are the catalyst for triggering a repricing of risk and financial assets – and this often causes an unwinding of any imbalances that have built up during the period of economic expansion. Prior to 2008, the United States had a dramatic housing boom that was supported by enormous household leverage financed through high-risk mortgage products that were being held on the balance sheets of many financial institutions. The imbalance was so large that the repricing of mortgage risk and mortgage-backed assets caused a financial system calamity.
Today, the dramatic rise in interest rates is still likely to be transformative. We have been living in a world where there was an assumption that interest rates would remain low forever, and many economic and financial decisions were shaped by this expectation. With inflation still hot, central banks will resist lowering interest rates. This sustained higher interest rate environment will alter credit flows and lead to an adjustment in the prices of many financial assets and lower demand for goods and services.
However, the impact of rising interest rates today are different. The underlying economic and financial imbalances of today are much less pronounced, implying the associated financial losses should be more manageable.
One lesson from 2008 is that financial institutions need to hold adequate capital to absorb any financial shock. After the 2008 bank crisis, there were concerted efforts to ensure that it never happened again. There were many regulatory changes, but the most basic lesson was that U.S. banks needed to hold more capital. A key reason Canadian banks avoided the financial pains of their international peers was that they held abundant capital – yes, there were other factors, but adequate capital was key to investor confidence. Then as today, Canada’s financial system is well capitalized. While time will tell, and even if some U.S. banks clearly do not hold an adequate capital buffer, I suspect that most do.
Another lesson from 2008 is that when there are financial strains, policy makers need to ensure banks have access to short-term funding, referred to as liquidity, to balance the books at the end of each day. This normally comes through lending between banks, but central banks must fill the gap when financial turmoil occurs. This is why policy makers today have been so quick to announce additional liquidity funding. Similarly, U.S. announcements of expanded deposit guarantees are aimed at fostering confidence. These announcements should not be interpreted as warning signals.
The end of the low-forever interest rate environment will certainly create some painful economic and financial adjustments. It started with weaker real estate markets and now we are seeing the impact on some bank balance sheets. This is likely only the start of the multifaceted fallout as it takes 12 to 18 months for central bank rate changes to have their full effect and we have only reached the one-year anniversary of the start of the Federal Reserve monetary policy tightening. The recent bank problems likely set the stage for tighter credit conditions in most major economies, and this will contribute to the coming economic slowdown and potential recession.
However, the bottom line is that just because something sounds familiar, it doesn’t mean that it is the same. The coming economic weakness will help to bring inflation down, which is the single greatest economic imbalance today, and the eventual adjustment to higher interest rates will create the necessary condition for the next upswing in economic growth.