By MICHAEL ROBERTS*

The dilemma of choosing between 'moral hazard' and 'liquidation'

As I write, US regional bank stock and bond prices are falling. And a large Swiss international bank, the Credit Suisse, is on the brink of bankruptcy. A financial crisis not seen since the 2008 global financial crisis appears to be unfolding. What will be the response of the monetary and financial authorities?

In 1928, then-Secretary of the Treasury and US banker Andrew Mellon pushed for higher interest rates to control inflation, and credit fueled speculation in the stock market. Under his bequest, the Federal Reserve Board began raising interest rates, and in August 1929 the Fed raised the rate to a new level. Just two months later, in October 1929, the New York Stock Exchange suffered its worst crash of its history on what was called “Black Tuesday”. Does history repeat itself, like old creative destruction or like a new episode of moral hazard?

In 1929, Andrew Mellon was undeterred. He advised then-President Hoover to “liquid off labor, sell off stocks, sell off farmers, sell off real estate . . . The high cost of living and the high quality of life will fall. People will work harder, live more moral lives. Values ​​will be adjusted and enterprising people will learn from less competent people”. Furthermore, he advocated the elimination of “weak” banks as a prerequisite, albeit a difficult but necessary one, for the recovery of the banking system. This “elimination” would be accomplished by refusing to lend money to banks (taking loans and other investments as collateral) and refusing to put more money into circulation. The Great Depression of the 1930s followed a major banking collapse.

In 2008, when the global financial meltdown unfolded, policymakers initially aimed at something similar. They allowed the investment bank Bear Stearns to fail. But then came another, Lehman Bros. The Federal Reserve hesitated, but finally decided not to bail it out with a credit bailout. What followed was a mighty crash in stocks and other financial assets and a deep recession, the Great Recession. Fed Chairman Ben Bernanke at the time was supposedly a scholar of the Great Depression of the 1930s, and yet he agreed to the bank's failure. He later acknowledged that, as “lender of last resort, the Fed's job was to prevent such collapses, particularly for banks that are 'too big to fail,' which would only spread collapses throughout the financial system.

It is now clear that governments and monetary authorities want to avoid a repeat of “settle, settle, settle” given the experience of the Lehmans crash – even if such a policy will clean up the 'dead wood' and 'rot from the system'.' for a new day. Politically, it would be disastrous for governments to allow another banking collapse; and economically, it would likely trigger a new, deep recession. Therefore, it is better to 'print more money' to bail out bank depositors and bondholders and avoid financial contagion – the banking system, as we know, is very interconnected.

That's what the authorities finally did in 2008-9, and that's what they'll do this time too. Authorities were initially uncertain about rescuing the Silicon Valley Bank. They quickly changed their minds after signs of nascent US bank runs. Interviews with authorities involved in or close to the discussions paint a picture of 72 frantic hours. O Credit Suisse it will also likely get similar financial support.

There are advocates of Andrew Mellon's approach today and they are still right. Ken Griffin, founder of a large hedge fund Citadel, told the Financial Times that the US government should not have intervened to protect all depositors of the Silicon Valley Bank. He continued: “The US was supposed to be a capitalist economy, and it is crumbling before our eyes… There has been a loss of financial discipline with the government bailing out depositors in full,” he added. We cannot have “moral hazard,” he said. "Losses for depositors would have been immaterial and would have made it clear that risk management is essential."

Moral hazard is a term used to describe when banks and companies consider that they can always get money or credit from somewhere, including the government. So if they make reckless speculations that go wrong, it doesn't matter. They will be helped. As Andrew Mellon might have said: it's immoral.

The other side of the argument is that banks that are in trouble must not mean that those who deposit their money in them must not lose it through no fault of their own. Therefore, governments must step in to save depositors. And they are also right. As another hedge fund billionaire, Bill Ackman, said when the collapse of the Silicon Valley Bank arose, the Federal Deposit Insurance Corporation must “explicitly guarantee all deposits now” because “our economy will not work nor will our community and regional banking system”.

Mark Cuban expressed frustration with the FDIC insurance limit that insures up to $250.000 in a bank account as being "too low"; he also insisted that the Federal Reserve buy all the assets and liabilities of the Silicon Valley Bank. Representative Eric Swalwell, a Democrat from California, joined the chorus, tweeting that "we must ensure that all deposits exceeding the FDIC's $250.000 limit are honored."

The irony here is that those demanding bailouts now are the very venture capitalists who are usually staunch advocates of “free markets and no government intervention”. Another bailout advocate is Sacks, a longtime associate of investor Peter Thiel, who is a fervent believer in 'free markets' and 'capitalism'. But it was Thiel's Founders' Fund that helped start the bank run that sank the Silicon Valley Bank in the first place.

FT columnist Martin Wolf explained the dilemma. “Banks fail. When they do, those who are losing cry out for a state bailout.” The dilemma is that “if the costs threatened are great enough, they will succeed. This is how, crisis after crisis, we created a banking sector that is private in theory, but in practice comes to be sustained and protected by the State. The latter, in turn, tries to curb the desire of shareholders and management to exploit the safety nets they enjoy. The result is a system that is essential to the functioning of the market economy but does not operate according to its rules”. So it's a moral hazard because the alternative is Armageddon. As Wolf concludes, "It's a big mess."

So what is the solution on offer to avoid these continual banking confusions? Liberal economist Joseph Stiglitz says that “the Silicon Valley Bank represents more than the failure of a single bank. It is emblematic of profound flaws in the conduct of regulatory and monetary policy. Like the 2008 crisis, it was predictable and foreseeable”. But having told us that regulation wasn't working, Stiglitz argues that what we need is tighter regulation! "We need tighter regulation to make sure all banks are safe." Well, how has it worked so far?

Nobody has anything to say about public ownership of banks; nothing about making banking a public service and not a vast sector of wild speculation for profit. O Silicon Valley Bank collapsed because its owners gambled on rising government bond prices and low interest rates to increase their profits. But the thing went off the rails and derailed. Now other banking customers will pay for it in increased fees and losses to the Federal Reserve – and there will be less productive investment funding to pay for yet another banking mess.

Now, I have to repeat here what I said 13 years ago: “The answer to avoiding another financial meltdown is not just more regulation (even if it hasn't been watered down like the Basel III rules). Bankers will find new ways to waste our money by gambling with it to make profits for their capitalist owners. In the 2008-9 financial crisis, it was the purchase of 'subprime mortgages' wrapped in weird financial packages called mortgage-backed securities and collateralised debt obligations, hidden on bank balance sheets, which nobody, including the banks, understood. Next time it will be something else. In the desperate pursuit of profit and greed, there are no Promethean limits to financial cheating.”

Let's go back to the dilemma of choosing between 'moral hazard' and 'liquidation'. As Mellon said, liquidating the losers, even if it means a recession, is a necessary process for capitalism. It is a process of 'creative destruction', as the 1930s economist Joseph Schumpeter described it. The liquidation and destruction of capital values ​​(along with mass unemployment) may lay the groundwork for a 'leaner and fitter' capitalism, capable of renewing itself for further exploitation and accumulation on the basis of greater profitability for those who survive The destruction.

But times have changed. It has become increasingly difficult for capital strategists, monetary authorities and governments to consider liquidation. Instead, 'moral hazard' is the only option to avoid a major crisis and political disaster for incumbent governments. But bailouts and a fresh sore of liquidity injections would not only completely reverse vain attempts by the monetary authorities to control the still high inflation rates. It also means continued low profitability, low investment and productivity growth in economies unable to escape their zombie state. Just continue down the long road depression that started in 1997.

*Michael Roberts is an economist. Author, among other books, of The Great Recession: A Marxist View.

Translation: Eleutério FS Prado.

Originally published on the website The next recession blog.

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