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Stock markets are falling, oil dropped to prices not seen since 2021 and gold is trending higher. The general symptoms that would be expected as a recession developed. The collapse of three banks in the US, and Credit Suisse not only once again dropped to record lows but had the largest drop in its stock price in history. It’s not surprising at all that the market is having jitters. The question is whether this is a passing issue, or can we expect the situation to get worse?
 

The contagion issue

There has been a lot of talk in the media about “contagion”. That implies that there is a problem in, say, SVB which passes on to other banks, causing them to have issues. And so on for a cascading effect. Regulators have come out to repeatedly assure the market that there isn’t any “contagion” risk.

The problem with this is that it could lead people to think that a company that doesn’t have investments in SVB (or any of the other banks in trouble), then it’s safe. There is no contact through which there could be contagion. While that certainly is a concern, it’s also possible for other banks or businesses to be in trouble without a direct link to one of the banks that recently went under.
 

Is it the tip of the iceberg or just a mirage?

Take Credit Suisse, for example; it is experiencing difficulties and isn’t related to SVB. However, it is operating in a similar environment. A prolonged period of low-interest rates led banks to build up a large amount of low-interest reserves that is now causing them unrealized losses when interest rates go up.

The problem isn’t necessarily “contagion”, but that other banks could be in a similar position, and SVB was just the first. Sort of a canary in the coal mine scenario. Ultimately, the problem that the three banks that just went under had – and increasingly Credit Suisse has – is difficulty accessing liquidity. Tight liquidity means they are forced to sell assets at a discount, pushing down the value of those assets. If enough institutions find themselves in that position, then the whole market goes down in a crash.
 

It’s now down to monetary policy

If other institutions don’t end up having a liquidity problem, or their central bank provides liquidity, then SVB might just be a hiccup in an otherwise steady market. The focus, therefore, turns to what the central banks will do. Until now, they’ve been pushing rates higher to get inflation down. But the current crisis could lead to putting an end to that, which could allow inflation to start rising.

Until recently, the fear of inflation was that it would cause central banks to raise rates and slow the economy. But if central banks don’t raise rates, inflation can still be a problem, since the erosion of purchasing power can lead to demand destruction. So far, central banks have been relieved that there has been no wage-price spiral because wages have increased less than inflation has. That’s fine if inflation is transitory. But central banks give up on fighting inflation, and wages don’t keep up with prices, then there could be an extended economic slump instead of a crash.

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