HS interview | Martti Hetemäki, an expert on economic crises, warns: The worst may be yet to come

The big ones risks are gnawing at the world economy again. Inflation is far too fast, and financial markets are shaken by the fear of another banking crisis.

Economists around the world are wondering where all this is going. The working life professor of economics has a lot of experience in handling international financial crises in Finland Martti in Hetemäki.

While working as undersecretary of state and chief of staff at the Ministry of Finance, Hetemäki participated in resolving the financial market crisis that escalated in 2008 and the euro crisis after that.

What does Hetemäki think now that inflation is faster than in decades and banks have collapsed in the United States and Europe?

“Especially in the United States, the authorities have resorted to very extensive measures to protect deposits and ensure the adequacy of banks’ collateral, which points to major problems in the banking system.”

Banks the problems and too fast inflation overlap in the sense that both are the responsibility of the central banks.

As a result of the long-lasting monetary stimulus of the central banks, households, companies and the government now have a lot of debt.

Due to large debt burdens, Hetemäki thinks there is a risk that central banks will not tighten monetary policy enough to tame inflation.

“Getting inflation under control is even more difficult due to high indebtedness. Aggressive tightening of monetary policy has its risks, but the longer inflation remains high, the harder it will be to tame it,” says Hetemäki.

Interest rate hikes by central banks have a wide-ranging effect on the economy.

When households’ debt servicing costs increase, they have to reduce their consumption. Companies, on the other hand, postpone their investments. Governments have to cut back on their spending, because an increasingly large part of their income goes to increased financing costs.

The danger is therefore a back lock of the economy. This raises the question of whether central banks should have tightened monetary policy more moderately last year. In Hetemäki’s opinion, it’s more about being late.

“Before and after the coronavirus pandemic, the monetary policy stimulus continued for too long. Now the war and geopolitical tensions increase the inflationary pressure, which causes disruptions in the supply chains.”

If the monetary stimulus had been abolished earlier, in his opinion, inflation would not necessarily have accelerated as much as last year. In that case, central banks might not have had to tighten monetary policy aggressively.

There is also another side to the matter.

Whereas rapid increases in key interest rates often cause problems, calmer interest rate increases last year would probably also have caused great financial distress.

Inflation would have accelerated faster than it is now. As a result, real household incomes would probably have collapsed and inflation expectations would have risen more.

Monetary policy extortion is also organically connected to the banks’ difficulties, even though it may sound peculiar.

Generally, an increase in interest rates improves the profitability of banks, because their net interest income increases.

“Now the inversion of the yield curve, i.e. the rise of short-term interest rates higher than long-term interest rates, weakens banks’ profitability.”

Banks take out short-term loans, the interest rates of which are regulated by the central bank through monetary policy. Similarly, banks typically grant long loans, whose interest rates should be higher because the risks are higher.

In the past, the inversion of the yield curve has almost always preceded a recession in the United States and the euro area. In other words, investors are expecting a recession, but it is not in sight in the key economic forecasts.

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“When they get into a tight spot, they [pankit] know that the central bank will come to the rescue again.”

Stateside the rise in long-term interest rates particularly damaged Silicon Valley Bank. It invested the deposits it received from customers in long-term federal government bonds, but recorded them on the balance sheet at nominal value.

When the central bank has raised its key interest rate nine times within a year in order to fight inflation, the prices of federal bonds have fallen significantly.

Due to the flight of deposits, Silicon Valley Bank had to sell bonds at a significantly lower price than they were recorded on the balance sheet. The problem was particularly bad because the bank had not bought an interest rate hedge.

In Hetemäki’s opinion, the failure of Silicon Valley Bank’s risk management may partly return to the question of the prolonged monetary policy stimulus.

Professor of Economics at the University of Chicago Raghuram Rajan and his colleagues have found that banks continued to grant loans liberally and take risks even after the US central bank started to tighten monetary policy.

“It’s a good question why the banks increased their risk-taking even when financial conditions were tightening. One answer is that when the going gets tough, they know the central bank will come to the rescue again.”

And that’s exactly what happened in March with Silicon Valley Bank and Signature Bank. The Ministry of Finance, the Deposit Protection Fund and the Central Bank announced that the deposits of the failed banks will be fully guaranteed.

At the same time, the central bank said it would accept federal bonds as collateral for emergency loans offered to banks at their full face value.

Under normal circumstances, central banks accept bonds as collateral at their market value, and the value of the collateral must be greater than the loan.

“The fact that the central bank has repeatedly had to support the financial system in different ways since the financial crisis is not a good thing, because it increases the problem of morale loss.”

Moral lapse means pursuing one’s own interest or taking an unreasonable risk when one is not responsible for it.

Hetemäki says that he follows with interest how the actions of the US authorities affect Europe. Governor of the US Federal Reserve Jerome Powell said in March that all deposits are secured. That was saying a lot.

“Once all deposits are secured in the US, the competitiveness of the European banking system will weaken. In Europe, the pressure for similar measures is increasing so that banks do not lose deposits to the United States.”

However, this would not remove the root cause of the current problems. That is, the contradiction between securing banks’ funding and their excessive risk-taking.

“If, for example, monetary policy suddenly has to be tightened a lot, the disturbances in the banking system will become more serious. In this case, the position of the central bank as the last financier of banks is emphasized. In a certain way, the balance sheets of commercial banks and central banks are closer to each other because of this.”

One an oft-repeated question is how banks’ risk-taking could be reduced in order to avoid disruptions and crises in the financial markets. The answer is simple: not really without jeopardizing the banks’ ability to finance households and businesses on tolerable terms.

Instead, the authorities that supervise banks should be on the lookout for Hetemäki. Solvency is an important measure, but it alone is not enough.

“The International Monetary Fund [IMF] based on studies, the market value in relation to the bank’s book value was a better warning of the financial crisis than the solvency. Also at Silicon Valley Bank, the depreciation of the market value in relation to the book value alerted the bank to difficulties and only later solvency.”

The market value is calculated by multiplying the share price by their number. Book value means the value of the assets, from which the liabilities have been deducted.

According to Hetemäki, if you look at market value in relation to book value, US banks are in better shape than European banks.

“This is a good indicator in the sense that the market value of a bank with a credible business model should be clearly higher than the book value.”

That is, if the bank has taken too much risk or its business model is unreliable, it will be reflected in the market value. If other banks and investors lose confidence in a certain bank, its business model is not sustainable.

The operation of banks is based on trust for a very long time.

Time from time to time it is suggested as a cure for bank failures that they have as many high-quality, quickly convertible securities on their balance sheets as deposits. Hetemäki is not excited about this.

“In that case, banks’ opportunities to finance households and companies would be much weaker, because their business model would not be profitable. The market value of banks in relation to the book value would weaken and financing costs would rise.”

Hetemäki thought that the solution model for banking crises might have been better in the past. After all, the banks saved each other.

In the 19th century, there were regional bank confederations in the United States. They issued bonds that saved the troubled bank and later merged with other banks. Economist Bengt Holmström has drawn attention to the advantages of this model.

“At this point, every bank has an incentive to act responsibly, because the banks know that bailing out means the end of them. On the other hand, there were many banking crises in the 19th century and the unions did not manage to prevent them, but the crises were smaller,” says Hetemäki.

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“The more central banks bear commercial banks’ risks, the more commercial banks take on risk.”

In order to prevent banking crises, the Bank of Banks was established in 1913, i.e. the US Federal Reserve. It became the financier of last resort for banks, which can finance banks even before the problems progress into a crisis. At the same time, this has created the problem of loss of morale in banks.

In Hetemäki’s opinion, at least theoretically, it would be worth considering such a system from the 19th century, where banks save each other.

“The big question is whether it would be possible to reduce the moral hazard in a controlled manner by turning the clock back in time, increasing the mutual responsibility of the banks and reducing the responsibility of the central bank.”

Returning to the past might have another good side.

“Before, there was not such a big conflict between the central bank’s control of inflation and securing financial stability. The more central banks bear the risks of commercial banks, the more risk commercial banks take. Rescuing the banks may require actions that conflict with the fight against inflation.”

It is also known from the past that disturbances in the US financial markets are almost invariably reflected in the rest of the world. As the old saying goes, when the US economy sneezes, the world economy catches a cold.

“The economic cycle of the United States and the actions of the central bank are usually widely reflected in the economy in different parts of the world.”