Can Joe Biden escape the fallout from the US banking crisis? | Banking

Economic point of view

If the president isn’t worried about re-election prospects after one of the biggest economic bubbles in 100 years, he should be

There’s nothing to see here, so please move on. That was the message from the White House to those who fear that the collapse of three US banks in as many months could spell serious trouble for the world’s largest economy.

Joe Biden is right, although the line that the US financial system is fundamentally sound has become harder to maintain as it becomes clear that Silicon Valley Bank was not an isolated bank. The US economy has slowed but continues to grow. Jobs are still being created. The unemployment rate is low at 3.4%. Manufacturing companies are heading to the United States to take advantage of the green subsidies contained in Biden’s Inflation Cut Act.

The idea is that nothing that has happened so far – let alone the collapse of a small number of regional US banks – should come as a surprise. Indeed, what is surprising is the good performance of the American economy. The United States will emerge relatively unscathed, as it always does. What to worry about?

A lot, in this case. The United States has just witnessed one of the biggest bubbles of the last 100 years. This was followed by the fastest rise in interest rates in four decades, which took official borrowing costs from near zero to over 5% in just over a year. If Biden isn’t worried about the implications of this for his re-election prospects in November 2024, then he should be. Things could go wrong very quickly, for the economy and for the president personally.

Under these circumstances, it will be almost miraculous if the Federal Reserve – the US central bank – manages to fine-tune a soft landing for the economy. Wall Street expects interest rates to start falling in July and to just over 4% by the end of 2023, but markets are getting ahead. Job growth is slowing, but that won’t be enough to convince the Fed to start cutting rates. For that to happen, many more banks would have to start failing.

It’s entirely possible. The longer rates stay high, the harder life becomes for vulnerable banks. These financially healthier institutions will limit the flow of new credit to businesses and individuals. Inflation will be squeezed out of the economy, but at a high cost. The Fed will eventually cut interest rates aggressively, but by then it will be too late to avoid a hard landing.

To a large extent, this will be a recession of the central bank’s own initiative. At the end of 2021, asset prices were booming in the United States. Stocks, residential real estate, bonds, cryptocurrencies: all were part of a buying mania. With some justification, it’s been dubbed the “everything bubble.”

For students of economic history, there were distinct similarities between the frenzy of the US economy’s exit from the Covid pandemic and previous bubbles: the rise of the Wall Street crash of 1929, the stock boom and real estate in Japan in the late 1980s; the dotcom implosion of 2000 and the global financial crisis of 2008.

There was a key difference, however. The previous four bubbles had all occurred at the peak of economic cycles, when the strength of the underlying economy provided some justification for financial market optimism. The “everything” bubble was not like that. Asset prices – lubricated by vast amounts of cheap Fed money – have soared, but the real economy has not.

So, as you might expect, asset prices were the first to suffer when the Fed began to tighten policy early last year. The first phase of the bubble unwind involved house, bond and stock prices all of which suffered in 2022. In the second phase, the focus shifted to banks caught up in the unexpected and rapid rise in interest rate. Phase three, which has only just begun, is when the real economy will really start to suffer. By the time unemployment begins to rise, the recession will already be underway. Some economists believe this is already the case.

The bursting of two of America’s previous mega-bubbles – in 1929 and 2008 – had long-lasting and profound consequences. It took the military spending of World War II to end the Great Depression, while the impact of the crash of 2008 is still being felt 15 years later.

The fallout from the other two bubbles – Japan in 1989 and the end of the internet stock mania – were not so severe but still painful. Japan suffered a lost decade in the 1990s and the US economy suffered a brief recession after the dotcom collapse.

Even if it’s not the equivalent of 1929 or 2008 (and the signs so far are that it isn’t), Biden could still be in political trouble. It would be unusual for a bubble as large as the one that peaked in late 2021 to deflate without more collateral damage than has been observed so far.

Only three sitting US presidents who have sought re-election since World War II after serving a full first term have failed to win a second: Donald Trump in 2020, George Bush senior in 1992 and Jimmy Carter in 1980 .battle because of a struggling economy. In Carter’s case, there was a double-dip recession after the Fed – under legendary inflation hawk Paul Volcker – raised interest rates, cut them before inflation was totally gone. subdued, then picked them up again. The Fed will no doubt want to avoid a repeat performance, and since its chairman, Jerome Powell, has admitted he doesn’t know of any painless way to bring inflation down, the question is how tough the recession will be. and how soon it will be over.