The Silicon Valley Bank Collapse And The Business Cycle
Written by Dr Carmelo Ferlito, CEO, Center for Market Education, Sergio Maria Calzolari, Affiliate, Center for Market Education
First published in Business Today on 15 March 2023
Silicon Valley Bank (SVB) collapse seems to have little to say to economists, and, in turn, economists seem to have little to say about it; the situation recalls what happened with the Great Recession in 2008. Some of the readers could maybe recall that on November 4, 2008, Queen Elizabeth visited the London School of Economics and, while she was given an explanation of the origins and effects of the global financial crisis, at the end of the briefing she asked one question: “Why did nobody notice it?”.
It seems to us that three phenomena are correlated: the gradually declining interest, in economic theory, for explaining the business cycles, the obviously consequent inability to see and interpret them, and their growing frequency.
It is no mystery that, after World War 2, mainstream economic science grew passionate about the study of static equilibria, abandoning the interest in economic fluctuations which was central instead during the years between the two wars and culminated with John Maynard Keynes’s General Theory (1946). The subject of the crisis experienced by economics as a scientific discipline and its teaching is not new; however, economics remains under the spotlight for its inability to understand and interpret the real economic world. Furthermore, so-called heterodox economists have often criticized mainstream economics on a pro-planning and anti-market basis (ideological ground), rather than with regard to the actual theoretical edifice; in fact, as pointed out by Geoffrey M. Hodgson, the neoclassical core of mainstream economics has been used to support socialism as well as capitalism. In a nutshell, different policy recipes did not reflect substantial theoretical differences.
What is happening with Silicon Valley Bank and other financial institutions calls for the re-discovery of those theoretical approaches which tried to link economic development, innovations and the financial system as the three key elements for a comprehensive understanding of the cyclical nature of the capitalist dynamics; the mind goes to Joseph A. Schumpeter and his student Hyman P. Minsky.
Why do business cycles matter in the realm of the present reflection? In his seminal work on innovation and entrepreneurship, published more than a century ago, Schumpeter explained that economic development happens when special human beings called entrepreneurs create innovations, but he was adding that such innovations cannot happen without the creation of purchasing power by banks; the banker, thus, does not exchange purchasing power, it creates it ex nihilo, characterizing himself as the ephor of the exchange economy. The financing of innovations and the entrepreneurial imitative process generates in turn a boom-and-bust cycle.
Hyman Minsky, a student of Schumpeter, further developed such an approach, shifting the focus from the disruptive role of entrepreneurial innovation toward the risks implied in the financialization of the economy. Following Joan Robinson’s Economic Heresies (1971), Minsky (Stabilizing an Unstable Economy, 1986) explained that, in the economic cycle, there are periods in which rapid disruptive changes are not taking place and they can be called periods of tranquility; however, «tranquility is disrupted by investment booms, accelerating inflations, financial and monetary crises, and debt deflations».
When emphasizing the role of financial innovations, Minsky explained that «during periods of tranquil expansion, profit-seeking institutions invent and reinvent “new” forms of money, substitutes for money in portfolios, and financing techniques for various types of activity: financial innovation is a characteristic of our economy in good times».
However, available new money will introduce additional demand for capital and financial assets, or for more investment, and this results in higher asset prices, which in turn raises the demand price for current investment. In a nutshell, financial innovation «tends to induce capital gains, increase investment, and increase profits: the economy will try to expand beyond any tranquil full-employment state».
During the boom following a tranquility period, thus, innovative debt practices and speculative excesses are encouraged and an unrecognized system fragility evolved. This explanation does not contradict, but rather it complements, the Schumpeterian original vision according to which the overheating of the economy is due to imitative entrepreneurial processes, which means second-wave entrepreneurs that try to benefit from a general positive climate surrounding an innovation; in fact, without the creation of credit and financial innovations, those imitative processes could not happen.
Minsky’s scenario, called Minsky’s financial instability hypothesis, is becoming more common in the present capitalistic dynamics and it can be used to explain, for an example, the 2008 financial crisis, as done by Axel Leijonhufvud in 2009.
Our reasoning brings us to two main conclusions. One is that economic theory does possess the tools to understand the current financial turmoil, which is indeed a mix of entrepreneurial and financial innovations. However, economics needs to rediscover the importance of pure theory, shaped by the observation of reality, moving away from its condition of second-grade statistics which has today become.
Second: the financialization of the economy is an issue that enormously grew with the ruling and unchallenged system of fiat money (this is visible in Malaysia, for an example, in the high share of household debt over the GDP). A new monetary system is very much needed for preserving the value of money over time and to reduce the gap between the real economy and the financial economy: today the first is too much of a victim of the second.
With the fall of Bretton Woods, the value of our savings has fallen victim to financial turbulence and central banks’ monetary manipulations. At the same time, industrial investments became gradually less attractive when compared to speculative initiatives. Potential alternatives are present in the theoretical debate: free banking, competition among currencies, a new crypto-based standard, and the elimination of fractional-reserve banking. It is time to discuss these alternatives more seriously.