Unexpected Shocks Often Lead to Recession

With the Federal Reserve in the midst of raising interest rates, there is the risk that higher rates could slow the economy abruptly and push the economy into recession.  Higher interest rates often reveal hidden weaknesses within the financial system, especially after a period of easy money or increased financial sector deregulation.  However, it is usually an unexpected shock to the financial system that triggers the recession. 

Over the past 50 years, it was usually an unexpected blow to an already weakening economy that caused the recession.  For example, in the early 1980s, the Fed aggressively raised interest rates to combat soaring inflation.  That helped trigger the collapse of Continental Illinois National Bank & Trust, then the seventh-largest commercial bank in the U.S., and pushed the economy into recession.  It remains to be seen if the collapse of Silicon Valley Bank is the catalyst that pushes the U.S. into recession.

History has shown that over-leveraged sectors of the economy, investment funds with heavily concentrated exposure, or banks with too much risk get exposed as interest rates increase. In 2001, the bursting of the dot-com bubble set off a recession.  Then in 2008, an over-leveraged housing sector sparked the collapse of Bear Stearns and Lehman Brothers.  In each case, a rapid series of events turned wariness over slowing growth into fears of what could happen next.  That prompted investors and lenders across the economy to withdraw to safety and caused consumers to retrench and employers to begin cutting payrolls.

When confidence in the economy takes a sudden downturn, unemployment tends to rise sharply.  The U.S. jobless rate in 2009 jumped to 10% from only 4.4% in mid-2007 because of the fallout from the global financial crisis. Even during the mild recession in 2001, unemployment rose from 3.9% in 2001 to 6.3% in mid-2003.  The collapse this month of SVB Financial Group, Signature Bank of New York, and Silvergate Bank were heavily concentrated in technology companies.  The technology sector expanded too rapidly during the pandemic and is already cutting workers, even as the rest of the economy continues to add jobs.

All three banks that collapsed this month had made significant purchases of long-term U.S. Treasuries and mortgage-backed securities that plummeted in value as interest rates rose.  Concerns have risen that other lenders are similarly exposed.  That prompted U.S. agencies on Sunday to guarantee all uninsured deposits.  But Capital Economics said, “this is not a Lehman moment, and if the crisis ends tomorrow, it is not going to be the event that causes the U.S. economy to fall into recession.”  Also, Bloomberg Intelligence said it’s “reasonably confident” that the risk of contagion will be stamped out and this event won’t prove to be one that triggers a recession.  “But, it’s hard to be totally certain of anything once a crack has appeared in the façade.”

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