 Hi welcome to the reason live stream. I'm Zach Weissmuller and today We're gonna be talking about the recent collapse of the Silicon Valley Bank of Silicon Valley Bank and the subsequent Interventions from the FDIC Also a couple, you know other bank failures that are relevant We'll be talking about and I'm joined by two very knowledgeable guests who help walk me through And walk us through what exactly happened First we've got Arnold Kling an economist a senior scholar with the Mercatus Center He worked in the Federal Reserve System and for Freddie Mac. He writes a Great blog called in my tribe a substack that I am a subscriber to Welcome Arnold to the reason live stream. Good to see you Hi Zach and I'm also joined today by Lynn Alden of Lynn founder of Lynn Alden Investment Strategies and author of the strategic investment newsletter, which is a free Investment advice newsletter Lynn. Thank you for joining us as well. Thanks for having me happy to be here So to start the conversation, you know, there's a few competing Explanations out there of what exactly happened here with Silicon Valley Bank in particular You know, who's to blame? Why did it happen and I think the best place to start is just the basic question of you know What happened? I think most people understand the concept of a bank run People get nervous want to take their money out the money's not literally there in the vault but what is the reason that there was a bank run Arnold in in you know, if you had to boil it down What happens to Silicon Valley Bank? Okay, so the story I think goes like this. This is you know, I've not been in the bank. I'm not a bank examiner I'm not a bank auditor. I only know what I read in the papers. So what I read is Their deposits shot up between 20 early 2020 and early 2022 Silicon they their customers were Silicon Valley startups startups were just getting flooded with money. They hadn't spent it yet They deposit it with the bank and then they would use it over time to make payroll and what have you? Then and so what what do you do with all that money? Well, they said that will be sort of conservative with it We're going to invest it in Treasury securities, but short-term Treasury securities hardly pay anything Long-term Treasury securities pay let's say between one and a half and two percent. So we'll we'll go for that Then 2022 comes along we get inflation is Inflation fighting is the new thing at the Fed and Long-term rates are no longer at two percent. They're more like four percent What that does to the value of a two percent bond when rates are four percent is it roughly cuts it in half? So their bonds weren't worth much or worth weren't was worth as much as when they bought them then as I understand it the as the Silicon Valley tech boom falters the Deposits start to dwindle and now the bank has to do something to Deal with the deposit outflow. How's it going to pay its customers? So it hey if it sells the bonds it has to sell them at a loss if it sells them at a loss It kind of looks bad So it's pretty reluctant to do it, but I think they ended up having to do it and then the old story of You know, I went bankrupt in two ways slowly then suddenly and the suddenly happened a few weeks ago the depositors these tech firms that had deposits were in the position of having very very large bank deposits and the federal the insurance limit up until last week was $250,000 for a deposit and they might have you know two million in deposits So now they think they could lose quite a bit if there's something wrong with the bank They're hearing that there's something wrong with the bank So what do you do you go and you say I'm going to take my excess out of the bank and put it somewhere else Where it'll be safer and enough people do that and like to the tune of like 40 billion dollars And the and the bank is just in no position to meet that Yeah, no, thank you for that and I just want to invite Lynn to You know add anything to that explanation that you think is relevant. I did you know, there's this this chart here that shows the This is kind of the banking system as a whole to the point that that Arnold was Raising there about this, you know, the bank buying up a lot of bonds that then became less valuable you see the the amount of cash and treasuries as a total percentage of bank assets across all commercial banks and You see a spike there, but let me just invite Lynn to you know modify add or you know fully agree with that explanation Well, I think it was a great explanation a couple details I think I could add is that you know bank deposits across the country went up pretty significantly in 2020 and 2021 because of the stimulus be a You know big increase in the money supply But some banks got more deposits than others because they were more like a hot area So for example Silicon Valley bank any bigger rise in its deposits than the typical bank because tech startups were a very big You know thing in that period And they did invest in those long duration assets So what makes it we know where that that chart you just pulled up that shows how it's very different in 2008 because 2008 The problem was that so many banks made bad loans And they had very little exposure to cash and treasuries which are considered some of their safer assets Uh, and they were instead were heavily involved in in subprime mortgage and a lot of those defaulted This time it shows that the in some ways. It's the opposite problem. They hold very very safe assets It's just that the prices of those assets Um went against them and in silicon valley's case. They made a very big bet on duration So banks had to invest their deposits their new deposits somewhere And there's some banks like j.p. Morgan that were conservative and they mostly kept in short duration types of assets Whereas silicon valley bank made a very big bet on those longer duration assets And so if you if you look at banks across the board silicon valley bank had unrealized losses on their on their securities that that, you know, roughly equaled their total capital Meaning that if they if they had to have a bank run and have to sell those assets for a loss Uh, you know, depositors might not get every every dollar back And you know, the thing is if they can hold those assets to maturity, um, you know Some of them are can't default other ones have a very very low default risk But if they get their their deposit funding pulled and they have to sell it a loss Then they basically, you know, that gets marked a market and they have a problem And the the last point i'll make is that um, you know, because fdic ensures deposits up to 250,000 You know a typical bank that just has a lot of retail deposits That's a pretty solid deposit base because people are not going to freak out too much if they if they think their bank has a problem Whereas the issue of silicon valley bank is it they had an higher than normal percentage of uninsured deposits And that's because most of their depositors were businesses. So there are some businesses that would hold even tens of millions of dollars in an account You know, the average deposit was not that big, but they you know, they could be half a million could be a million could be a million and a half It could be five million Um, and so if they perceive that combination of high unrealized losses Which silicon valley bank had more of than normal and they have the combination of mostly uninsured deposits Which which again silicon valley bank was a standout Then that's a prime target for a bank run because people have a greater incentive to pull out and then it causes the problem So the it raises the question of which you've already kind of answered of why was Why was so much of their money in these bonds? Um, and One, uh, person who's been very vocal about this, uh, I just pulled up his tweet is belaji srinivasan um, uh who we've had on the show before and He says he he points the finger directly at the fed for Causing this problem. He says hey remember when Powell said that he wouldn't raise rates in april june july in october 2021 and people trusted him and the fed And bought bonds with billions in customer deposits because of those assurances Well, they got wrecked and that's how the fed caused this crisis and he points to this concept of forward guidance Where that, you know, the fed sends out these signals of what they're going to do The part I have highlighted here says when central banks provide forward guidance individuals and businesses will use this information In making decisions about spending and investments Um, what is your what what do you think about, uh, arnold, uh, what belaji is the argument that he's making there? Um, I don't think that's the most Interesting or useful case to make against the fed Um, so let me back up a little bit. We've been talking about government bonds as risk-free, but there are two dimensions of risk there's, uh You know and and lin mentioned both of them one of them is credit risk Which means it's a default and let's assume that there's no credit risk from um From government bonds that that's that's that's that's your standard assumption I won't depart from it But there is this duration risk or interest rate risk as if if you buy a long-term government bond And rates go up the value of your bond declines so, um You're taking you're taking interest rate risk Regardless of what powell says. I mean anyone who says that You know powell can keep interest rates low forever for as long as he wants Uh, doesn't understand finance and so I I'm not going to excuse anybody No, no one if someone came to court You know and said, you know, I plead innocent. I listened to powell You know, no one's good. I wouldn't accept that no no one in finance would accept that But let's back up a little bit Um, I mean gosh, there's so much financial history we could discuss I mean, I I think in a lot of ways this is a complete rerun of the savings and loan crisis of the 1980s And a lot of my perspective comes from that being an being old enough to have been a kind of An active observer of that um I don't want to go back that far right now. Let's just go back to 2008 So the government decides to run big deficits And the federal reserve decides to do this thing called quantitative easing Which and what quantitative easing consists of is the fed doing what svb did I want you to hear that the fed Starts issuing short-term liabilities Uh called paying interest on reserves And it buys long-term assets including mortgage back securities and long-term government bonds At the time that was we were told that was a temporary thing To deal with the recession that followed the financial crisis It never stopped And then in 2020 the pandemic hits the government blows out Even bigger deficits And we have even more quote quantitative easing and they come up with even a new tactic Called reverse repo. I won't explain how that works, but it's another way where the fed is borrowing short and lending long As we speak The fed is the most bankrupt bank in the country You know, they're they're not going to collapse They can always take more money from the treasury, but that is just that's just the reality They they're in the position of svb In terms of you know, the market value of their portfolio um, so I think you know when you go so You know, I think the process by which svb went down is as I described it When you talk about blame, then you have to talk about who could have done differently And you know, a lot of people would say I think this is really strange, but a lot of people would say that the uh venture backed Firms should have behaved differently They'll say well, they shouldn't have put You know five million dollars in deposit At this one bank they should have spread their deposits around they shouldn't have put the money in And I've also heard the sort of the opposite which is they shouldn't have all taken their money out Uh a couple weeks ago. They should have left it in so they shouldn't have put as much in when they thought the bank was Solving and they shouldn't have taken as much out when they thought the bank was in trouble So that's you know, okay It's probably true that if they hadn't done those things we wouldn't have had this bank run But that kind of blame I don't fit The blame that I think I'm inclined to is to go all the way back to that deficit spending and the quantitative easing There you're really putting the whole country at risk There's no, you know, it did it does not end well It it leads to the inflation the inflation leads to the high interest rates The high interest rates bankrupt a bunch of companies including And a huge portion of the banking system I think there's something like still 600 billion dollars of embedded losses in the in all the banks And only about two trillion in equity. So they've lost about a third of their equity um So all that I trace back to the loose deficit spending and the quantitative easing Lynn i'm interested in this concept of That arnold mentioned in a answer of the fed being broke and that having You know that can having a contributory effect here and and you In one of your recent newsletters wrote about that exact issue And and claimed that that the fed is broke Uh, you you had embedded this chart here Showing basic. Well, I'll let you explain, you know, what this is But it's showing in my understanding that The money going from the there is no money now flowing from the federal reserve Into the treasury. So could you give us an explanation of what the situation with the fed is right now and how it's different from you know You know anything in our our memory of of what's been going on with the fed Sure, the federal reserve, you know as arnold pointed out does have a similar problem to a lot of these banks with the key difference being that They can't do a bank run on the central bank And so basically it's it's in a position where You know, they've raised their liability side Interest rates much higher Compared to their asset side, which were longer duration fixed rate assets And so you know for most of the fed history, you know, their liabilities are things like banknotes which don't pay any interest bank reserves And reverse repose and then their asset side is mostly treasuries and mortgage backed securities And those are longer duration assets. And so for most of fed history for decades Um, you know, their assets pay a higher average interest rate than their liabilities And so they they make a profit they cover their expenses and then they send the remaining to the treasury as a remittance Um, whereas what we've seen since september of last year was that because they raised their interest rates side so quickly Now their liabilities are paying a higher interest rate than their assets It's actually worse than most banks because most banks, you know, if look at their deposit rates, they're nowhere near as high as current interest rates Whereas the feds are so actually the fed is operating on a loss and it has something like a trillion dollars in unrealized losses with a key difference being that, you know You know, those like that liability side can't go anywhere. It can't get rapidly pulled down The the main kind of downside from that is that the treasury is no longer getting their remittances anymore And even if the fed would become profitable in the future, they still get to pay themselves back Uh before they would resume those remittances So it's basically contributing to the the fiscal budget deficit And if we go back to the prior question of, you know, who's to blame here You know, a lot of you see a lot of people say just blaming the fed or just blaming that bank And it's just kind of a mix of a lot of factors because the federal reserve Did create a very difficult operating environment when you have say rapid increase in the amount of broad money supply Very low interest rates and you know when asked about the rapid increase in the broad money supply The the federal reserve chairman said he didn't really see this being inflationary Then of course it was inflationary and then they you know, they had they had to pivot their whole monetary policy They raised rates. They also sucked liquidity back out of the the banking system And so basically banks are undergoing this gigantic whipsaw That is just a difficult operating environment to work through but then of course some banks manage that risk better than others So there there are banks that manage their duration risk Very well, and they also choose their depositors I mean, it's a choice for silicon valley bank to go after those big business depositors that are that are more of a flight risk And it was their choice to invest almost exclusively in long duration assets Which have bigger price swings and so it's certainly the case that that bank made severe errors of judgment in terms of risk management But it's also the case is just across the banking sector It is just a more challenging environment to operate in when you have kind of record swings in interest rates and You know just overall cash in the system So if the governments federal governments, you know deficit spending policies and and the treasury's money printing and the federal reserves interventions have created this whipsaw and You know, certainly let's at least say poured fuel on the fire here and and You know created a level of uncertainty you know the the argument that you were hearing from a lot of the proponents of Of bailing out the depositors above that 250,000 minimum Beyond we can get to what we'll get to the you know systemic issue later But you know one argument that they that I heard being made was basically the government created this situation and so it is kind of their responsibility to swoop in and Cover those uninsured deposits Um Do you buy do either of you buy that particular argument? well I think that You know from the standpoint of march They had to do it. I mean, you know, you know, you could You know, this is one of those situations where if they don't do it, uh, you know, you can you know Get your apple cart and take it out on the street and that's how you're going to make your money going forward I mean, you're gonna have you could have really drastic consequences However, what is going to happen going forward is um, I mean what you think of You can think of any kind of deposit insurance or government guarantee is a subsidy from the government to the banks Subsidies don't come free The tax that pays for the subsidy Is going to be regulation and and there has to be the these banks are what I call zombie banks That is they have negative net worth the only way that Uh executives and shareholders can come out out of it really well Is if they go out and take big gambles and they pay off and if those gambles don't pay off It'll be on us the taxpayers to pay for it So That has to be regulated. They're going to be put in a straight jacket So we are going to have you know, we don't see it immediately But we're going to have over the next few months the next several years a much more regulated banking system Uh, I think somebody I read somewhere. Uh, I guess this was robert altman a former treasury secretary saying we've we've We've basically nationalized the banks and that's one way to think about it. We the the the private sector financial The private part of the financial sector has just shrunk dramatically And the regulated part of the financial sector has just Gone up dramatically and we'll just we'll see that over the next several months and years to Follow up on that. Could you explain a little bit more what you mean by the phrase zombie banks? Uh, it's just a bank where if you marked all of its assets and liabilities To market or if you just said all right today You just have to sell all your assets and pay off your depositors, you know liquidate the bank Uh, if you tried to liquidate the bank you would not end up Uh with any any equity anything left for the shareholders and executives So this and I called is it's called a zombie. It's not really my term It goes back to the savings and loan crisis when the savings and loans Were given the opportunity to keep going even though that they were they were insolvent they went nuts they bought junk bonds they bought commercial real estate And as uh one economist pointed out what what what the zombie banks would Savings and loans would do is they would pay higher interest rates Because they were so desperate to kind of You know keep gambling and they would buy weaker Uh invest in weaker loans and what does that do to a healthy? Bank or savings and loan well now they're you know, their Ability to compete has gone away. So these zombies are really dangerous And that's why There will be just justifiably Very tight regulations another You know another villain that's been blamed I guess, uh, and this is coming from the highest echelons of government including Biden himself is the concept or is deregulation basically that Back during the trump era Uh, the the the assets Mix that the big banks had to hold did not apply to the smaller and mid-sized banks And we're going to just play a clip of biden here in a second talking about The role that he thinks that played and I'd like to get both of your response to the idea that um deregulation Um weakening Dodd franc is what led to this problem. Um adam could you play that clip? During the obama-biden administration We put in place tough requirements on banks Like silicon valley bank and signature bank Including the dodd franc law to make sure that the crisis we saw in 2008 would not happen again unfortunately The last administration rolled back some of these requirements I'm going to ask congress and the banking regulators to strengthen the rules for banks To make it less likely this kind of bank failure would happen again Uh Lynn do you have any thoughts as to whether because that that goes to the question of you know the types of assets that the banks are holding To make them more resilient against bank runs. Do you think uh, biden has a point there? But I think one of the issues is that the types of assets that cause this this particular banking problem We're not the same types of assets that caused the 2008 crisis for the most part. Those were more credit problems These are more duration problems And so some of the regular a lot of the regulations put in place during that time Were more meant for that that prior type of problem It's also pointing out that you know that you mentioned the dodd franc, uh bill Frank was on the board of directors of signature bank, uh, which which is one of the ones that was taken down And so and a lot of it shows that It's kind of a different set of problems they're dealing with. I mean ultimately at the end of the day It's still the same thing of trying to keep your assets higher than your liabilities But there's different ways that your assets or liabilities can fall You know can change and so some of the regulations were basically not the same types of regulations that would have prevented this Um, I think basically this this would have been mitigated by say if they were if banks are either required to or just on their own You know if they want to manage risk better just not take as much duration of risk in addition to not taking as much credit risk So a lot of the prior regulations were focused around limiting how much credit risk Uh banks can take And uh, yeah, I'm curious to hear your thoughts on that too, uh, arnold because you know It kind of goes to your your previous answer that you know, you're saying that We're we're kind of barreling towards de facto Nationalization because there's just no tolerance for any kind of risk in the banking sector Um, so is that uh, is that plausible to say You know is is biden's argument that you know weakening dot dot frank, uh, is is a plausible mechanism. Um, and What what do you expect to see? as the the regulations um to you know further Decrease risk uh in small and mid-sized banks. What effect is that going to have? Okay well the Going back to his argument What is true Is that banks that are have over over? Well under dod frank banks that had over 50 billion dollars in assets were regulated differently than banks that had under 50 billion dollars and He he mentions trump and everyone mentions trump But actually it was a bipartisan decision in congress because congress was bribed You know, you know, both parties were bribed To exempt to raise that From 50 billion to 250 billion Having said that We don't know whether Regulating them differently would have produced a different result That's what no one has filled in and I don't see any reason why that's true There was nothing nothing to stop regulators from coming in and getting Silicon Valley bank to change its behavior In fact, the the rapid growth of silicon valley bank Was the reddest red flag a regulator could ever see So there was just and and they could see the balance sheet. There was nothing Stopping them. You can't just wave your hands and say deregulation. There was deregulation They had the power the knowledge. They could have done it Conversely, if it had been in the 250 billion dollar category, the regulators could have let them go I mean if they let them go As they stood they could have let them go at 250 billion. There's just So that's what's demagogic about blaming deregulation. There was enough discretion Either above the 250 billion dollar level or below it to make whatever make whatever decision they wanted And they made they didn't make the best decision I'm also curious to know what you think the effects of Because now it's unclear that With with the fdic stepping to cover all the deposits. It's it's unclear like You know, if other banks go down What is the what is the limit there? And and all of this raises questions about what we call moral hazard and that's a question that Larry Summers the former treasury secretary former president harvard Said is not something to worry about At this or you know, he said in the lead-up to the bailout of the depositors that it's not really a question that Can be front of mind for regulators what we're going to just play that clip real quick And then I'd like to get your both of your reactions to the moral hazard problem that this kind of intervention, you know might Might raise going forward I don't think this is a time for moral hazard lectures or for talk about teaching people Lessons we have enough strains and challenges in the economy without adding the collateral consequences of A breakdown in an important sector What's your reaction? I agree with him, uh, you know larry's my age He remembers the savings and loan crisis and he knows what moral hazard is But he also knows that You know, this is this is an emergency that if you if you let the If you stick with the $250,000 ceiling Obviously a lot of tech firms get wiped out and you know I don't feel like they deserved it and I don't think it I think it would have been horrible for all of the The people who worked for them, you know cause Cause all sorts of chaos And on top of that you have all these other banks where you know, everyone can you know can look at their financial statements and see that You know a certain percentage of them are underwater not as badly as svb, but they are underwater And so you'll have bank runs all over the place total chaos in the financial system So yeah to worry you worry about moral hazard tomorrow Not today. I don't think larry would say you'd never worry about moral hazard And I think he knows you're creating a ton of moral hazard And my point about zombie banks is that they are the ones who the owners there are the ones who have lots of moral hazard Especially now that all their deposits are guaranteed if they're underwater They have nothing to lose by taking money to las vegas and betting And they have everything to gain and the only thing that stops them from doing that is regulation And that means that the regulation is going to be tighter And I think that that is going to last forever. There's this basic trend that government Financial policy whether it's monetary policy whether it's regulatory policy It all the policies that survive are the policies that allow government to allocate credit To its preferred uses especially to its own spending And that's what we're going to see another ratchet of that. We saw a ratchet in 2008 Where prior to 2008 the government did a lot to support housing maybe too much I could argue that it's too much But after 2008 it basically took the money that would have gone into housing and then used it to finance its own deficits And that's you know, that's the trend that's going to be exacerbated as we ratchet up government's control over the banking system Lynn do you agree that that's going to ultimately be the effect of this and if so How do we do you have any ideas about how to escape that or how that you know the banking are there any ways around that or is this kind of just an inevitable process that We've got to learn to live with If you look back in 1940s, which was the last time that federal debt the gdp was as high as it is now Banks did become basically these vehicles where just a lot of government debt was was monetized in there And that's it's unfortunately kind of common to happen in countries that have this level of deficit and debt spending Where the banks essentially become like utilities in that regard We've also seen it's a multi-decade trend of bank consolidation You know it used to be like tens of thousands of banks now There's like 4 000 banks the top 10 banks have like half of all assets Right now there's a depositor flight from small banks to big banks. So that's a continuing trend You know as far as more hazard goods, I mean at least the Shareholders were not billed out, right? So there was no, you know, there's still risk from investing in a poorly managed bank You know as far as depositors go Most indicators show that they would have gotten like 80 cents back on their dollar If that were allowed to to play out You know, it's not I don't think it's a moral case that those depositors had to be billed out But I from their perspective of preventing Future bank runs in an emergency. I can see why they wanted to do it But like, you know, most more hazard decisions are kind of that trend to fix the problem now And then address the moral hazard later and then never really address the moral hazard Either because they just don't or because it's it's you know, they've kind of created a situation that we can't really address it And so I you know, I think that's just a general trend that just keeps happening. Yeah, so do you Think that you know aside from the you know, the moral hazard question Do you think that it was necessary? Do you think uh, it is it your opinion that this was a real systemic risk and everything, you know, that we would have just seen kind of a Cascade of bank runs if the FDIC hadn't intervened in this way I think you probably would have I think there's different ways that they could have They didn't necessarily have had to backstop the depositors in this bank. Yeah, uh, they did clearly had to provide some sort of liquidity facility Um, because banking system from its very foundations not really a free market activity to begin with Um, and you'd have a cascade where you know, a typical bank a small bank has something like, you know Less than 10 of its deposits in in liquid cash ready to go And so you could get like a really bad liquidity squeeze So clearly they had to provide some sort of liquidity facility to prevent kind of mass for sales mass disruptions things like that Partially based on their own actions that they themselves caused by you know contributing to such a volatile monetary environment of rapidly increasing You know bank reserves and then contracting bank reserves and rapidly increasing and falling interest rates and all that Um, but they didn't necessarily have to backstop the depositors. That was kind of an extra step I think they took to shore up confidence in further banks and prevent Large-scale bank runs. So there's clearly an array of choices. They could have made But doing nothing wasn't really an option Another choice I wonder about is, you know, there's this there's reporting from semaphore here that I'm displaying Why the biggest banks were first shut out of bidding on silicon valley bank and the report says that uh, you know, the largest us banks didn't submit a bid for silicon valley bank over the weekend largely because they were initially excluded from the sales process by the federal deposit insurance corp and ran out of time as a result I mean, wouldn't that kind of be the natural Market solution is that one of the bigger banks would just scoop them up and What was the reason that what would be the reason for The government to block that sort of acquisition Well, I guess I I don't sit in on those meetings. So I don't know but you have to rise. There's a negotiation that's going to go on Uh, the buyer is going to say all right. I want to be held harmless against certain things And I want to have certain sweeteners And the government who's in the you know, who's basically taken over the bank as a process of selling it has to negotiate um and There's actually so the perception among people on the left is that the In the 2008 crisis when when you know, a lot of banks were merged suddenly Is that the government didn't negotiate hard enough? And the the perception of jayme diamond and some other bankers is that the government didn't negotiate in good faith because You know, he bought he buys some bad banks and then years later those bad banks are fined For behavior that took place before he bought them and he's he has to pay up So I don't know who you know Who's right and who's wrong in this particular negotiation because like I said, it wasn't in the room The I'm I'm curious to ask uh, lin about um, you know the What you think about the future of banking and um, there's you've argued in in Uh, let me pull it up here. Um There's you've said that ironically regulators want banks to be reasonably safe, but not too safe And that there's this kind of deeper question that nobody's really talking about which is One way to to avoid bank runs would actually to just be to hold more cash reserves, but that because of the way that um the the federal reserve and um The fdic and just banking regulation works It's a lot harder to set up and get a an approved charter if you run a bank that way One example of that is custodia bank, which i'm showing here, which I believe holds actually over It holds like 108 percent of its of its deposits in cash So people can always get the bank always get their money out theoretically and They pay they they fund this through fees instead of um, you know, uh loans so could you talk a little bit about that that issue, uh, lin of um fractional reserve banking Yeah, there have been a number of attempts over the years for people to try to create full reserve banks. Um, where You know instead of having just a percentage of deposits, uh in cash They would have, uh, you know, at least 100 percent of deposits in cash and and you know, one of the main examples was the narrow bank Um, you know these start as as state charter banks and what they what they do is they apply to have access to the federal reserve And the narrow bank basically just you know They wanted to take deposits and then put them on deposit with the fed as a bank reserve And therefore from a from a depositors perspective You just have like, you know, you'd be basically banking with the federal reserve except you'd have a thin layer of of administrative overhead between you and the fed because they'd be operating, you know, the basic banking services that you need um, and their their, um application was kind of held in in Stasis for a number of years, uh, there's been courts, you know court things over that It's like ironically, they're trying to make from a depositor perspective about as safe as a bank you can make But they they get criticized as it contributing to systemic problems because then it could suck deposits out from fractioning reserve banks towards that one Uh, at least for certain types of depositors and then the more recent case just this past year was custodia bank Um led by katelyn long and they want to do more than just that but they're but from the depositor perspective They do plan they plan on putting 108 of deposits At the fed so that they could withstand 100 deposit bank run if it were to recur Again, they would do other services on the side But in terms of that deposit and and what they do with it And and they were also held for a long time in stasis and then ultimately denied And so and there's been other attempts like that in other countries too And in a low interest rate environment, they'd have to try, you know They'd have to charge a positive some sort of fee to for those services In the current environment, they actually wouldn't have to because banks get paid pretty high Interest rates on their reserves and so they could essentially cover that overhead with those and then even even potentially pass Some deposit interest onto depositors Yeah, and it's just it's not something that the federal reserve has wanted to exist for a variety of reasons D is what do you think about that? Um, arnold Is there a sense in which you know, there that innovation in banking has been stymied and that That is contributing to a more fragile environment Like how do we break out of this, you know hyper fragile regulated System that we're we seem to be stuck with right now and headed more so in that direction Well, john cochran who's an economist at the Hoover institution Uh has always been an advocate of what you know, when Rightly calls narrow banking and you can think of of of banks is serving two purposes one is They operate a payment system. So, you know, they make sure that That you can pay for things smoothly I mean, it's sort of You know when I was growing up that meant checking accounts and people writing checks and you know now We've forgotten all about that. We you know use our phones or our credit cards or what have you but ultimately banks are kind of You know doing the payment processing And what what john would like to do is separate out Payment processing from what I might call real banking Uh, so payment processing, you know, you're just If if somebody's got a deposit with you like lin said you have you put a hundred percent backing of that So if they walked it if every depositor walked in today and asked for their money You could give it to them. You know, you just you know hundred percent reserves Um, and he wants that type of bank to be required to be in the payment system So he would actually like every bank to be like custodia bank in that sense I don't know that all the details about custodial bank but he would like there to be the fed And then a layer of private banks operating the payment system and depositors and that's one banking system and then what I don't I'll call this real banking because uh banks are in the business of Uh putting onto their balance sheets uh long-term risky assets And short-term riskless liabilities. So that's that kind of mismatch is there um You want some of that banking to take place. I mean it just it helps the economy But if they do too much like svb did uh, you get you know You get too much of a of a Of a minceki cycle of people Getting too exuberant the economy doing really well and then all of a sudden they they don't and they don't take enough risks. So um So that's a challenge uh Getting real banking right in some sense You do want to subsidize it in some ways you have to tax it by regulation in some ways um We can talk about what might be the optimal structure to Kind of make that happen But reality is government is not aiming for the optimal structure government acts as if it's aiming to get the most credit for the allocated to channel to the um its desired uses including its own spending and that's that's the reality that we deal with and that that's I don't know how to fight that because Regardless of what they say they're doing regardless of what we might want them to do That's what they're doing well, so There's one line of argument that I think is worth getting into here because it's it's the Bitcoin solves this line of argument that you have to totally exit the banking system the banking cartel because There is no all the incentives are lined up in the way that you just laid out for the government Arnold what uh, say you to that lin is you know the the kind of bitcoin maximalist approach the only way Out of this to to force the issue Well, I mean I think part of the reason fractional reserve banking exists because you've always had the you know historically It grew over a gold base system because you had that mismatch in speed gold was slow Um, and people needed services on top of their gold, but then that creates a mismatch What you know once a bank realizes that only a certain percentage of their depositors are likely to ever withdraw at once They start realizing that they can make a profit by using that liquidity difference to their benefit And once one bank does that they create cost pressures that that you know incentivize a lot of other banks to want to do it Um, I think it's the problem in the current environment is that they won't even let a full reserve bank exist as an option Um, whereas I think I think the you know, I think it's reasonable for people to have that choice But that's just the current incentive structure that they have in place They don't I can see why from the central banking perspective They don't particularly want that even though obviously from a user perspective there are people that want it A lot of people is to say why can't someone you know, if they have more than a quarter million deposits Why can't they just spread that around and one way to think about it is is businesses Businesses have a lot of incoming and outgoing cash flows They generally need to hold larger amounts at a given time And if they have multiple bank accounts, that's more overhead to manage There's also things they can do like sweep extra funds into money markets. Sometimes there's limits on how many times they can do that So they can still get caught with um, you know, some of their deposits Uninsured, um, there's also fintech layers so that they can like say from their perspective It looks like they're running on one bank but behind the scenes they're using like, you know, 10 different bank accounts And so they're their overall FDI sure Insurance is limit and a lot of those things are basically to go around the fact that you know A full reserve bank doesn't currently exist in the system as far as bitcoin is concerned. I think um When you look at that it helps look globally, right? So in the united states, you know, we're talking about bank failures in the united states But I mean there's few places in the world where you'd want to hold money to bank more than the united states I mean, you know, maybe switzerland a few others, but especially at the long tail of You know developing countries, uh, which is where the majority of people live, uh, their banking systems are notoriously unreliable Uh, I think I think with safety and almost they calculated that the average Uh currency growth rate of a country was 29 per year compounded And that's obviously some of them are much higher than that most of them are less than that the average developed market currency grows it Broad my supply of like high single digits Um, and so a lot of people face just one is ongoing currency problems And then two if they try to hold something like dollars in their bank account, they're they're liable to have those be confiscated That happens quite often You know, I know people in egypt that are literally just holding cash dollars uh physical For lack of knowing what else to do with the in in egypt, right? They don't really want to want to hold the egyptian pound It just got cut in half They don't particularly want to put those dollars in banks You know, sometimes they hold gold and things like that And then they hold cash dollars. So they're getting All the inflation of the dollar without the interest rates in any way to kind of offset that Um, and so I think it's natural that a lot of these countries you've seen interest in either stable coins Which is a way to access dollars outside, you know, they have counterparty risks But they're the those counterparties are outside of their host country. So if you're in nigeria and and you want to hold dollars Uh stable coins have been an option Uh, and then bitcoin is one that there's no counterparty risk, but then instead you have to take on the volatility risk Um, and that the overall risk of the network either, you know, we'll keep growing as it has been or we'll stop growing as it has been Uh, and so I I do think that bitcoin's an interesting solution in the long term and but people obviously have to manage their exposure to it because You know, you while nobody can you know, if you hold the private keys Nobody can take your bitcoin, but your bitcoin can fluctuate dramatically in terms of purchasing power in a given time period What what do you think about that arnold? I know you've been a cryptoskeptic. You've described, uh, cryptocurrencies as largely a pyramid scheme but bitcoin, you know, some bitcoin as Viewing it as a hedge against Real instability in the banking sector. Does that make sense to you? That that doesn't excite me I think the use cases are more like what linds said for people who don't have a reliable government and banking system The Well Put it this way if our banking system collapses I think I think the best hedge against that is to have a vegetable garden Okay, because if the banking system collapses, you know, are we going to have an electric grid? Are we going to have the internet? And without those are we going to have any bitcoin? So, um Yeah, uh, so I I can't see that one the you know, um speaking of crypto there is a a lot of crypto enthusiasts believe that What is happening with some of these banks is constitutes? Part of an ongoing war against crypto. We we had, uh, Nick Carter on a few weeks ago who put out this idea of operation chokepoint 2.0, which this time is focused on Basically clamping down on cryptocurrency Uh, this is all of course in the context of post ftx collapse Um, you know, you mentioned lin earlier barney, uh, barney francs, uh bank signature Or, you know, he's on the board at signature. Um, and he has claimed That the reason that signature bank was seized by a new york state agency Is not because it was insolvent. He said it was not insolvent But that what part of what was happened was that regulators wanted to send a very strong anti-crypto message Do you think that the government is currently sending that message? And if so, why? I think there's merit in the observation that some of the Crypto participants have that that some of these banks were, uh, treated differently. So basically the signature bank, uh, silicon valley bank and silver gates are, um, you know, well Two of them, uh, had a big crypto business silicon valley bank less so but it it was still somewhat crypto friendly Um, and those were, you know, among the three that that failed Uh, signature banks the one that's under scrutiny in the way because they weren't necessarily insolvent They were illiquid because they had a similar problem where most of the depositors were businesses and therefore uninsured and therefore You know, had a flight risk. Um The the interesting thing is that both silver gate and, um, signature bank operated, uh, these kind of real time Uh, transaction, uh, services. So if if a company deals with crypto trading, the problem is that crypto trades 24 7 and banks don't Um, and so what those banks would do is like you could you could send money 24 7 to like other, uh, Uses of that bank and therefore money dollars can move around or at least, you know Claims on dollars can move around as quickly as as crypto could and so that was an important part of the liquidity for for the trading ecosystem And what we've kind of seen in the past say 48 hours or so is that on the on the negotiations around purchasing signature banks assets Um, one of the conditions and this is reported by Reuters is that they can't buy the crypto assets that basically that that service that they're operating is something that The federal government does not particularly seem interested in allowing to continue to exist Um, this is also where so I I do think there's merit in the choke point thesis and that is worth people pursuing getting transparency on Um, you know, uh, seeing if there's kind of unfair crackdowns on an industry by industry basis Um, but I think it's also worth pointing out that in this case bitcoin companies and crypto companies Are kind of it's almost like a vent diagram that overlaps a little bit in the middle But they're they're actually quite different in the sense that most of the crypto ones are very vc funded Uh, they're essentially on registered securities in a way They have rather centralized teams And a lot of it is very active in that trading environment, which is inherently kind of speculative whereas in the bitcoin space Um, they're less so reliant on those those, um, you know, kind of trading Rails that say silver gate and signature ran Um, and they have less concentration of their, you know, whatever companies do exist in the bitcoin space less of their Funding is kind of concentrated in those hubs Um, yeah, and so it's less kind of a direct attack on bitcoin But I do think it's a somewhat of a crackdown on some of the the crypto vc space And then as far as as kind of bitcoin as alternative asset goes I mean, let's say you did have a big problem in a country and everybody needs vegetable gardens One of the kind of the useful aspects of bitcoin is that if someone has their private keys they can leave Uh, that region and go to another region And then be able to access their bitcoin In that other region in a way that, you know, you can't bring cash to an airport You can't bring gold to an airport and so for example, I know I know someone from Venezuela that left the country with his bitcoins And he would not have been able to do that with with gold for example because you can bring your bitcoins by remembering 12 words Um, as your as your c phrase and you know, you can reconstruct your ability to access bitcoin when you get away So, you know, I think that's when you when you kind of look at that global scale I think is when you can see why bitcoin's interesting Whereas in the context of developed countries, we mostly treat it like a portfolio asset You might have say a bitcoin slice next to your stock slice next to your t-bills You know people treat it as like a slice and diversified portfolio Whereas people in some of these other types of countries treat it as more of like an actual utility asset That they find useful in in certain contexts where say gold or even physical cash dollars would not be Let let me ask you about that. Uh, Arnold is our kind of Resident crypto skeptic here, you know, do you view these as fundamentally different like, you know, bitcoin Is different from ethereum is different from nfts is different from whatever token ftx came up with There there's clearly a lot of suspicion now in the government of kind of crypto as a broad asset category But you know, is there in a sense are things just being painted with too broad a brush at this point Or or is it warranted that the government is really taking a much harder look at the entire space right now? Um, that that's like a probably a 20 minute question to which i'm probably not even qualified to answer Uh, let me see if I can take a pick a slice of the question to answer Um I guess you know an interesting question is how will Crypto assets intersect with the what I'd call the formal banking system You know the the system that government Supervises and cares about Um, and that's a question that people in government. I'm sure are asking Uh, and uh, I don't know what the right answer is. I mean the the venezuelan taking bitcoin across the border uh Is not really interested in being involved Certainly in the venezuelan government banking system They're interested in escaping it Uh, and if your motive is to escape government, well government's not that motivated to help you And it may be motivated to harm you and I guess you shouldn't be surprised at that I guess the the other aspect i'll take is So there's sort of a dilemma for the crypto people. Do you want to be? Friends with government or enemies? And if you want to be friends how friendly so that the other dilemma is centralized versus decentralized So the promise of bitcoin certainly is decentralized Uh, maybe it's true with some of these others, but The more decentralized it is it seems like the harder it is to use and the more profit opportunities there seem to emerge in coming up with centralized solutions And these centralized solutions tend to bring in a lot of the fragility and Uh potential problems that you're trying to get away with with the decentralized system. So Resolving that issue. I think is tough and I don't claim to have an answer Fair enough As we wrap up here, let me bring in one of our audience questions and then I want to zoom out and look at the economy as a whole at interest rates at Um inflation and how these things are all interacting and get both of you to talk a little bit about Where you expect things, you know, might be headed from here Is is it all doom and gloom or is there, you know, hope of the soft landing that We've been told about several times But let me bring up this question first from Benjamin Dover who says Is there a systemic risk of deposit insurance being substantially weakened by covering svp deposits? Either of you have an opinion on that My first thought is no that I mean as lin pointed out, they weren't svp wasn't that far underwater to begin with And you know, there's a lot of money in the insurance fund. So that's I don't know lin agrees or not, but I I agree. I think I would separate the theoretical from the practical. So theoretically fc insurance only covers less than one percent of total deposits and a little bit over one percent of insured deposits And so in theory, it's always this kind of thin layer of protection But in practice, uh, since 1933, there's never been a insured deposit that they that they didn't cover And one of the I think one of the few bipartisan things Would be essentially backstopping fdic. Um, that seems unlikely to Be the thing they let go. So I think in practice Um I don't really have I would assign a very very low probability that fdic insured deposits would would fail So, uh, to to wrap up here. I want to bring up this this chart, uh from the board of governors and the treasury and All of our slides, by the way are linked below if anyone wants to see that the data we're using here, but It's got several lines here and you can see a sort of Unprecedented at least in this snapshot here situation where the blue line The federal debt to gdp ratio is, you know, higher higher than ever The that's, you know, new new territory here at the same time the fed Is trying to tame inflation, which is the green line. You see it spiking up down there and using Higher interest rates, which is the red line Also, you know, obviously on an upward trajectory So given this What looks to me like a rather unprecedented situation Where do both of you expect this is all headed? I'll start with arnold and then led lin way in Uh, I wish I knew I'll I'll play the old man again Um, and take you back to an incident in 1970 That is covered in a book called super money Uh, that was I think came out in 72 Um, Penn Central railroad went bankrupt in june of 1970 and exactly this time The tape of scenario played out that the fed was in the middle of trying to stop inflation And They looked at the situation over the weekend and they said If we don't do anything, it'll be the apple cart scenario. You know, it'll be another great depression We can't we have to do something So they in in The telling of the story in this book You know, they just got on the phone and called every bank and said just make whatever loans you need You know, we're not you know, we're not trying to constrain credit anymore um What followed were things like the New economic policy of Richard Nixon, which devalued the dollar and he tried wage and price controls And inflation kept getting higher and higher You know the 70s were not a good story Are we headed to the same thing? Are we, you know, there's a lot of talk about abandoning any effort to fight inflation I think and I think John Cochran would think that any effort to fight inflation has to include A serious effort at reigning in the deficit And not just any one year, but all the out years and that includes Social security and medicare Are we going to see that? Probably not. So does that mean we're going to relive the 1970s with a lot of floundering and You know random policy changes that don't do anything and you get a lot more inflation. So Anyway, it's it's not an easy thing to answer. I just say that the one precedent that comes to my mind says Watch out for, you know, lots more inflation and more troubles And just to be very clear about that what why is it that bringing the deficit and Eventually the debt under control is the essential component there from your viewpoint Because ultimately that's what You know how the government injects money or wealth into the economy is by just running these deficits and if you don't and you know How do you how do you get rid of government debt? You can Formally default. Do you say wake up tomorrow and say, sorry bondholders. You're not getting anything Or you can actually cut spending raise taxes or you can inflate it away There's no sentiment to Formally default there's no sentiment to Bring the deficit under control. So what you're left with it seems to me is inflation And lin what's a nice day as But no, let's uh, I'm sure you're going to cheer us up here I think unfortunately not. I think I have to agree with the inflation thesis. Um One I guess a bit of color all at is that the 1970s when you look at that inflation dynamic Even though there was a deficit problem a lot of it was from Very high levels of bank lending. That was our fastest pace of bank lending in in u.s history And that really coincided with You know people that were born and you know the baby boomer generation entering their home buying years And so you had that surge of demand that at the same time as you had obviously the oil supply constraints and so a lot of There was more money creation from bank lending than there was from fiscal deficits. Whereas if you look back further to 1940s That was an equally as an inflationary decade Um, and it was very little bank lending and it was almost entirely a fiscal driven Phenomenon the the basic massive depths is to fight the war were highly inflationary And the current environment we find ourselves in in the 2020s in many ways is more similar to 1940s Which is the vast majority of the money creation and the inflation Was not because of excessive bank lending. I mean bank lending levels are pretty normal And almost all of it was from unusually large fiscal deficits that we'd not seen since world war two as a percentage of gdp And I also I don't really see a realistic path to cutting that anytime soon because You have social security medicare. That's very popular programs Uh, it's just it's it's you know, kind of that third rail that the politicians don't want to touch Um, you have military spending, you know, we have 750 foreign military bases Over 800 billion a year on that but especially what's going on geopolitically. It's it's, you know, that's not likely to be cut anytime soon Um, and also then you have a lot of politicians that some of them do want to raise taxes other ones don't Uh, it seems like there's enough of a mix that it's it's taxes are unlikely to go up materially And so I think that you know, we look at the 1970s They because debt the gdp was so low one of the things that they were able to do was sharply raise rates To try to bring down bank lending get the positive real rates Um, and that helped get inflation under control whereas 1940s because you had over 100 percent debt to gp Um, it was very hard to raise rates. And so instead they just kept rates low despite high inflation And anyone holding dollars bonds, uh and things like that really got devalued on an ongoing basis And so I think that unfortunately the 2020s are kind of shaping up in that direction Where, you know, they might get the positive real yields for brief periods of time Uh, especially if they, you know, they're willing to cause a recession to do it But I think the majority of the decade probably is just going to be have a tough time getting inflation under control Because I don't think they're going to get the depths. It's under control Um, and I also don't think that interest rates are going to be high enough to compensate people for it Have a nice day. Yes our closing messages. Hold on to your hats folks I want to but I do want to thank, uh, Lynn Alden and, uh, Arnold Kling for joining me to talk through all this today It's been really informative and I recommend subscribing to, uh, Lynn's newsletter subscribe to Arnold's uh, sub stack and of course subscribe to reason tv We'll be back here next week, uh with another conversation Uh, we're going to be talking with Ethan natelman about the case for legalizing all drugs Maybe that will help, uh, you know numb some of the pain going into this But uh, thank you, Arnold. Thank you, Lynn. Thank you to adam solovan our producer and thank you to our audience for tuning in We'll see you next week