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Prepare for Economic Downturn as Money Supply Declines and Government Spending Surges
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U.S. Banking Sector: $500 Billion in Unrealized Losses Represents a Considerable Risk
At the recent Austrian Economic Research Conference hosted by the Mises Institute, Dr. Steve Hanke emphasized the critical role of commercial banks in money creation and the broader economy. While public attention often focuses on the Federal Reserve, the reality is that around 80% of the money supply—measured by M2—is generated by commercial banks through lending. However, delinquencies on loans, including mortgages, credit cards, and auto loans, are rising, prompting banks to increase provisions for loan losses. Though concerning, Professor Hanke believes the banking system remains generally safe for now.
The stagnant money supply—flat since mid-2022 and growing only about 4% annually—signals economic slowdown and declining inflation, now at 2.3%. This monetary stagnation and increased bank provisioning indicate a likely recession. Another key concern is “regime uncertainty,” a term that describes rapid, unpredictable policy changes, including tariffs, fiscal plans, and regulations. This uncertainty discourages investment and has led many companies to stop issuing earnings guidance. Corporate profits may remain flat or even decline in 2025.
Impact of New Banking Regulations: Basel III and the Supplementary Leverage Ratio
There is a growing risk within the U.S. banking system, particularly the $500 billion in unrealized losses on investment securities held by banks. While these losses remain off the income statement for now, if it's deemed unlikely that they’ll be recovered within a reasonable timeframe, banks may be forced to recognize them, posing a potential threat to financial stability. This scenario mirrors the problems faced by Silicon Valley Bank, though a full-scale banking crisis remains unlikely. Instead, the broader concern is that such balance sheet strain makes banks more conservative, dampening their willingness to lend. Combined with tepid loan demand, this results in sluggish credit growth.
Regulatory changes are another key issue. Basel III regulations, scheduled to take effect in July 2025, and the supplementary leverage ratio could further tighten credit conditions. However, there’s uncertainty over whether the U.S. will fully adopt these measures. The Trump administration has hinted at repealing the supplementary leverage ratio, which could ease lending constraints—a move supported by banks and some economists.
Dr. Hanke commented on the post-2008 regulatory approach, arguing that heavy capital requirements have made banks risk-averse, stifling economic expansion. A more balanced framework, detailed in the book Dr. Hanke co-authored with Matt Sekerke, Making Money Work: How to Rewrite the Rules of Our Financial System, advocates for smarter, not stricter, bank regulation. The book urges a renewed focus on the central role of commercial banks in money creation and economic health, asserting that more pragmatic oversight would enhance both financial stability and economic performance. Stay tuned for a detailed review of the book with Dr. Hanke on World Affairs in Context!
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Money Supply
The money supply is currently weak, which is contributing to falling inflation. Since inflation responds to changes in the money supply with a lag, bond yields—predominantly the 10-year—would also typically decline. However, yields are rising due to regime uncertainty and fiscal concerns. Many investors mistakenly expect higher inflation due to tariffs, but tariffs only shift relative prices, not the overall price level. This has led to market confusion and mispricing. Ultimately, Dr. Steve Hanke believes that inflation will eventually bring 10-year bond yields down, correcting the current market mispricing as inflation continues to decline.
Trade Deficit: Foreigners Are Not “Ripping Americans Off!”
Contrary to popular belief and political rhetoric, particularly from former President Trump, the U.S. trade deficit is not caused by foreigners "ripping off" America. Instead, it results from Americans spending more than the nation produces (its Gross National Product). To balance this excess spending, the U.S. runs a trade deficit—an accounting necessity, not a sign of economic failure. The deficit is financed by capital inflows, as foreigners purchase American assets, such as bonds and equities. This inflow of capital makes the trade deficit sustainable and even beneficial in some ways.
The trade deficit is thus not a policy failure or threat, but a reflection of broader macroeconomic choices. Efforts to "fix" it through tariffs are misguided. Tariffs do not reduce the overall trade deficit; they only shift where imports come from, distorting trade patterns rather than correcting any imbalance. For instance, heavy tariffs on Chinese goods would reduce imports from China but increase them from other countries. Ultimately, the misunderstanding of basic accounting identities leads to unnecessary concern and harmful trade policies. The focus should be on smarter economic policy, not blaming foreign nations or relying on counterproductive tariffs.
Follow Dr. Steve Hanke on X (former Twitter): https://x.com/steve_hanke.
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