The banking crisis that hit Silicon Valley Bank (SVB) last week has spread. We recall with horror the aftermath of two recent financial crises: the 1997 Asian financial crisis, which led to a deep Asian recession, and the Great Recession of 2008, which led to a global recession. A new banking crisis is hitting a global economy already devastated by pandemics, wars, sanctions, geopolitical tensions and climate disasters.

At the heart of the current banking crisis is the tightening of monetary conditions by the US Federal Reserve (FRS) and the European Central Bank (ECB) after years of expansionary monetary policy. In recent years, both the Fed and the ECB have kept interest rates close to zero and pumped liquidity into the economy, especially in response to the pandemic. The easy money led to inflation in 2022, and now both central banks are tightening monetary policy and raising interest rates to curb inflation.

Banks like SVB accept short-term deposits and use them for long-term investments.

Banks pay interest on deposits and seek higher returns on long-term investments. When central banks raise short-term interest rates, the interest paid on deposits can exceed returns on long-term investments. At the same time, the profits and capital of banks are reduced. Banks may need to raise capital to stay afloat and secure. In exceptional cases, some banks may go bankrupt.

Even a solvent bank can fail if depositors panic and suddenly try to withdraw their deposits, a phenomenon known as a bank run. Each depositor is in a hurry to withdraw their deposits before other depositors. Since the bank’s assets are linked to long-term investments, the bank does not have the liquidity to immediately lend money to panicked depositors. SVB suffered from such a bank run and was quickly turned over to the US government.

Bank runs are a common risk, but they can be avoided in three ways. First, banks must maintain sufficient capital to cover losses. Second, in the event of a bank run, central banks should provide banks with emergency liquidity, thereby ending the panic. Third, state deposit insurance should reassure depositors.

All three mechanisms could fail in the case of SVB. Firstly, it is obvious that the SVB’s balance sheet was seriously affected, and the regulators did not react in time. Second, for unclear reasons, US regulators closed the SVB instead of providing emergency liquidity from the central bank. Third, guaranteeing US deposits of only up to $250,000 did not stop large depositors from fleeing. Following the bank run, US regulators announced they would guarantee all deposits.

The immediate question is whether the SVB failure is the beginning of a more general banking crisis. The increase in market interest rates, caused by the restrictions of the Fed and the ECB, hit other banks as well. Now that the banking crisis has taken place, depositors are more likely to panic.

Even a solvent bank can go bankrupt if depositors panic and suddenly try to withdraw their deposits.

Bank runs in the future can be avoided if the world’s central banks provide sufficient liquidity to the banks that run into them. It is for this reason that the Swiss central bank provided credit to Credit Suisse. The US Federal Reserve has provided $152 billion in new loans to US banks in recent days.

However, emergency borrowing partially offsets the efforts of central banks to curb inflation. Central banks are in a dilemma. By raising interest rates, they increase the likelihood of a run on money from banks. But if they keep interest rates too low, inflationary pressures are likely to continue.

Central banks will try to achieve both: higher interest rates plus emergency liquidity if needed. This is the right approach, but you have to pay for it. The economies of the United States and Europe have already experienced stagflation: high inflation and slowing growth. A banking crisis will exacerbate stagflation and possibly push the US and Europe into recession.

Part of the stagflation was a consequence of COVID-19, which forced central banks to pump out huge amounts of liquidity in 2020, which caused inflation in 2022. Stagflation is partly the result of shocks caused by long-term climate change. The climate shock could be exacerbated this year if another El Niño occurs in the Pacific Ocean, the likelihood of which scientists say is increasing.

However, stagflation was exacerbated by economic shocks caused by the war in Ukraine, US and EU sanctions. against Russia and rising tensions between the US and China. These geopolitical factors have disrupted the global economy by impacting supply chains, driving up costs and prices, and slowing down production.

We must view diplomacy as a key macroeconomic tool. If diplomacy is used to end the war in Ukraine, phase out costly sanctions against Russia, and reduce U.S.-China tensions, not only will the world be safer, but stagflation will also be reduced. Peace and cooperation is the best cure for growing economic risks.

Mr. Jeffrey D. Sacks is Professor and Director of the Center for Sustainable Development at Columbia University and Chairman of the United Nations Network for Sustainable Development Solutions.