Michael J. Howell - Capital Wars: The Rise of Global Liquidity

Cover illustration: vladimir3d, shutterstock.com

This Palgrave Macmillan imprint is published by the registered company Springer Nature Switzerland AG

The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

History, particularly financial history, is not random. The key idea in this book is that economic cycles are driven by financial flows, namely quantities of savings and credits, and not by high street inflation or the level of interest rates. Their sweeping destructive powers are expressed through Global Liquidity, a US$130 trillion pool of footloose cash. Our Central Bank policy-makers should, consequently, about-turn and focus more on financial stability than on hitting phantom consumer price inflation targets. The economist John Maynard Keynes distinguished the economys financial and industrial spheres in a similar way to how we might, today, separate the asset economy from the real economy. Trying to stimulate the real economy with liquidity always runs the risk of creating asset price bubbles instead. In the 1930s, facing a near-identical situation to the post-GFC years, policy-makers then unleashed an analogous stimulus with the same outturn: near-flat high street prices, but soaring asset prices. A fractured, uncertain World encourages investors to hold excessive amounts of safe assets, like cash and government bonds and, particularly, US dollar assets, rather than putting money to work productively. When the State fails to produce sufficient safe assets, then the private sector steps in with less good substitutes, whose values unfortunately move procyclically. Governments austerity policies and quantitative tightening programmes might not sound such good ideas in this light? Think of this mechanism as the so-calledprecautionary demand for money, hurriedly skipped over in the traditional textbooks, but which seems to better describe the growing systemic risks we face than the better-known speculative motive, which assesses the chances of rising (as opposed to falling) interest rates and can lead to a liquidity trap. I argue that Global Liquidity is never trapped: it waves no flag, knows no boundaries and shifts all too rapidly between markets and asset classes.

What appear as two puzzling features in the latest policy debates, in fact, emphasise the importance of Global Liquidity. First, the widespread consensus view, underpinned by repeated Central Bank claims, that more QE (quantitative easing) lowers, and does not raise, term premia and hence government bond yields. The academic argument, summarised by Gagnon (2016), quantifies this as 67 basis points (bp) per 10% of GDP injected via QE. Second, many believe that the slope of the yield curve is an unambiguous predictor of the business cycle. Hence, an inverted yield curve should warn us that a recession is fast approaching. In fact, neither statement is true. The former is easily refuted by the data, which show that QE periods in the US have unequivocally been associated with higher yields, with term premia rising by an average 134 bp through each past QE phase. The efficiency of the Treasury yield curve as a predictor of the business cycle is analysed elsewhere (Howell 2018). This confirms that the standard 10-2 year yield curve slope is, at best, a flaky predictor. This analysis points out that, because different maturity spreads work at different times, what also matters is the curvature of the term structure. In other works, slope and curvature must be assessed together. A key component explaining curvature is the pattern of term premia. Term premia are liquidity phenomena, largely reflecting the excess demand for safe assets.

The liquidity shocks that ricocheted across the World in 1989 as the Berlin Wall fell ultimately forced interest rates down and helped to reverse the polarity of the global financial system. Capital raced Eastwards along what I call theFinancial Silk Road, while politics and people marched West, causing too many countries, and notably China, to lean too heavily on the US dollar and the US Treasury market for safety. Linked to these changes, todays financial markets increasingly have to serve asrefinancing mechanismsrather than asnew financing mechanisms, making the capacity of capital, i.e. balance sheet size, more important than the cost of capital, i.e. the level of interest rates. The heightened supply of poor quality safe assets, or what I more formally describe as theshadow monetary base, compromises the ability of private balance sheets to roll over the huge volumes of outstanding debts left over from the GFC era. Ironically, a reduced supply of liquidity and safe assets, increases the demand to hoard them. Together these features amplify the swings in Global Liquidity and explain why, as the World has got bigger, it has also become more volatile. The underlying scarcity of high-quality assets leads on toCapital Wars.Here, the battleground embraces money, technology and geopolitics, with the struggle fought out between the two key superpowers: Chinese industry and American finance. Chinas presence is weighing more and more: in the year 2000, China accounted for 5.9% of Global Liquidity, or less than one-fifth of Americas share; Chinas share reached 10.1% at the time of the 20072008 GFC and, today, it has swelled to a whopping 27.5%, significantly out-pacing Americas slipping 22.5% slice. China matters hugely to both the World economy and World finance. I conclude that whereas America needs to reinvigorate her industry, China has the more pressing need to rapidly develop her financial sector. Like history, these are processes, not events, but we can still ask whether the final victor in the markets will be the US dollar or a digitally based Chinese Yuan?