Key Takeaways
1. Global Liquidity, not inflation or interest rates, drives economic cycles.
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.
Financial flows dominate. Contrary to conventional economic wisdom, which often fixates on consumer price inflation or interest rate levels, the true engine of economic cycles is the vast pool of global liquidity. This $130 trillion reservoir of "footloose cash" is currently two-thirds larger than World GDP, demonstrating its immense and often destructive power. Trying to stimulate the real economy with this liquidity frequently results in asset price bubbles rather than stable growth, a pattern observed since the 1930s.
Asset economy's influence. The distinction between the asset economy and the real economy is crucial. When policymakers inject liquidity, it often inflates asset prices—stocks, bonds, real estate—while high street prices remain flat. This phenomenon, seen in the post-GFC years, highlights that financial stability, driven by these flows, should be the primary focus of Central Banks, rather than elusive consumer price inflation targets.
Beyond traditional metrics. The book challenges the widespread belief that quantitative easing (QE) always lowers bond yields or that the yield curve is an unambiguous predictor of the business cycle. Data refutes these claims, showing that QE periods in the US have often been associated with higher yields and rising term premia. This underscores that liquidity dynamics, particularly the demand for "safe" assets, are more complex and influential than traditional metrics suggest.
2. The rise of Global Liquidity is fueled by financial flows, not just savings.
Global Liquidity embodies the idea that money, here meaning savings plus credit, is never entirely exogenous to the economic system, even at the national level and even for the World’s largest economies.
Credit's crucial role. Global Liquidity is not merely the sum of global savings; it is fundamentally driven by the gross flows of credit and international capital. While savings contribute, the expansion of credit—national and international IOUs—dominates this pool. This means liquidity is endogenous, meaning it's created within the economic system itself, and highly procyclical, expanding during booms and contracting during busts.
Beyond bank deposits. Traditional definitions of money supply, like M2 (bank deposits), are insufficient to capture the true scale of global liquidity. Modern money extends far beyond these, encompassing wholesale money markets, such as:
- Repos (secured borrowing)
- Commercial paper
- Eurodollars (unsecured foreign currency deposits)
These market-based instruments, often outside traditional banking regulation, form a "shadow monetary base" that significantly amplifies liquidity.
Global interconnectedness. The cross-border dimension of liquidity is especially vital, linking Emerging Markets to Western wholesale money markets. Large global banks, funded by US dollar-denominated repos and commercial paper, on-lend these funds, often against local currency collateral. This mechanism means that US dollar devaluation can encourage greater leverage, further fueling the global liquidity cycle and making it more volatile.
3. Central Banks have power but lack control over the increasingly complex financial system.
Central Banks have power, but they do not always have control.
Limited influence. While Central Banks possess significant power through their ability to supply liquidity at fixed policy rates and manage their balance sheets, their control over the broader financial system is increasingly tenuous. This is due to the proliferation of alternative monies, the rise of shadow banking, and the sheer volume of cross-border capital flows. Their traditional tools, like setting short-term interest rates, are often inadequate, especially when rates approach zero or become negative, potentially even hampering credit supply.
Balance sheet as a lever. Unconventional monetary policies, such as Quantitative Easing (QE) and Quantitative Tightening (QT), have become commonplace. These balance sheet policies aim to affect asset prices and financial conditions by altering the composition of private sector balance sheets. However, their impact on term premia and bond yields often contradicts conventional academic predictions, suggesting that market dynamics and investor behavior play a more significant role than Central Banks acknowledge.
Beyond national borders. The US Federal Reserve, in particular, acts as a de facto international lender of last resort due to the dollar's global dominance. Its swap lines, while crucial during crises, have become politicized, excluding key dollar users like China. This highlights that Central Banks' national mandates are often at odds with their global responsibilities, further complicating their ability to exert full control over the vast and interconnected global liquidity system.
4. The scarcity of 'safe' assets creates systemic fragility and amplifies liquidity swings.
The underlying scarcity of high-quality assets leads on to Capital Wars.
Demand for safety. In a fractured and uncertain world, investors hoard "safe" assets like cash, government bonds, and US dollar assets. This precautionary demand is a critical driver of financial flows. However, austerity policies and quantitative tightening programs by governments and Central Banks have inadvertently limited the supply of these high-quality safe assets.
Private sector substitutes. When the State fails to produce sufficient safe assets, the private sector steps in with less reliable substitutes. These privately-produced "safe" assets, often collateralized by lower-quality debt, compromise the ability of private balance sheets to roll over the huge volumes of outstanding debts. This creates a dangerous feedback loop: reduced supply of high-quality assets increases the demand to hoard them, further amplifying swings in global liquidity.
Procyclical fragility. This reliance on lower-quality collateral makes the financial system inherently procyclical and fragile. In downturns, when liquidity is most needed, these private sector instruments lose their "safeness" and evaporate, leading to sudden stops in funding. This structural shortage of high-quality collateral, exacerbated by Central Bank asset purchases that remove them from the market, is a core vulnerability of the modern financial system.
5. China's financial rise is reshaping global liquidity and challenging US dollar dominance.
China matters hugely to both the World economy and World finance.
A new financial powerhouse. China's share of Global Liquidity has surged from a mere 5.9% in 2000 to a staggering 27.5% today, significantly outpacing America's 22.5%. This exponential growth, particularly since its WTO entry in 2001, has transformed China into a major player in global finance, with its Central Bank (PBoC) now one of the largest in the world by balance sheet size.
Financial immaturity. Despite its industrial might and vast liquidity pool, China's financial system remains relatively immature. Its international balance sheet is heavily skewed towards official holdings of US dollar forex reserves, and its private sector has a minimal international presence. This forces China to be a heavy dollar user and re-exporter of dollars, rather than promoting its own currency, the Yuan.
Internationalizing the Yuan. China's strategic goal is to displace the US dollar in Asia and capture seigniorage gains. This involves:
- Invoicing more trade in Yuan
- Developing Yuan trade credit markets
- Opening its domestic bond market to international capital
- Establishing and promoting a digital Yuan currency
These initiatives aim to broaden China's gross international balance sheet and diversify its asset base, moving away from its current reliance on the US dollar.
6. The US dollar's global role creates a "Financial Silk Road" of capital flows.
Capital raced Eastwards along what I call the Financial 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.
Dollar's enduring supremacy. The US dollar remains the undisputed global anchor currency, involved in over 44% of all foreign exchange settlements and anchoring economies representing 70% of World GDP. This dominance allows the US to issue "safe" assets (currency, Treasuries) in high demand globally, which it then uses to acquire riskier international assets. This "exorbitant privilege" is a key feature of the global financial system.
Three phases of dollar dominance. The dollar's journey to supremacy has evolved through distinct phases:
- Gold Exchange Standard (1945-1971): Post-WW2 Bretton Woods era.
- Oil Exchange Standard (1974-1989): Crude oil priced solely in USD, creating new demand.
- Emerging Market Exchange Standard (1990-present): EM growth and dollar-pegging policies fueled demand.
This continuous demand, despite the US economy's relative decline, underscores the dollar's entrenched network effects.
The Financial Silk Road. The fall of the Berlin Wall and China's WTO entry unleashed billions of "new producers," leading to a massive Eastward shift of capital. This "Financial Silk Road" describes how capital flows from Western money centers are pulled towards the high-growth opportunities in China and Central Asia. Paradoxically, this has caused China to lean heavily on the US dollar, creating a vulnerability that China now seeks to address by internationalizing the Yuan and establishing its own regional financial influence.
7. Modern finance is a refinancing system, making balance sheet capacity paramount.
Linked to these changes, today’s financial markets increasingly have to serve as refinancing mechanisms rather than as new 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.
Debt rollover imperative. Modern capitalism, with its towering and complex capital structures, has evolved into a vast refinancing system. The sheer volume of outstanding global debt, estimated at $250 trillion, constantly requires rollover and renewal. This makes the capacity of financial institutions to facilitate these debt rollovers—their balance sheet size and liquidity—far more critical than the cost of capital, i.e., interest rates, for new investments.
Liquidity over interest rates. In a refinancing-dominated world, access to credit lines and the ability to secure funding are paramount. When maturing debts cannot be easily refinanced, borrowers often accept higher interest rates to ensure continuity, highlighting that liquidity is not fungible and its availability trumps its price. This challenges the traditional Central Bank focus on interest rate targeting as the primary monetary policy tool.
Fragile elasticity. The shift from traditional bank deposits to wholesale money markets (repos, commercial paper) as primary funding sources introduces a "fragile elasticity" to the system. This collateral-based funding is highly procyclical and dependent on stable collateral values. When funding stops or slows, often due to a lack of sufficient high-quality collateral or withdrawal of Central Bank support, crises can erupt, underscoring the importance of robust balance sheet capacity.
8. Financial crises are systematic liquidity shocks, often amplified by policy missteps.
Modern financial crises tend to be neither purely national, nor simply isolated events.
Systemic, not idiosyncratic. Financial crises are not random occurrences but systematic liquidity shocks that ricochet across the globe. They are typically larger, longer-lasting, and more pervasive than the shocks modeled by economists. These crises are often preceded by economic booms fueled by cross-border capital inflows, leading to inflated asset and real estate prices, and are triggered when global credit providers' appetite for new debt slows.
The debt-deflation mechanism. The pattern of these crises remarkably mirrors Irving Fisher's "debt-deflation" model: a credit boom, followed by a sudden contraction in credit supply, forcing hasty asset liquidations to repay debts. This process is amplified by a sliding national currency and banks shrinking their loan books, leading to further falls in asset values and tighter credit conditions. This global factor, driven by liquidity, explains the commonality of crises across different economies.
Policy's unintended consequences. Policy responses, particularly austerity measures and quantitative tightening, can inadvertently exacerbate these vulnerabilities. By limiting the supply of government bonds (prime collateral), they force the private sector to create lower-quality debt substitutes, increasing financial fragility. This highlights a critical disconnect: policymakers, despite acknowledging the importance of global liquidity, often implement measures that worsen the problem, leading to persistent financial market volatility.
9. Geopolitics and technology are driving a shift from globalization to regional capital blocs.
Capital wars are not simply the battles for currency supremacy.
Deglobalization's rise. The post-2008 era is witnessing a retreat from globalization towards a new regionalism, driven by geopolitical tensions and technological competition. The US is explicitly containing China's economic and geopolitical challenge through trade, technology transfer, and capital flow controls. China, in turn, is pursuing policies to thwart US dollar hegemony and establish its own regional economic and financial influence.
Technology as a weapon. The battleground of these "Capital Wars" embraces money, technology, and geopolitics. Leading-edge technologies like AI, 5G, digital money, and quantum computing are not just economic tools but strategic assets with military and cybersecurity implications. Control over these technologies and the capital flows that fund them is a central axis of rivalry, posing a significant threat to traditional globalization.
Emergence of regional blocs. Capital is being re-routed along new "Financial Silk Roads." German capital is shifting East into Eastern Europe and potentially Russia, while China consolidates influence in Asia and expands into Central Asia, Europe, and Africa via the Belt and Road Initiative. This suggests the emergence of de facto regional currency blocs, characterized by internal exchange rate stability but greater flexibility between blocs. This geopolitical reordering will fundamentally reshape global liquidity flows and the international financial system.
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