Michael Howell, author of the book “Capital Wars,” believes that the international financial system has been transformed into a system that serves “debt refinancing,” and the traditional view that interest rates are the main driver of the economic cycle may be wrong.
In April, US stocks ushered in a cruel season. The US economy and job market are hot, and inflation is on the rise again. Wall Street's expectations for the Fed to cut interest rates have been completely reversed, from seven times at the beginning of the year to less than two today. Federal Reserve Governor Bowman even believes that if inflation never falls to the Fed's target line of 2%, it may be necessary to raise interest rates again this year.
As expectations of interest rate cuts have faded away, US stocks have also experienced a sharp correction. As of Monday, the S&P 500 index had a cumulative decline of 4.64% in April, and the cumulative increase during the year was reduced to 5.05%.
Why can the US economy continue to advance rapidly under the highest interest rates in 40 years? Michael Howell, CEO of the research institute CrossBorder Capital and author of the book “Capital Wars,” believes that due to the crazy expansion of global debt over the past few decades, the international financial system has been transformed into a system that serves “debt refinancing”. Liquidity is the weather vane of the economy. Interest rates or inventory cycles are not that important anymore.
Crazy debt expansion
According to the International Monetary Fund (IMF), in 39 advanced economies, debt as a share of GDP rose from 110% in the 1950s to 278% in 2022. After the 2008 financial crisis, a combination of global financial imbalances and ultra-loose monetary policies led to a surge in debt size. From the mid-2000s to 2022, developed economies' public debt as a share of GDP has risen from 76.8% to 113.5%.
The situation is similar for non-financial companies, with outstanding bonds reaching a record $16.6 trillion in 2021, more than double that of 2008. The US accounted for 40% of the total amount of debt issued during the same period.
Among many advanced economies, the debt problem is most acute in the US. As mandatory spending such as defense spending, health insurance, and social security, and rising interest costs increase the growing deficit, a potential crisis is also brewing.
According to the US Congressional Budget Office (CBO) forecast, by 2033, the size of US debt will increase to 52 trillion US dollars within 10 years, increasing by an average of 5.2 billion US dollars per day.
More dangerously, America's debt will grow much faster than the overall economy. According to CBO data, the federal government debt held by the public will reach 118.9% of GDP by 2033, which is 20 percentage points higher than 98.2% this year. In today's peace-time period, US government spending accounts for 44% of GDP, which is higher than the peak during World War II.
Howell believes that the actual result of a government debt default is inflation, because the government will not substantially default and will choose to monetize the debt by purchasing bonds with the central bank. As a result, the Federal Reserve's balance sheet has grown by more than 500% over the past decade.
According to CBO estimates, by 2033, the US Treasury bonds held by the Federal Reserve will increase from the current nearly 5 trillion US dollars to 7.5 trillion US dollars. After 2026, the net interest expenses that the US government needs to pay to US debt holders will reach 1 trillion US dollars. Howell believes that this forecast may be too low, particularly in terms of expanding defense spending. More realistic figures suggest that the Federal Reserve needs to hold at least $1 billion in treasury bonds. This means that the Federal Reserve's liquidity will continue to grow in double digits for a few years.
As a result, there aren't many alternatives to the Federal Reserve's quantitative easing policy in the future. The tax base has been dried up, and the continuation of large-scale QE is a matter of course.
According to Howell:
Financial markets require liquidity to revolve around huge debts accumulated by businesses, households, and governments. We estimate that currently, out of every eight dollars transferred in the world financial market, seven dollars are used to refinance existing debt. A growing portion of the remaining $1 is being used to fund the growing government deficit.
How did the global debt boom come about?
The tasks of the financial system used to be simple.
After World War II, financial systems in developed countries generally operated as follows: the household sector saved for prevention and retirement; through the banking system and capital markets, these savings were transferred to the government to finance budget deficits, and then to the corporate sector to finance working capital and investments.
However, as the pace of technological iteration slows, developed countries are increasingly dependent on debt to drive economic growth. Although debt expansion cannot increase productivity, it can stimulate output growth by increasing demand and investment.
In this process, developed countries intend to create excess liquidity through central banks to reduce debt costs. At the same time, they use cross-border trade and capital flows to export excess cheap liquidity to other countries, raise the debt levels of these countries, and bring the world into the risk of a debt crisis.
The Bank for International Settlements once pointed out in a report that without the amplification of various financing channels, the financial crisis in Latin America and Asia in the 1980s and 90s of the last century would not be that serious. High levels of debt and weak financial structures make these emerging economies vulnerable to internal and external shocks:
As the economy slows and the global financial environment tightens, the banking sector in these countries will reveal its fragility, making it more difficult to refinance existing debt. The shortening of debt and the foreignization of debt have exacerbated the problem. As these economies' currencies depreciated, soaring debt burdens challenged the ability of private and government departments to meet their debts, and the urgent need to repay foreign lenders in foreign currency triggered a balance of payments crisis.
“Debt refinancing” has become the new financial order, and the focus on interest rates is wrong
According to CrossBorder Capital's estimates, the total global debt is around $350 trillion, with an average maturity date of five years, and annual refinancing needs between $60-70 trillion. Liquidity, or the availability of capital to meet these refinancing needs, is the key to dominating today's financial cycle. A refinancing crisis occurs when demand for debt rollover does not match liquidity. From the Asian financial crisis in 1997 to the 2008-2009 global financial crisis and the 2022 British debt crisis, they all fall into the refinancing crisis described above:
Last year, the recession predicted by most economists did not occur. This may be partly because the old financial cycle based on the new wave of capital expenditure is dead, and our thinking needs to be updated. It was replaced by a new financial cycle based on liquidity and driven by the need to refinance debt. The underlying global liquidity fluctuation cycle is determined by an average debt maturity of 5/6 years.
This year, the world's debt is expected to be as high as $500 billion to $600 billion (about one-seventh of total global debt). Borrowing old debt to pay off new debt has become the main theme of the global economy.
As Howell said:
Due to the accumulation of large visible capital reserves in the past, modern capitalism must run a huge refinancing system. Its main purpose is to refinance debt to sustain economic growth rather than raise new capital.
Howell emphasized that in a world dominated by debt refinancing, the economy is no longer as sensitive to interest rates as it used to be, and the traditional view that interest rates are the main driver of the economic cycle is wrong. The US economy is the best example. The most aggressive interest rate hikes in the past 40 years have not had much negative impact. Howell says that higher bond yields will also generate higher profits and be converted into consumption.
He also pointed out that this new financial order of “debt refinancing” can also explain the current bull market for gold and bitcoin. Gold and Bitcoin can be seen as a hedge against the depreciation of fiat currency, and the demand for debt refinancing will drive the continuous growth of banknote printing and debt issuance, causing so-called “monetary inflation (monetary inflation),” which pushes investors to hoard gold and Bitcoin. Instead, geopolitical factors play a less important role in this round of gold and bitcoin bullish markets.
Editor/Somer