In the last post I gave an overview of how the rise of institutional cash pools has impacted financial markets. It was a long and detailed post, but even then it could only give you an overview.
In brief, underperforming insurance companies and pension funds (ICPFs) borrow from the cash pools, using an instrument called repo, to leverage up their portfolios (and if you don’t know what that means, you’ll have to read the last post).
So why does any of this matter? Well the first point to remind you of is the sheer scale of what we’re talking about here. As I showed you 3 weeks ago, the wealth in cash pools tripled in size from 1997 to 2014 (the most up-to-date data I have), from $2tn to over $6tn (more than double UK GDP that year). And in the early ’90s they were barely a significant phenomenon. So in about 25 years we have seen a concentration of wealth grow from being insignificant to having the size to impact on a global level.
As I pointed out 4 weeks ago, this is all the result of the rise in wealth inequality, specifically the marked shift in the proportion of GDP going to profits rather than wages. Many people are bothered by this inequality and see it as unjust, but few consider the economic effects of such a concentration of wealth. And those that do are not looking at what, precisely, has happened to this concentration. This is why Pozsar’s work, summarised over the last few posts, is so profoundly important.
The second point to note is the shift in the source of capital market lending. Economists usually talk in terms of households lending to businesses, and focus on the role of banks and financial markets in intermediating between savers (the households) and borrowers (the businesses). This can give the impression that personal household savings (i.e. what people squirrel away in savings accounts), or an individual choosing to buy shares rather than hold their savings in a bank account, are significant to the economy. This is basically ridiculous. With the exception of the super-rich (the 1%), the only significant source of household savings is our pension funds and insurance policies.
But what we now see is the ICPFs borrowing off the business sector. It’s a complete reversal of the story told in textbooks. Don’t you think such a complete revolution in the structure of our economy is going to have an impact?
Two weeks ago I explained that one of the three main types of cash pools is the cash balances of global corporations. Normally we would think of profits being distributed to shareholders or spent on investment by the company in question. But now, multinational groups of companies have become such giants that their cash reserves are vast pools, which, until a couple of years ago, they were lending to underperforming ICPFs, who were using leverage to increase the performance of their fixed income portfolios (fixed income means bonds rather than stocks).
Now let’s carry out a couple of “thought experiments”. As mentioned, the standard story about saving and investment is that financial markets intermediate household saving (ICPFs) to businesses. Imagine if, as well as holding fixed income portfolios, the ICPFs borrowing off cash pools also held stock portfolios that include the shares of the global corporations who own these pools. If those companies then paid greater dividends rather than sitting on their reserves, the ICPFs would simply receive that cash as earnings on their portfolio: they wouldn’t need to borrow it, it would already be theirs.
I have no idea whether any ICPFs do own shares in these companies, or what the make up of share-ownership is – this is just a “thought experiment” to point out the natural set of relationships implied by conventional thinking. And here’s another one.
The cash pools were typically borrowing government bonds off the ICPFs. Governments are selling bonds to bridge the gap between their tax revenue and their expenditure. But they could simply tax these large corporations, and not have to take on further debt. We know that one reason some corporations hold such vast cash pools is to keep them offshore and avoid paying tax. Having avoided funding the Government through taxation, they then fund the Government through lending and get paid for the privilege!
This is again a highly simplified scenario. It’s not a straightforward case that firms avoid paying tax from the very governments whose bonds they are buying – but again it highlights how the relationships we might normally assume to be in place have been distorted, and that there could be better ways for markets to be organised.
These distortions occur because of the concentration of wealth in a small number of hands. Over the next couple of weeks I’m going to look further at the global imbalances caused by the distortions – Pozsar has some fascinating comments on this. Addressing these imbalances is a key component of how we create an economy that provides enough for everyone.