Over the last 5 weeks I’ve outlined what has happened to all the wealth flowing over decades from wages to profit. While we might expect these profits either to be distributed to shareholders (which include our pension and insurance funds) or invested by the businesses concerned, it turns out that global corporations are sitting on these profits in huge institutional cash pools.
These cash pools are looking for safe, liquid investments. They want access to this cash (which is why they are not making long-term investments) but leaving it in a bank is high risk as only a tiny proportion would be covered by deposit insurance. So they lend the cash to insurance companies and pension funds (ICPFs) using repo. The collateral in these loans is usually government bonds, so the proceeds of tax avoidance often ends up funding government spending through another route, more costly to the taxpayer.
The story here is of a complete reorganisation of the ownership and use of wealth, as more and more wealth is concentrated in a smaller and smaller number of (institutional) hands. Of particular note is that no longer are households the primary source of funds for capital market lending – it is now the retained earnings of global corporations, rewriting the description in every textbook ever written.
To complete our understanding of this picture we need to consider the other two sources of cash pools. Three weeks ago I outlined three types and focused my attention on one of these – cash balances of global corporations. This week we will look at the other two types: cash balances of institutional investors and foreign exchange of central banks.
Cash balances of institutional investors
These are investment funds pooling together the resources of various investors. The total pool is invested across a wide range of assets, diversifying risk (one of the benefits of having a large pool). Pozsar lists several reasons why these funds will accumulate large cash pools, but only briefly (see page 22 of his 2015 paper). What he highlights is that through these funds the vast wealth of a large number of institutions is being managed by a relatively small number of asset managers. This brings into focus a point raised in the introduction to this post, that so much wealth is being brought under the control of so few players, giving them an incredible influence on the global economy.
Foreign exchange reserve regimes of central banks
All central banks maintain foreign exchange reserves. Again, they don’t simply hold these in a bank account. Typically, they hold them in government bonds, which are guaranteed to hold their nominal value and pay a regular coupon payment. However, such bonds are at risk of losing real value through price inflation or currency devaluation, so again central banks will hold a diverse portfolio of assets to hedge this risk.
The marked trade imbalances in the world have led to large levels of reserves with a small number of central banks, particularly in South East Asia. In the UK or US we are very used to the fact that we have a trade deficit – it just seems normal to us now. But if some countries have a persistent deficit, other countries have a persistent surplus, and these countries are accumulating foreign reserves. In particular, they want US dollars because this is the currency of international trade. Hence, unlike any other currency, there is always a high demand for US dollars regardless of whether anyone actually wants to buy US goods! It’s as if the US is funding its national spending by borrowing from the Chinese (through Chinese central bank purchase of US bonds), while the Chinese profits from US purchase of its consumer goods, and then saves its profits in US bonds, and so on and so on…
This is a gross oversimplification, but both sides do need the other – the US needs the cheap goods from China, and China needs US markets. Both have an incentive to maintain this practice of China buying US Government debt. Except that this is another imbalance that is potentially destabilising to the global economy.
So the picture we now have is of a series of imbalances in the global economy:
- Ever greater wealth being concentrated in a tiny number of hands (the 1% and 0.1%);
- Such vast wealth being managed by a small number of asset managers;
- The concentrations – the institutional cash pools – looking for safe, liquid investments (e.g. government bonds), rather than investments in private sector productivity that carry more risk but help grow the economy;
- Meanwhile there is an imbalance between the performance of ICPF portfolios and the promises they have made to their clients, making them willing to take on leverage to achieve their targets;
- And finally there is the imbalance in trade, with some countries producing the goods (particularly South East Asia) and others consuming them (particulary the US and UK) – the US funding this through sale of dollar demoninated assets, for which an almost insatiable demand exists only because the dollar is the currency of global trade, and the UK being the centre of this international trade in dollars.
This is what you would have found under the bonnet of the global economy from before the crash right up until 2015. The last 3 years have seen interesting changes in response to post-crash regulatory requirements and the Federal Reserve seeking to move away from its post-crash crisis measures, but these imbalances still remain – indeed, the failure to address them is a central feature we need to look at.
Because, rather like greenhouse gases and climate change, these imbalances threaten the stability of the economy and its ability to provide enough for everyone. The last few weeks may have been detailed and technical, but a description of the global economy that doesn’t take these imbalances into account would be somewhat like explaining how a car works by saying, “Engine goes brrrm, car moves.”