I was intrigued by Capital Wars: The Rise of Global Liquidity after reading John Plender’s review for the FT: ‘As a description of the workings of the modern global financial system and the interrelationship of finance and the real economy, it has no current rival.’ Actually, there is a rival — Adam Tooze’s Crashed. Although it is true that Tooze’s book focuses on the financial crisis and the unraveling of the global order in its wake, instead of being an interrogation of contemporary global financial intermediation per se. Even so, the picture of global finance and economics that emerges from Crashed and Capital Wars is congruent — both being deeply informed by the macrofinance intellectual revolution.
The other rival is, of course, Trade Wars are Class Wars by Matthew C. Klein and Michael Pettis. Klein and Pettis are less in thrall of macrofinance which leads them to mistakenly trace the origins of the GFC to global imbalances driven above all by China’s high savings strategy that Pettis has done more than anyone else to highlight over the years. What is truly original about Trade Wars is the framing of the high savings strategy of the later-developing industrial nations as a class war. The underconsumptionist strategy works by suppressing the real wages of the mass of workers in the high savings countries; the ensuing global imbalances undermine the competitiveness of center country firms, at least in the tradable sector; which in turn suppresses real incomes of the mass of workers in the core of the world economy. In effect, Sino-American economic relations amount to a class war against the working classes of both nations. The influence of Trump’s trade war against China on the genesis of the book is obvious. Even though Trump is history, the logic identified by Klein and Pettis is still very much in play and their recommendations for reforming global economic relations remain highly salient.
Unlike Tooze, Klein and Pettis, Howell is pure macrofinance. The focus of Capital Wars is global liquidity — the elasticity of global financial intermediation. It is a highly sophisticated meditation by a seasoned analyst of global financial markets. Plender’s quite right to warn that the book is ‘Not for beginners, but essential reading for market practitioners.’
Michael Howell is the CEO of CrossBorder Capital, a London based macro research firm that publishes the Global Liquidity Index. He started off a strategist at Solomon Brothers during the 1980s’ Big Bang of Anglo-Saxon finance. The situated knowledge of the consummate financial insider comes through clearly: ‘Many of Salomon’s traders believed,’ Howell notes, ‘that watching money and capital flows was the nearest thing to obtaining insider information.’
In Kyle’s seminal 1985 paper, the informed investor is described as an insider because she is an information monopolist. More generally, market microstructure theory considers investors to be informed if they have access to some kind of superior technology or source of information that makes them more informed than the market-makers. The question we posed in that earlier dispatch is still open: While it is clear how a trader may be more informed about the future price of a security than the market-marker, how can anyone be relatively more informed than the dealers about systematic risk? After all, according to intermediary asset pricing theory, systematic risk is a function of fluctuations in the risk-bearing capacity of the dealers themselves.
I am coming around to the view that part of the answer to this question is that there are more logics at play in finance than the procyclical balance sheet management of global banking firms. And that it is indeed possible to understand these logics better than the centrally-situated intermediaries with eyeballs on order flow from all directions. That is, it may be possible to systematically outwit JPMorgan and Goldman Sachs. But how?
The first hint emerged when I tried to replicate the predictive information contained in Howell’s liquidity measure about the future strength of the dollar. Recall that dollar strength is itself informative about the relative tightness of global financial conditions — when the dollar strengthens, financial conditions get tighter. I couldn’t reconstruct Howell’s measure. But I found that cross-border financial flows strongly predict dollar strength. My takeaway was that the flux of global banking flows contains a very strong signal of the global financial cycle — identified by Hélène Rey as the joint fluctuations of risk premia across global markets.
We had seen previously that national stock markets covary strongly in a manner that suggests the existence of a single global systematic factor posited by Rey. Moreover, we argued that the comovement of national stock markets contains information on the core-periphery structure of global markets. We represented this global structure as a phylogenetic tree constructed from a hierarchical clustering algorithm applied to national stock market returns. The amount of information contained in this tree is simply astounding. This is a better map of core-periphery structure of the world economy than anything else I have ever seen.
Then I realized that these two results could be combined. The predictive contained in global credit flows should allow us to dynamically price global markets. The twist was that one had to go full macrofinance and imagine that the marginal investor in global markets is a market-based intermediary reckoning her profits and losses in dollars. We showed that the global financial cycle is priced into the cross-section of global stock market returns — there is a positive and significant risk premium associated with exposure to fluctuations in global liquidity.
Digging further, we found an extremely surprising pattern. Contemporary macrofinance expects the risk-appetite of global banks to be the first mover. More precisely, the patterns documented by the pioneers of macrofinance — Shin, Rey, Gourinchas, Borio, Adrian, Etula, Muir, Poszar, and others — suggest that risk appetite drives financial conditions, which in turn drive risk premia in global markets. That was not what we found. Instead, we documented that cross-border financial flows predict risk appetite, not the other way around. It seems that the tail wags the dog.
Moreover, despite the fact that they predict risk appetite and are priced into the cross-section of international stock market returns, cross-border banking flows are not priced into the cross-section of stock returns in the US, although risk appetite still is. That is, domestic investors are not compensated for exposure to fluctuations in global liquidity. How can we make sense of these patterns? Clearly, something is not quite right with the contemporary macrofinance consensus on the causal diagram relating risk appetite, global financial conditions, and risk premia in asset markets.
Another extremely intriguing revelation in Capital Wars is the predictive information contained in the share of investor assets allocated to equities. Howell claimed that equity allocation predicts 2-year forward market returns. But he had once again failed to detrend his feature. Once we stochastically detrend the series, it turns out that shocks to equity allocation predicts next quarter’s returns on the market portfolio. We documented an unheard-of level of return predictability. We showed that equity allocation accounts for 25 percent of the variation in next quarter’s return on the systematic factor.
We also showed that the predictive information contained in equity allocation can be exploited by informed investors (sensu market microstructure theory) to make superior risk-adjusted returns. Specifically, we proved that it is possible to use superior models of risk premia to systematically beat the market without any leverage whatsoever. So, as it turns out, fluctuations in the risk appetite of cumbersome and slow-moving patient investors, as captured by their equity allocation, track fluctuations in risk premia better than the risk appetite of the centrally-situated market-based financial intermediaries. Perhaps real money investors are not as irrelevant as macrofinance would have us believe?
Yet another intriguing revelation in Capital Wars is related to Howell’s decomposition of asset purchases by hard currency-issuing central banks. He divvies them into liquidity, maturity and credit components in line with current macrofinance thought about banking functions now parceled out to shadow banking institutions by the dealers. He shows that they have different effects on risk spreads. Specifically, he shows that, intuitively, the liquidity component compresses liquidity risk premia and the credit component (largely MBS) compresses credit spreads (mostly by lowering pre-payment risk it seems). But counterintuitively, maturity transformations by the Fed increase the term spread. It is a very intriguing result. But again, I’ll have to check it with my own hands to understand what the hell’s going on with term risk premia.
In general, Capital Wars provides an eccentric and intriguing synthesis of the discoveries of macrofinance together with the seat-of-the-pants embodied knowledge of a seasoned market observer close to the center of the action since the Big Bang. There are some weakness in the argument; bits that I found unconvincing.
First, there is a claim that reappears in passim throughout the book: ‘the true price of money is the exchange rate’ not the interest rate. In as much as he is talking about the information about monetary conditions contained in the value of the dollar, that is a well-documented fact. When the dollar strengthens, funding conditions are tighter, and we can say that the price of money, sensu loanable funds, is high; conversely, when the dollar weakens, funding conditions are looser, and the price of money can be said to be low. But this has to do with the specific structure of dollar centrality in global financial intermediation. There is no evidence to suggest that this applies to any other currency. And there is certainly no reason to believe that it applies beyond the hard currencies in which official safe assets are denominated — the dollar, the euro, the yen, the Swiss franc, and the pound sterling. In particular, it does not apply to the yuan or the rupee.
Second, there’s the inclusion of Chinese liquidity in Howell’s overly complicated measure of global liquidity. As Howell himself notes, China ‘effectively re-exports dollars, when she should export yuan.’ No country in the world uses the yuan to invoice trade; no central banks accumulate the yuan as a reserve currency; there is simply no evidence of any third party cross-border credit being denominated in yuan. The Chinese shadow banking system exists behind a shield of financial repression. What is the point of including Chinese liquidity when one is trying to construct a barometer of the elasticity of global financial intermediation? Sure, if and when China liberalizes its financial system and the yuan emerges as a hard currency, the inclusion would be warranted. But why jump the gun?
Third, and this seems like the fault of the publisher rather than the author, there’s simply no story in the book that could be labeled “capital wars.” Yes, there was a confrontation over trade during the Trump years. And the Harris-Biden people seem convinced, like many others in the West, that measures to check Chinese influence are now in order. But this has little to do with “capital wars” — no matter how one interprets the phrase. The United States and China are not competing for funds in global funding markets, nor are American and Chinese capitals engaged in a Hobsonian competition to acquire foreign outlets for their surplus capital. The framing is absurd and unnecessary.
In fact, the Sino-obsession of contemporary Western analysts can severely cloud their judgement. In Howell’s case, we get the following zinger: ‘[T]he roots of the GFC instead trail back to the 2002–2006 US real estate boom, with the trigger revealing clear Chinese fingerprints: once again underlining her growing economic and financial sway. Closer inspection of capital flow and credit data highlight the People’s Bank (PBoC) tightening Chinese credit conditions in early 2008.’ It boggles the mind that an observer as sophisticated and informed as Howell could fall for this conspiracy theory. We know exactly how the American housing-finance boom came to grief:
The shortage of safe assets in the global financial system led dealers to manufacture safe assets from residential mortgage-backed securities (RMBS) to serve as collateral in the secured lending markets — which generated the housing-finance boom. The problem was that the wholesale funding flywheel only worked as long as there was no credit risk in the collateral. When the credit risk unknowingly embodied in AAA-rated RMBS materialized in the form of mortgage defaults and credit rating downgrades as a consequence of excessive lending during the boom, the funding markets froze. But even at the peak of the crisis, the wholesale funding flywheel continued to spin rapidly in the tri-party repo market (where there was no counter-party risk) but only with state-backed collateral (T-bills and agency-RMBS). So the instability was exclusively due to compromised high quality collateral.
Despite these issues, Capital Wars is too important and interesting to skip for anyone interested in understanding global markets. Perhaps I’ll have more results to share based on his insights soon.