Book review: Capital Wars
What the mainstream media doesn't teach you about finance
The standard economics and finance paradigms ignore money and liquidity. Markets are assumed to exist everywhere and at all times, and frictionless trade is supposed to occur. Yet paradoxically, illiquidity is the ultimate friction and without sufficient liquidity there would be a widespread market failure and no trade.
I learned how the global financial system works by listening to 100+ hours of Jeff Snider podcasts. Lots of other peripheral resources too, but Jeff was my primary guide. While I enjoyed the process, strictly speaking it wasn’t the most efficient method of instruction.
For the person who wants to learn the financial system as quickly as possible, I would suggest Capital Wars. Best viewed as a textbook, this comprehensive treatise is not always an easy read, however, if you put in the work you’ll emerge a far more knowledgeable market participant.
To kick things off, Capital Wars introduced me to a new way of thinking about exchange rates. Unfortunately I didn’t save the quote but Michael’s argument goes something like this.
Exchange rates are not primarily determined by interest rates, as the field of economics would have you believe. Rather, exchange rates are determined by the quality and quantity of capital.
Central banks create quantity capital, I.e. bank reserves, and this QE tends to push exchange rates down
Productivity and industrial sector output create quality capital, I.e. revenues/free cash flows from profitable businesses. This high quality capital tends to push exchange rates higher, since foreign investors want to participate in these markets
I find this to be an intuitive and useful way to conceptualize exchange rates. Furthermore, Howell also addresses the link between high productivity, asset prices, and how liquidity flows can lead to bubbles.
Economies with strong productivity growth and net capital inflows often enjoy rising asset prices, especially when their nominal exchange rates are relatively stable. And, because appreciating capital asset prices tend to attract more investors, these moves can be amplified by further capital inflows, thereby, fueling an asset price spiral.
The refinancing system
The predominance of refinancing, as opposed to financing, was another key takeaway from Capital Wars. Howell argues that our financial system is no longer a mechanism for investing in new businesses, entrepreneurs and economic expansion. Rather, our system’s function is to rollover the massive amount of existing debt.
The fact that the modern financial system has turned from a new financing system to a refinancing system that is more than ever dependent on the supply of potentially flaky safe assets to help rollover increasingly flaky debts creates a negative feedback that highlights the inherent dangers in credit markets.
If economic conditions are unfavorable a business can put off building a new factory, or an entrepreneur may wait before they apply for financing. New capital creation can, at least to some extent, be adjusted based on market conditions.
On the other hand, refinancing is mandatory. If a company can’t rollover its debt it could go bankrupt even if the business has a good revenue stream. Howell repeatedly makes the point that the most important factor in our financial system isn’t interest rates (the cost of borrowing) but rather, balance sheet capacity (the ability to borrow).
M2 we hardly knew you
Michael takes a dismissive view of traditional money supply measurements like M2.
It is our contention that ‘modern money’ really starts where conventional definitions of money supply end. In other words, the well-known monetary aggregates, e.g. M0, M1 and M2, are only the tip of the growing iceberg of short-term claims that, as the 2007-2008 GFC shows, can severely disrupt the markets. - M2 money, the broadest official US monetary measure, comprises notes and coins, as well as insured household deposits.
It excludes the uninsured claims of institutional money managers, corporations and Forex reserve managers, as well as offshore Eurodollar balances. Together this combined broad funding pool stands close to US$26 trillion, easily dwarfing the US$15 trillion that makes up M2 money supply.
I am not qualified to comment on the precise flaws of M2, but I do have a good understanding that this metric fails to take into account many assets that we use as money.
A small example: Tether. The USDT stablecoin has a market cap of $68 billion. While this is only a drop in M2’s bucket, it is a drop nonetheless and as far as I know, M2 does not account for stablecoins.
A more pertinent example could be the $80 trillion in dollar swaps the BIS recently dug up. While I understand that these aren’t money in the traditional sense, the existence of these FX swaps has an effect on the demand for dollars, and hence the dollar’s value.
Howell charred mainstream economics with that previous quote, but in the following passage he turns up the heat and burns econ to a crisp.
A plausible reason why liquidity is shunned in the traditional literature is that it is perceived to be both hard to measure and difficult to define. But just because a task is challenging, there is no reason not to try.
Economics is itself often guilty of raising to heights of great importance factors that are easily measured. This fallacy can be colourfully described by the tale of the drunkard searching for lost keys under a streetlamp: not because this is where they were lost, but simply because that is where the light is better! Often economic truths lie in the shadows where they can be hard to see.
CREAM
The forensic accounting firm Wu-Tang summarized the state of the economy adroitly with their catchy rallying cry of CREAM: Cash Rules Everything Around Me. It’s all about the cash, and Howell provides a perfect summary of why the American dollar squeezes higher during periods of crisis.
The huge US current account deficit, sustained over two decades, which persuaded many experts ahead of the GFC that the US dollar would slump, actually hid a massive build-up of short-term offshore gross US dollar borrowings by foreigners that required all too frequent refinancing. These were offset by foreign holdings of longer term US ‘safe’ assets, such as US Treasuries.
Not surprisingly, the unfolding of the GFC was accompanied by a sharp US dollar appreciation, as those foreign financial institutions that had also used short-term dollar funding to invest in riskier long-term dollar assets were forced to hurriedly deleverage.
I recently published an article about why the dollar isn’t going to be replaced anytime soon, and Brent Johnson has been making the same point for years. There are tens of trillions in foreign held, dollar denominated debt. The interest payments on this debt creates a constant demand for dollars, especially during bouts of volatility. Betting against the dollar is like going to Vegas and betting against the house. You might win all afternoon, but as the night thickens the odds weigh heavy on your shoulders.
The big Kahuna
Longtime readers will know that I’m a keen observer of what Emil Kalinowski has called “the silent depression.” Emil’s idea is that the rate of growth in our economy never returned to its pre-2008 trendline, hence by 2023 we’ve lost trillions in global GDP compared to where we should be. In addition to Emil,
Hugh Hendry has also stated on multiple occasions that we’re in a depression
Jeff Snider has argued that our financial system is broken, it doesn’t lend and drive economic growth the way it should
Ben Hunt has shown that we’ve papered over a lack of real growth by going into debt and financing the government with QE
Let’s say that these gentlemen are correct. Maybe we don’t like to use “depression” to describe the funk we’re in, but there is a certain economic malaise hanging over our collective heads.
Accepting that as true isn’t difficult, the real tricky bit is trying to answer why it’s happening. I’ve been tossing this quandary around for a year or two and I’ve made a bit of progress, but Capital Wars proved instrumental in taking my thinking to the next level. Let’s take a look at one section in which Howell discusses a dearth of safe assets in our financial system.
With its vast and visible stock-piles of past capital accumulation, modern capitalism has to operate a huge refinancing system. This, in turn, demands a stable credit instrument that is able to support these debt rollovers. - The new supply of international safe assets appears to have increased at around a 10% clip prior to the 2007-2008 GFC, but has since skidded lower to a barely positive pace.
Even a decade of such sub-par growth would create a sizeable shortfall gap of some 80% compared to the pre-crisis trend. What’s more, as the supply of safe assets has dwindled, so the expansion of Global Liquidity has similarly faltered.
Anytime we talk about a macro phenomenon as far reaching as a “silent depression,” it would be imprudent to blame it on one factor. However, Howell makes a compelling argument that regulatory limits on balance sheet growth, and a lack of safe assets, have likely played an outsized role in the anemic levels of growth we’ve experienced since 2008. Here’s an example of how the supply of safe assets is decreasing.
According to the IMF (2021): “…the number of sovereigns whose debt is considered safe has fallen, which could remove some US$9 trillion from the supply of safe assets… or roughly 16 percent… Private sector production of safe assets has also declined as poor securitization in the US has tainted these securities, while some new regulations may impair [supply]…”
In short, there aren’t enough safe assets! And if banks and other money lending institutions can’t get enough high quality collateral to lend against, they’re not going to lend as freely as they once did. That results in lower levels of growth and economic malaise.
I’m obsessed passionately interested in the silent depression / brokenness of our financial system and there’s a temptation on my end to keep bringing in more quotes to aid in this discussion. However, at a certain point I’m forced to admit that I can’t just quote the whole damn book! So I’ll leave it there for now, although I’m certainly not ruling out a future article devoted to this topic.
Finale
I’ve provided a decent cross-section of Capital Wars in this review, but it’s just scratching the surface. If you’re ready to take your financial acumen to the next level then this is the book for you. I read Capital Wars over the course of five months, but I think with diligent effort, enough coffee, and an attention span that hasn’t been ravished by Tik-Tok you could get through it in a month or two.
Every Sunday I publish a recap of all the best finance articles and podcast episodes I’ve found thought-provoking. Here’s the latest edition.
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Great review. I'm a big fan of Howell. I've had Capital Wars on my desk for a few months now without cracking it. Your note motivated me to buckle down, open it up and start taking notes.