People tend to misjudge what is going on in the financial system because they do not realize the world we live in. Weare now dealing with a series of issues we never faced before. For this reason, approaches are much different than even a few decades ago.
The global debt numbers are astronomical. We are now over $350 trillion. The average duration on this debt is 5 years. That means we are now at the point where $70 trillion has to be rolled (refinanced) every year.
That creates a completely different market as compared to what we would have otherwise. No longer is the traditional metrics the main barometer. Instead, we have other things cropping up.
Balance Sheet Capacity
This is a topic that is not the most exciting but is vital.
Balance sheet capacity is the primary factor in financial markets. Here is where we see liquidity, or not. If there is adequate balance sheet capaicty, the world can fund global growth. However, absent that, we are in trouble.
We have discussed the idea of balance sheet constraint. What this means is that financial institutions, especially banks, cannot leverage their balance sheet for loans. This is an issue since this is what is needed for global trade. WIthout this capacity, things inevitably contract.
Some might say this is a good thing. They hold this view right up to the point when they get laid off from work or their business goes under. When you do not have the ability to fund global trade, bad things happen.
Balance sheet capacity, or more accurately a lack thereof, is the most important aspect to the financial world right now. This is why we are in an era of deflationary money.
Refinancing Means Liquidity, Not Interest Rates
Let us use the example of refinancing a house.
Does the interest rate matter? Most will takl how important this is. However, not if there is no loan. In other words, the interest rate is secondary to if the borrower can't get the money.
If there is no liquidity in the system, lending does not take place. Hence, if we think about the choice between getting a loan or not, interest rate really isn't part of the equation.
That is what makes the actions of central banks such as the Federal Reserve pointless. It isn't a question of interest rates. The financial system doesn't have the balance sheet capacity to lend. Hence, adjusting rates isn't going to impact those decisions.
What is required is liquidity. Unfortunately, the Fed looks at the world like economists. It believes that central bank reserves are currency that banks can use. The banking system doesn't care about reserves because they cannot be used as collateral. Thus, when QE is taking place, the central bank is actually tightening financial conditions.
Effects Of Deflationary Money
These conditions are obliterating the banking system. We can trace the problems there to this factor.
When banks take in deposits, they buy government approved securities. The problem is when these drop in value, which happens to bonds as interest rates are pushed up. This reduces the price on the open market.
A bond is valued at par because if held until maturity, all money would be paid. However, if one needs to use it as collateral, lenders do not care about the par value. They look at what is available on the market and the liquidity the asset has.
Here is where the banks run into problems. When their balance sheet declines in value due to the assets prices dropping, they are limited in what they can do. Even if they do not have to hold a fire sale, the ability to lend is restricted.
Picture this happening throughout the entire financial system.
We have $350 trillion in global debt that is in need of refinancing. To do this, we need a lot more assets out there. Here is where I maintain cryptocurrency and DeFi can step in. It can fill a major void.
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