One of the surprising things I repeatedly observed as a CEO of a public company investing in financial services in Africa was that banks there—and in many emerging markets—don’t actually lend, at least not to businesses or people. Rather than provide much needed loans to fund working capital and help businesses grow, or provide a mortgage for an aspiring homeowner, the banks primarily invest in the sovereign debt of their country’s government. These depository institutions are public banks in name, but in practice are funding tools of the State.
In a highly inflationary environment, and one in which governments often can only issue debt by offering high single or even double digit rates of interest, this is a profitable business for the banks. And it is much less risky and complicated than traditional banking. Since African citizens and businesses often didn’t trust their banks—or their governments—they keep their savings and wealth elsewhere if at all possible. This isn’t a particular concern for the banks, as they rely on deposits from well-intended but misguided NGOs and non-profits, as well as wholesale funding from development finance institutions sponsored by governments around the world.
We are seeing the U.S. banking system start to adopt this model.
After growing loans by over twenty percent after lockdowns through 2023, banks have started to restrict private credit. As a whole, the banks are sitting on over $500 billion in unrealized losses on investment securities, making additional lending problematic. Over the past year, total U.S. banking system loan growth has stagnated, increasing by just over two percent to $12.4 trillion. At the same time, the banks’ investment in U.S. Treasury and agency securities has increased by nearly four percent to $4.2 trillion. This figure is up from $3 trillion at the start of 2020. The large commercial banks have grown their credit card portfolios by over 44 percent since the beginning of 2021. But as consumers grow more indebted, banks are both raising interest rates, which on average now sit above 23 percent for new customers, and capping their exposures.
Since the end of the Global Financial Crisis, an increasingly onerous regulatory regime has fundamentally changed banking. Dodd-Frank in the U.S., and the internationally applicable Basel III, among other regulations, all with stricter standards for capital requirements, leverage, and liquidity, have collectively created an incentive system that penalizes traditional banking activities of deposit taking and extending loans, as well as trading and investment banking activities, and rewards investments in “risk-free” government securities. No one can possibly know whether the banking system is any safer as a result.
In another era, the U.S. government might have been more concerned that the banking system was becoming unable to support economic growth. But in this moment, as fiscal dominance takes over, the government has more urgent priorities, like supporting its runaway spending. Total U.S. federal debt has grown by $4.5 trillion to $35 trillion in just over one year, deficit spending has neared $2 trillion, and debt service costs (interest payments) have reached $1 trillion annually, all assuring that issuance of net new U.S. Treasury debt will continue to grow by leaps and bounds. So for the U.S. Treasury the primary question becomes, who will buy all of this debt going forward?
Foreign nations and international investors, including China and Japan, hold about a quarter of U.S. government debt, but those countries have been reducing their exposure for the past decade. With declining credit worthiness, alongside interest rates likely to come down due to recessionary pressures, U.S. government debt will become less and less attractive to private market investors. The U.S. banks will be pressurized to fill the gap and to purchase more and more of their government’s debt.
This process of increasing co-dependence began after the bailouts of 2008-2010 effectively nationalized the world’s largest banks. Around the western world, large banks are more beholden to government than ever, and western governments to their large banks. If the banks comply, which they will as long as possible, they will keep their government from moving on to the final step in the financial Ponzi scheme, which is the monetization of the debt. This is the point at which no market buyers remain, and only the Federal Reserve (in the U.S.) and its peer central banks in the U.K. and the E.U. are left to buy government debt. This is the point when out-of-control inflation will really kick in.
The indebtedness of the governments, the condition of the banks, the weakness of the consumer, all of this, is negative for recovery from recession, and for economic growth. The U.S. government’s policies are absolutely pro-inflationary. Even in a weakening economy, with rising unemployment rates as we are seeing now, inflation is likely to reignite once the Federal Reserve lowers interest rates. This is the definition of stagflation.
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