DOGE and The Collateral Squeeze

DOGE is an exciting initiative, but let's not forget the backbone of global finance: U.S. government spending and debt. Even small improvements in America's fiscal health could send ripples across the world's financial systems, reshaping the game.

The United States government, often criticized for its fiscal deficit and mounting debt, paradoxically underpins the global credit system. This seeming contradiction arises from the intricate ways in which U.S. government debt fuels worldwide credit creation. Understanding this dynamic is crucial, especially as the world grapples with immense debt refinancing pressures, geopolitical risks, and the need for policies that balance fiscal discipline with economic growth.

U.S. Government Inefficiency and Global Credit Creation

U.S. government debt plays a pivotal role in international finance. U.S. Treasury securities are considered "risk-free" assets and serve as foundational collateral (HQLA) for countless financial transactions across the globe. Financial institutions leverage these securities to secure loans, engage in derivatives trading, and support various investment products.

The mechanisms of rehypothecation—the repledging of collateral for multiple loans—and securitization amplify this effect. A single Treasury security can be used multiple times over, significantly expanding the system's leverage.

Moreover, stable employment incomes from government and semi-government jobs are often the quasi-underlying of mortgage and auto loans. These loans are likely to be securitized into financial products, and marketed internationally, which later fuels global credit creation.

This interconnected system implies that any move toward reducing U.S. debt issuance or improving government efficiency—referred to as the Department Of Government Efficiency (DOGE)—could act as a brake on global credit expansion.

Given the unmeasurable scope of financial leverage in the global financial system, a small decrease in US government securities supply would mean less collateral available for financial transactions, potentially tightening global liquidity and affecting financial markets worldwide. This would make financing dollar-denominated debt exponentially harder.

The Weight of Global Debt and Refinancing Pressures

The global financial system is heavily burdened by debt, totaling approximately $330 trillion, with half of it denominated in U.S. dollars. This massive debt load requires continuous refinancing and a steady flow of liquidity.

Annually, about $33 trillion is needed to roll over existing debt. In a high-interest-rate environment, this creates substantial strain on economies and financial institutions. Additionally, annual interest payments amount to around $13 trillion. When combined with refinancing needs, the global economy must finance approximately $45 trillion in USD denomination each year to maintain current debt levels.

Rising interest rates and tightening liquidity exacerbate these refinancing pressures. Such conditions heighten the risk of defaults and pose significant threats to systemic stability. The sheer scale of the debt and the reliance on continuous liquidity injections underscore the fragility of the current financial architecture.

Geopolitical Risks and the Decoupling of Economies

Increasing geopolitical tensions and the absence of a cohesive global growth strategy are pushing international finance into a defensive mode. Countries are shifting away from cooperative growth models, focusing instead on national interests. This shift leads to the rationing of resources and capital, disrupting global supply chains and financial flows.

Traditionally, economic theory suggests that deflation leads to lower interest rates. However, in a risk-averse environment, lenders may demand higher rates to compensate for increased counterparty risks. This creates a paradox where financing becomes more expensive despite sluggish economic growth, complicating efforts to stimulate the economy. The decoupling of economies further exacerbates these challenges, as coordinated policy responses become more difficult to achieve.

In parallel to the decoupling story, the so-called alternative reserve currency ambitions similar to the BRICS' would make earning USD significantly harder via global trade.

Balancing Fiscal Discipline with Growth-Inducing Policies

While improving US fiscal efficiency is essential, it must be balanced with strategies that promote domestic economic growth, particularly for the broader population. Policies focused solely on frugality may inadvertently stifle economic activity and exacerbate social inequalities.

One approach is to implement income tax reductions to increase consumer spending power. However, augmented domestic consumer spending power does not necessarily augment domestic industrial production. A more comprehensive strategy involves investing in domestic manufacturing, infrastructure, and innovation to enhance productive capacity and competitiveness. Strategic deregulation can also be pivotal by simplifying regulations, removing business barriers, and encouraging expansion and efficiency in supply chains and production.

The broader vision should solidify the United States' position as a consumer and producer powerhouse. By fostering sustainable domestic growth and reducing reliance on global credit cycles, the U.S. can mitigate the potential negative impacts of fiscal efficiency improvements on global liquidity.

Conclusion

The inefficiency of the U.S. government, manifested in its escalating debt, paradoxically underlies the global credit infrastructure. Addressing US fiscal inefficiency through fiscal reforms is necessary but must be carefully managed to avoid unintended consequences on global liquidity. By coupling fiscal discipline with growth-oriented policies, the United States can navigate the delicate balance between reducing debt and sustaining economic vitality, ensuring long-term domestic and global stability. However, the rest of the world (RoW) is facing a bigger challenge, and their options are limited to a combination of devaluations, selling assets, refinancing at higher rates, or defaults.

This emerging dichotomy remains out of the headlines due to lacking a newsworthy catalyst. In such an event, capital flows will be primed into the safety and potential growth story of the US economy, leading to a self-reinforcing cycle of capital flows. All in all, the USA, with both fiscal and trade surpluses, might be the next black swan.

(Not an expert opinion. Based on the author's amateur research)

© Saip Eren Yilmaz, 2024