The connection between shadow banking and secular stagnation

Why are global investors in European bonds snapping up the corporate debt of Switzerland-based Nestlé SA at more than their face value, paying more than they are worth for the privilege of owning the bonds? And what does this have to do with the European Central Bank as well as growing economic inequality?

The easy answer is “it’s complicated,” but the more telling explanation has to do with the so-called shadow banking system. Shadow banking, simply put, includes banking activities (turning savings into loans) done by institutions that aren’t banks. Examples of shadow banks include certain kinds of hedge funds and money market mutual funds.

These shadow banks channel the savings from large pools of money that now slosh around outside of traditional banking. So where are these large pools of savings come from? Research by economist Zoltan Pozsar, a director of global strategy and research at Credit Suisse, sheds light on the more recent macroeconomic forces that have created the global shadow banking system. According to Pozsar, there are two major sources of what he calls “cash pools.”

The first is the large amount of foreign exchange reserves held by developing countries. China, Southeast Asian nations, and oil exporting countries are the primary driver of this increase in these reserves. Think sovereign wealth funds. As Pozsar put it, the source of this cash pool can be thought of as the imbalance in incomes between countries that run trade surpluses, such as China, and trade-deficit countries, such as the United States.

The second major cash pool is corporate cash balances, or the amount of savings held by corporations. The reasons for the increased savings of corporations are myriad. Globalization, according to Pozsar, is one part of the answer as international competition drove down U.S. wages. Another is that many companies can spend less than before, due to cheaper capital goods and the fact that leading companies spend less on equipment overall. Compare General Motors, which has to build factories, to Facebook, which deploys computer code.

Pozsar says this corporate cash pool is the result of the imbalance between income going to capital and labor. We can see this in the United States as the share of income going to labor has declined.

Now back to the European Central Bank and Nestlé bonds. All of these shadow banking players boast keen appetites for safe bonds, such as German government debt, just as the European Central Bank prepares to wade into the bond market buying European government bonds as part of its new quantitative easing program. Matthew Yglesias at Vox takes a deeper look at the resulting shifts in demand and supply of government bonds. And Matt O’Brien argues at The Washington Post that the shadow banking financial system desperately needs safe assets as the supply of government debt declines so investors are moving into corporate debt.

Now if these sources of savings sound familiar, it’s because you’ve heard of them in the context of another recent economic hypothesis. They are the same trends that Harvard University economist Larry Summers highlights as driving his concept of secular stagnation. The very forces that appear to have pushed down interest rates and fostered debt bubbles are the ones that created the shadow banking system. Secular stagnation and shadow banks are two sides of the same coin.

These forces, which are primarily about the distribution of income—between countries, factors of production, individuals and across time—may be at the heart of not only our current macroeconomic situation but the structure of our financial system, too.