The Collateral Squeeze
Fiscal prudence with D.O.G.E, tariff walls, withdrawing from geopolitical flashpoints, and politically induced market swings all shake the inverted Jenga tower of global credit—driving up the world’s hunger for high-quality collateral.
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 widely treated as the benchmark risk-free asset and qualify as Level-1 High-Quality Liquid Assets (HQLA) under Basel III. Because of their depth and liquidity, banks, dealers, and other financial institutions routinely pledge Treasuries as repo collateral, post them as margin on derivatives, and use them to underlie a wide range of investment products.
Rehypothecation—when dealers or prime brokers re-pledge collateral they have received—accelerates the circulation of U.S. Treasuries in repo and derivatives markets. Because a single note can be passed down a chain of repos, the Treasury collateral multiplier typically exceeds one, adding measurable leverage to the system. Separately, securitization packages loans or other receivables into tradeable securities. By funding these assets with new debt issued by special-purpose vehicles, securitization adds another layer of leverage to the financial system. To illustrate, stable employment incomes from government and semi-government jobs are often the quasi-underlying of mortgage (CDO) and auto loans (CLO) derivatives. These loans are likely to be securitized into financial products, and marketed internationally, which later fuels global credit creation.
U.S. Treasuries are to the eurodollar system what reserves are to domestic banking—a near-risk-free, endlessly recyclable foundation. Their size, liquidity, and acceptability give offshore dollar markets both the credit backstop and the interest-rate benchmark they need to function. To illustrate, a global bank in London pledges $1 bn of treasuries in a repo, receives $990 m cash, and lends that cash onward, and the borrower may pledge the same securities again. Each turn of this chain is another offshore dollar deposit, so the velocity of Treasuries sets the pace of eurodollar balance-sheet growth. Another utility of U.S. treasuries in the eurodollar system is that dealers arbitrage between Treasury bills/notes, SOFR swaps, and eurodollar futures. Without a stable Treasury curve, the entire offshore term structure would lose its anchor. In calm times, private repo markets recycle Treasuries seamlessly. In stress, central banks turn those securities into dollars via Fed swap lines or FIMA repo, preventing forced sales that would amplify volatility in both Treasuries and eurodollar funding. Scarcity (e.g., debt-ceiling impasse) or excess volatility (e.g., March 2020) in Treasuries transmits directly to the cost and availability of eurodollars. That is why regulators track the collateral multiplier and why the Fed intervenes quickly when the Treasury market malfunctions. In short, when Treasuries hiccup, the entire eurodollar edifice feels the shock. This interconnected system implies that even a slight 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.
Peace and stability of the post-Cold war decades have led to an immeasurable scope of financial leverage in the global financial system resembling an inverted Jenga pyramid; a small decrease in US government securities supply would mean less collateral (the foundation of the pyramid) available for financial transactions, potentially tightening global liquidity and affecting financial markets worldwide. This would make financing dollar-denominated debt exponentially harder. In parallel, an inverted pyramid cannot survive a volatile world; deleveraging is inevitable: the foundations should be expanded, and/or the top tiers should be shed.
The Weight of Global Debt and Refinancing Pressures
The global financial system is heavily burdened by debt, excluding off-balance sheet 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. To preserve domestic wealth, before resorting to capital controls, the first wave of policy tools might be raising trade walls, minimizing foreign aid, and minimizing the gray economy leaking USDs to RoW.
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, similar to an inverted Jenga pyramid. 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. Considering the geopolitical risks, deteriorating world trade, demographic challenges, and politically induced financial volatility, the rest of the world (RoW) is facing a bigger challenge, and their options are limited to a combination of devaluations, forced selling of US-denominated assets, refinancing at higher rates, or defaults.
This emerging dichotomy between RoW and the USA remains out of the headlines due to the lack of 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
