“Financial repression” was common in the four decades after the second world war and is essential to understanding policymakers’ responses to current credit problems in the US, Europe and China.
These are the conclusions of a BIS working paper by Carmen M. Reinhart and M. Belen Sbrancia, which was released on Friday as an updated version of this IMF paper published back in March. It’s an excellent starting point for understanding what is meant by “financial repression” and its policy consequences. And this version is especially interesting for the critiques contained in the appendix, which caution against reading too much into the idea.
If you know all about being financially repressed, skip to the second post in this series for the critiques. If you’re new to the idea or want a refresh, we’ve done a short-ish recap below.
“Financial repression”: A brief reminder
Together with Kenneth Rogoff, Reinhart famously argued that debt-to-GDP ratios usher in periods of low growth when they reach levels of around 90 per cent. (Other economists have warned against confusing causation and correlation but this is outside the scope of this post.) In the BIS/IMF paper, Reinhart goes one further. She and Sbrancia remind us that there are five ways to reduce this ratio:
1. Economic growth;
3. Default, or restructuring of public/private debt;
4. “A sudden surprise burst in inflation”; and
5. “A steady dosage of financial repression that is accompanied by an equally steady dosage of inflation”.
“‘Financial Repression’, means limits on interest rates and the direction of lending to the government by a captive domestic audience, say the authors. This can be the result of subtle (e.g. through ceilings imposed by the central bank on commercial bank lending rates) or less subtle (e.g. state ownership of banks) policies. For example, the authors cite Regulation Q, which capped interest rates on savings deposits, and the “forced home bias” regulations on portfolios under the Bretton Woods arrangements.
Anything, really, that uses a domestic audience to keep nominal rates lower than they otherwise would be in order to erode the real value of government debt. (Hence why it’s most potent with a burst of inflation.) When real interest rates are negative this equates to a transfer from savers/creditors to borrowers, which in the authors’ case is the government.
The ubiquity of these policies from 1945 – 1980 has been “collectively forgotten”, write Reinhart and Sbrancia.
Below are three charts from the paper. The first two show average ex-post real interest rates on T-bills and on deposits in both advanced and emerging countries from 1945 to 2009 (click to expand):
The third shows the frequency distribution of real interest rates in the UK over the last 130 years, which the authors say shows how there were two post-war periods: the financially repressed 50s, 60s and 70s; and the, erm, financially free 80s, 90s and 00s. (Click to expand.)
The authors construct a “synthetic” portfolio for government debts throughout the post-war period in order to identify how much and for how long countries relied on “liquidation” (or the “financial repression tax”) for debt reduction.
For the United States and the United Kingdom the annual liquidation of debt via negative real interest rates amounted on average to 2 and 3 percent of GDP a year. Obviously, annual deficit reduction of 2 to 3 percent of GDP quickly accumulates (even without any compounding) to a 20 to 30 percent of GDP debt reduction in the course of a decade.
All of this leads the authors to make some concluding points about the role of financial repression in today’s crisis:
To deal with the current debt overhang, similar policies to those documented here may re-emerge in the guise of prudential regulation rather than under the politically incorrect label of financial repression. Moreover, the process where debts are being “placed” at below market interest rates in pension funds and other more captive domestic financial institutions is already under way in several countries in Europe. There are many bankrupt (or nearly so) pension plans at the state level in the United States that bear scrutiny (in addition to the substantive unfunded liabilities at the federal level).
Markets for government bonds are increasingly populated by nonmarket players, notably central banks of the United States, Europe and many of the largest emerging markets, calling into question what the information content of bond prices are relatively to their underlying risk profile. This decoupling between interest rates and risk is a common feature of financially repressed systems. With public and private external debts at record highs, many advanced economies are increasingly looking inward for public debt placements.
That’s the theory — check out part two for some constructive critiques.
Help! We’re all being financially repressed! – FT Alphaville
China has ‘upped the ante’ in financial suppression, Dylan Grice says – FT Alphaville
Who pays? – Deus Ex Macchiato
A strange kind of bullishness – FT Alphaville
So we’re all being financially repressed in the developed world – but does that really mean poor bond returns? (+ competition time) – Bond Vigilantes