Financial Repression Redux

What’s at stake: Another concept with a catchy name – financial repression – is quietly starting to creep into the policy debate following European discussions of a ‘voluntary’ private sector involvement and American discussions on the debt ceiling. To avoid default and outsized fiscal retrenchment, capturing savings is an increasingly tempting alternative for fiscal authorities as it provides a third way apart from default and fiscal adjustment. Financial repression can take many forms: directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, bank nationalization. While it is generally agreed that monetary policy and regulatory policy could both make significant contribution fiscal consolidation efforts by directly or indirectly capturing large amounts of private sector savings, research on the matter has remained embryonic.

Holding down the cost of financing government debt by restraining savers’ options

Carmen Reinhart and Jacob Kirkegaard argue in the latest issue of Finance and Development that governments are once again finding ways to manipulate markets to hold down the cost of financing debt.Throughout history, financial repression — that is, official policies that direct to government use (and usually at below-market rates) funds that would otherwise go to other borrowers – has been used to reduce the debt to GDP ratio. While emerging markets may increasingly look to financial regulatory measures to keep international capital out, advanced economies have incentives to keep capital in and create a captive domestic audience to finance the existing public debt. In a box, at the end of the paper, the authors offer a preview of a forthcoming paper that they have on the return of financial repression in the aftermath of the great recession. It contains policies adopted in France, Japan and the UK among others.

The Economic Focus of The Economist points that the exchange rate and capital controls of the Bretton Woods financial system kept savers from seeking high returns abroad. High reserve requirements forced banks to lock up much of the economy’s savings in safe asset classes like government debt. Caps on banks’ lending rates ensured that trapped savings were lent to the sovereign at below-market rates. Such rules were not necessarily adopted to facilitate debt reduction, though that side effect surely didn’t go unnoticed.

Carmen Reinhart and Belen Sbrancia argue that when financial repression produces negative real interest rates (nominal rates below the inflation rate), it reduces or liquidates existing debts and becomes the equivalent of a tax — a transfer from creditors (savers) to borrowers, including the government.But this financial repression tax is unlike income, consumption, or sales taxes. The rate is determined by financial regulations and inflation performance, which are opaque compared with more visible and often highly politicized fiscal measures. Given that deficit reduction usually involves highly unpopular expenditure reductions and/or tax increases, authorities seeking to reduce outstanding debts may find the stealthier financial repression tax more politically palatable. The authors quantified the post–World War II wipeout of mountains of public debt in the advanced economies by measuring the so-called liquidation effect, the amount of government debt reduction wrought by financial repression. For the United States and the United Kingdom, the annual liquidation effect amounted on average to between 3 and 4 percent of GDP a year. From 1945 to 1955, the authors estimate that repression reduced America’s debt load by 50 percentage points, from 116% to 66% of GDP.

Bill Gross writes that with governments attempting to impose financial repression, bond investors should revolt. Gross argues that while the ancient Romans used to shave metal coins in an attempt to monetize debts, our evolving financial system has used more sophisticated techniques. Bond prices don’t necessarily have to go down for investors to get skunked.

In a recent working paper, Andrew Rose shows that lenders cut back more dramatically on their cross-border activity than on their domestic activity in the great recession as a result of public intervention. In particular, the authors finds that after nationalization, foreign banks reduced British as a share of total lending by about eleven percentage points, and increased interest rates on new loans to UK residents by 70 basis points. By way of comparison, nationalization does not seem to affect either the lending or interest rate decisions of British banks.

Financial repression today

Gillian Tett writes that while this phrase is not yet mainstream news, it is starting to generate a buzz among the policy elite in Washington and in some European capitals. Such moves horrify some free-market economists, who argue “repression” crimps private sector investments, thus undermining growth. But postwar politicians clearly decided this was a price worth paying to cut debt and avoid outright default or draconian spending cuts. And the longer the gridlock over fiscal reform rumbles on, the greater the chance that “repression” comes to be seen as the least of all evils; at least compared with others that may emerge from spiraling western debt.

Axel Weber recently argued in an interview that if voluntary contributions don’t add up, then the one tool that is still on the shelf is financial repression. To illustrate his point, Weber referred to the compulsory loans – the Zwangsanleihe – Germany had after WWI to help make reparation payments. With hyperinflation, the government could not get funding on capital markets and introduced this Zwangsanleihe, requiring all people with savings of more than 100,000 Mark to buy bonds with the contribution going from 1% up to 10% of savings up to one million deutsche mark. Greece also went a similar route in the 1920s that involved cutting banknotes in half, with one half still good as currency — at half the face value — and the other turning into a loan to the government.

The feasibility of financial repression

Ryan Avent argues that it's not clear that Bretton Woods– a system that enabled a period of financial repression that persisted from the end of the war to around 1980 – can be duplicated. Thirty years of financial liberalization has made markets broader, deeper, and more complex. It has also created strong constituencies in favor of liberalized finance, most of which were not dislodged by the crisis. Putting the genie back in the bottle will prove very difficult.But political leaders may have a strong incentive to pursue it. Rapid growth seems out of the question for many struggling advanced economies, austerity and high inflation are extremely unpopular, and leaders are clearly reluctant to talk about major defaults. It would be very interesting if debt (rather than financial crisis or growing inequality) was the force that led to the return of the more managed economic world of the postwar period.

Gavyn Davies concedes that the there is one obvious advantage to this route, which is that it might be more politically feasible than raising traditional taxes, or cutting public services. But today’s open capital markets make it more difficult to operate a policy of financial repression without risking capital flight. He also notes that inflation targeting has become an important mandate of politically independent central banks and that they are unlikely to let go of it so quickly.

Challenging Reinhart’s methodology and conclusions

Paul Krugman writes that he has some problems with the methodology, which is based on lopping off any years in which the real interest rate on government debt was negative. It’s easy to think of ways this could go wrong, when you have fluctuating annual inflation and debt of relatively long maturity.

Paul Krugman also highlights that the moments where financial repression was supposedly at its highest levels are also the times when median family income increased the most. Surely one’s response to this history should be “Yay financial repression!” What’s happening here is that Reinhart is using a term originally developed to describe an extremely distortionary policy in developing countries, and applying it to much more defensible policies pursued in advanced countries. It used to be common for third world governments to impose sharply negative real interest rates on savers year after year, driving saving down or pushing saving into unproductive channels. Maybe Regulation Q had something in common with those policies qualitatively; but the America of Regulation Q was an enormously successful economy with a much higher savings rate than we have had since financial repression, if that’s what it was, came to an end.

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