Financial Repression For Dummies
The term “Financial Repression” was popularized by Carmen Reinhart in a NBER working paper written in March 2011, titled The Liquidation of Government Debt. It has since become “accepted wisdom” among the financial community and the most common argument supporting the call for continued low interest rates. The term financial repression was first introduced in 1973 as a way of describing emerging market financial systems prior to the widespread financial liberalization that began in the 1980s. However, financial repression was also the norm for advanced economies during the post World War II era, and as we are very well aware, remains the norm today. I find it quite ironic that many of the terms formerly used to describe unstable emerging market economies (i.e. capital flight, currency crisis, terms of trade imbalances, etc.) are now more common among “developed” nations. The driver of this role reversal can be easily identified in the chart below, which illustrates the recent surge in public debt issued by advanced economies. It is no coincidence that this orange line is now reaching peaks last hit by the green line during the last round of emerging market debt crises.
The common denominator in both emerging and developed world crises is debt. Historically, periods of high indebtedness have been followed by a rising occurrence of default or restructuring of debts. But defaults and restructurings can occur in very different manners, resulting in very different consequences for markets and investors alike. Throughout history, debt has been reduced by (i) economic growth; (ii) fiscal adjustment and austerity; (iii) explicit default or restructuring; (iv) a sudden surprise burst in inflation; and (v) a steady dosage of financial repression that is accompanied by an equally steady dosage of inflation. Reinhart describes this more subtle type of debt restructuring as “financial repression” which includes: directed lending to government by captive domestic audiences (such as EU Banks), explicit or implicit caps on interest rates, regulation of cross-border capital movements (as in China), and a tighter connection between government and banks (as evidenced in the US, the EU and China). In a nutshell, low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt. Reinhart offers up Britain’s history as a pertinent example.
“Following the Napoleonic Wars, the UK’s public debt was a staggering 260 percent of GDP; it took over 40 years to bring it down to about 100 percent (a massive reduction in an era of price stability and high capital mobility anchored by the gold standard). Following World War II, the UK’s public debt ratio was reduced by a comparable amount in 20 years. The financial repression route taken at the creation of the Bretton Woods system was facilitated by initial conditions after the war, which had left a legacy of pervasive domestic and financial restrictions. Indeed, even before the outbreak of World War II, the pendulum had begun to swing away from laissez-faire financial markets toward heavier-handed regulation in response to the widespread financial crises of 1929-1931. But one cannot help thinking that part of the design principle of the Bretton Woods system was to make it easier to work down massive debt burdens. The legacy of financial crisis made it easier to package those policies as prudential.”
Similar policies are re-emerging today in dealing with our current debt overhang. However, they will likely emerge in the guise of prudential regulation rather than under the politically incorrect label of financial repression. Reinhart warns that one salient characteristic of financial repression is its pervasive lack of transparency. This should not come as a surprise. The process is already under way. Debt is being “placed” at below market interest rates in captive domestic financial institutions in Europe. There are many bankrupt pension plans in the United States that bear scrutiny and markets for government bonds are increasingly dominated by nonfinancial buyers (i.e. central banks), 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, and is nicely illustrated in the graphic below. Bottom Line: As income becomes more scarce, investors will continue to pay a premium for yield.