Financial Repression: Why You Should Care
Board: Macro Economics
Financial Repression is a term that has become popular in the last two years. You have probably seen or read about it in the media. Before 2011, the term was relegated to high level economic textbooks. That all changed in April 2011 when economists Carmen Reinhart and Belen Sbrancia published: The Liquidation of Government Debt. You might recall that Carmen is co-author with Ken Rogoff of This Time is Different which was the seminal work on 800 years of sovereign defaults.
The new paper is the seminal paper on Financial Repression (FR). It formalized what many economists and investors were thinking. It explained the historical precedent and outlined what advanced economies can expect going forward.
The definition of FR from the paper
1) Explicit or indirect caps or ceilings on interest rates, particularly (but not exclusively) those on government debts.
2) Creation and maintenance of a captive domestic audience that facilitated directed credit to the government.
3) Direct ownership of banks or extensive management of banks and other financial institutions.
The essence of the paper is that developed economies had high ratios of debt/GDP after World War 2. The paper reviews 28 counties in the post WW2 period. FR is a more subtle way of reducing sovereign (government) debts. You might have heard a few comments recently about high government debts in the US.
FR works by creating low or negative “real” interest rates. Real rates are the advertised aka nominal interest rates minus the inflation rate. By having negative real rates, the government has a chance to slowly devalue their sovereign debt. It is purposely a slow, gradual process. Yoda thinks it is similar to slowly boiling frogs. FR is a subtle form of defaulting on sovereign debt. Instead of a dramatic single event like refusing to pay bond principal/interest, the average bond owner hardly notices how he is losing money.
You might not know the statistics on US real interest rates from 1945 through 1980.
Real rates <=0% in 25% of the years
Real rates <=1% in 64% of the years
Real rates <=2% in 89% of the years
These are actually ~better numbers than for all of the other countries listed in the paper. They had more years with less than 0% real rates compared to the US.
FR WAS successful in reducing the debt/GDP. In the US debt/GDP was 116% in1945 and 66% in 1955. The paper calculates that debt/GDP would have been 141% had FR NOT been implemented.
The paper has a lot more details, data and graphs if you are interested.
Why should you care about FR?
1) The US is already experiencing FR. The Federal Reserve has forced negative real rates. The Fed is also buying a good portion of the newly issued treasury debt. The US has very strong control over the TBTF banks, even though they were not nationalized.
2) You might ask how long FR lasted according to the paper. The average number of years was 22.
3) Let’s do the math. The latest FR started in 2008. If the average holds true, it will last until 2030.
4) We are dealing with financial constraints that are 100% out of our control. The Fed has demonstrated the ability to force negative real rates longer than many people thought possible, Yoda included. The group of “bond vigilantes” that can force higher sovereign interest rates seems to be in hiding. Maybe they went extinct after the 1970’s. With the Fed influencing interest rates over the full range of maturities, they have the upper hand over any bond vigilantes that have been hidden in bunkers for the last few decades.
5) With the Fed buying a lot of the newly issued Treasury paper, we do not really know the outside demand at those interest rates.
6) ONE NEW POINT, WHICH MIGHT BE ON THE WAY. As part of the reforms on money market funds, there is a possible win-win situation for FR. IF money market funds hold sovereign debt, they are immune from all of the proposed, onerous solutions that the SEC has proposed. Onerous is what the money market managers like Fidelity and Vanguard call the proposed regulations. If you hold only government paper, you will NOT have to
a) Have floating net asset values instead of being fixed at one dollar
b) Keep a reserve of funds, like 5% ready for immediate redemption
This would be a comprise that the managers would probably prefer, as distasteful as it is. It also provides a ready source of funds to soak up even more sovereign debt.
7) Yoda’s opinion is that the nominal case forecast should be for FR through 2030. Let’s assume this is way too long and FR only lasts through 2020. That means we will have 8 more years of FR.
8) The Fed is incrementally moving towards FORMALIZING FR. Have you noticed that the expiration of ZIRP keeps getting pushed out? Originally it was going to end in one year, then two years, then three years and now they are “guaranteeing” ZIRP to beyond 2015. This begs the question if they really don’t know how long it will last or if they are reluctant to publicly announce it? Can you imagine Ben coming out and saying: “We plan to maintain ZIRP probably through about 2030? Check back every 5 years or so and see how it is working.”
9) Obviously, there are implications on preferred investment strategies that will perform better under FR. I will publish that as a separate post if there is any interest.
As you might suspect, there is a lot more to the FR story. There are many papers that have been written about it since the original paper in 2011. I dramatically edited the FR story down. You might get a different interpretation if you read all of the papers. Or maybe your eyes will glaze over and you go into a catatonic state. I don’t know.
 Reinhart and Sbrancia paper The Liquidation of Government Debt