Repressionomics - can 'financial repression' solve debt crisis?

  • 8 March 2012
  • From the section Business
  • comments

Even as the Greek default process moves towards completion, the wider problem in the developed world is the size of the debt overhang. How to solve it?

Well first, consider the dirt storm that has been stirred up by the writing off of one country's debts - a country whose entire GDP makes up 2% of eurozone GDP - near meltdown of the G20 summit; numerous riots, deaths, political chaos.

Now consider this: the combined public, household and corporate debts of selected countries:

The chart is out of date of course - Greek government debt alone is above 200% of GDP now, and in the United States the same figure should be 100%, not 84%.

The analysts who drew this up, at Boston Consulting Group, concluded that it would be impossible to write down these debts to a sustainable level (60/60/60, making a combined total of 180% of GDP).

They concluded that the austerity demanded would be too hard to bear politically, and that the likely outcome would be a turn to "financial repression" plus inflation.

It was economists Carmen Reinhart and Belen Sbranica who, in March 2011, issued a ground breaking study of what "financial repression" means.

If we hear today the National Association of Pension Funds complaining that quantitative easing has placed a £90bn hole in the pension system, we can judge how rapidly the concept of "repression" is moving from theory to practice.

So what is "financial repression"? Put simply it is a combination of inflation and capital controls designed to erode the value of debts - and therefore of savings. It is overtly designed to prevent market mechanisms responding to inflation, leaving the price of borrowing too low and the return on savings too low.

Reinhart and Sbranica pointed to the success of Western economies in "repressing" a mountain of debt after World War II - in a way that avoided fiscal austerity, and allowed a growth spurt, combined with inflation, to cancel out unsustainable debts. Here's the graph:

From left to right: the combined sovereign debts of the developed countries falls before 1914, rockets afterwards, but is then only bumpily reduced - by devaluations and defaults - contributing to the Great Depression. Then it rockets in WWII, but the post-war boom coincides with a reduction from 90% to 30% of GDP.

A second graph shows how it was achieved:

The orange line shows that real interest rates on deposits, in the advanced countries, were significantly negative throughout most of the post-war boom. That is, you were effectively paying the bank to hold your money in all those little branches of the Midland and the TSB.

It is no mean feat to achieve this. You needed capital controls, so people could not easily move their money from one country to another. You also needed further rules to force pension funds to hold a certain amount of home government debt. In this way you create and encourage a "national pool" of capital, from which savers can't escape.

Then you unleash inflation, preferably in one surprise spike at the start of the process. If then the real value of deposits is shrinking at 4% a year, then compounded over 10 years, you are soon well into double digit falls in the national debt (not to mention also corporate and consumer debt).

Now given we live in a globalised financial market, with free-floating exchange rates and no capital controls, how would you "do" financial repression?

Reinhart and Sbranica say: "Similar policies… may re-emerge in the guise of prudential regulation rather than under the politically incorrect label of financial repression."

You would need to cap interest rates - either explicitly or by market manipulation. You would have to penalise savers for failing to hold government debt. And you would have to make government debt hard to value.

Then, as the inflation kicked in, you would ideally make most government debt long term, with no need for countries to borrow anew for a period of 30-50 years. In that way the trapped saver cannot respond by raising the interest rate to compensate for the falling value of debt.

Now consider this: the Federal Reserve's quantitative easing III tactic explicitly targets the "risk free interest rate" - aiming to set it at a historic low, and thus influencing all related interest rates downwards. It is not (yet) a cap, but it is a way of repressing interest rates.

Then, with much of the European bond market effectively neutralised by the long-term purchase of government debt by the ECB (we are paid not to think about the market value, says one fund manager), you make a large part of the world's debts difficult to value.

Then you create a euro 1tn fund to buy the debts of Spain, Italy and Portugal and bury them for 20 years.

It is hard to escape the conclusion that "financial repression" - as mooted by Reinhart and Sbranica - is, if not under way, then being pieced together ad hoc out of the anti-crisis measures in Europe.

Indeed economists at Credit Suisse this week wrote: "We think it is appropriate to judge the ECB's LTROs as an accompaniment to, or part of, a re-emerging programme of 'financial repression' by which domestic financial institutions are strongly incentivised, or forced, to support the financing needs of their sovereigns." (Under Repression, 5 March, Alexopoulos et al)

What makes this time different, on a global scale, however, is the reality of floating exchange rates. Countries couldn't use competitive devaluation under the Bretton Woods system. Now they can.

What this means is, that to the extent that you can't do financial repression, or don't want to, you are forced to "repress" other countries: to do trade war, currency war, or - if you're powerful - force them to do austerity packages they don't want; or if you're belligerent, you just default on your foreign debts and raise an Argentine style two fingers to the rich and powerful.

What is important is that, despite the protestations of the pension funds, the scale of the UK national debt - and many others - is still large and growing, and exerts a drag on growth in most economic models.

However "repressed" interest rates and therefore savings returns feel, it would take much more of this to wipe out the debts in the graph at the top. And much more inflation. In fact what you would need was something close to double-digit inflation for a couple of years: an inflation "shock" that really gets you started.

There is only one sure-fire way to provoke an inflation shock and that is to close the Straits of Hormuz, or otherwise cause Middle Eastern oil to cease, temporarily. Diplomacy anyone?