The beginnings of 'financial repression'?

  • 20 March 2013
  • From the section UK
  • comments
Graph showing debt to GDP in the developed world following WWII
Graph showing debt to GDP in the developed world following WWII

There is one graph that has been mesmerizing policymakers for the past two years. It is not the Spanish bond yield, nor China's latest guess at its own growth rate.

It is this graph of debt to GDP in the developed world after WWII.

After 1945 the developed countries managed to shrink a debt pile equivalent to 100% of GDP to just 20% by 1970. And they managed it while at the same time generating two decades of unprecedented growth - the era of Doris Day, chrome-laden automobiles and the mainframe computer.

The term for how they achieved this is "financial repression". It was revived in a 2011 National Bureau of Economic Research (NBER) working paper by economists Carmen Reinhart and Beren Sbranica.

I've written on this subject on my blog before.

Here's how the post-war world did financial repression: they corralled people's savings inside national pools of capital, they capped the amount of interest you could earn on savings, they made national capital markets illiquid - so moving your money around in general became hard, and then they unleashed high inflation for a short period, which then wiped out the value of the savings, and thus the debt.

As a result, the real interest rate for the advanced economies between 1945 and 1980 was minus 1.94. Reinhart and Sbranica call this an effective "tax" on financial assets.

Financial repression is not, however, a term you are going to hear politicians come out with. It sounds scary and it is, to some, justifiably scary. Yet we today, in the developed world, have a near 100% debt-to-GDP ratio, and that is without having fought a world war.

There are some who believe the world's leaders are embarked on a covert policy of financial repression - the magazine Money Week, for example.

This week I think we've seen two signal moments in the beginnings of overt financial repression - the European Central Bank (ECB) grab on Cypriot bank deposits, and George Osborne's changes to the Bank of England's remit.

Chancellor George Osborne on Budget day 2013
The chancellor cut his official growth forecast in half.

Cyprus is a clear cut case. A 100,000 euros (£86,000; $130,000) deposit guarantee across the eurozone was flouted by "taxing" the deposits in banks that would otherwise go bust. It was an enforced write down of the value of savings and is accompanied by the most brutal capital controls possible - which is closing the banks and then re-opening them with a limit on withdrawals.

George Osborne's move today is designed to allow the Bank of England to play a bigger part in generating growth, due to the government's self-enforced inability to borrow more to spend on infrastructure etc.

He is effectively allowing the bank to "look through" the inflation figures, as they go above 2%, and to take unorthodox measures like buying company debt (aka lending to companies) even if it boosts inflation. This "looking through" I interpret as similar to the way the door security guy at a posh night club "looks through" you as you attempt to persuade him your are on the guest list. In plain English it means "ignore".

If, say, the Bank were to tolerate 4% inflation for several years, while the policy of quantitative easing (QE) held interest on savings at below 2%, the impact on savings would be eventually the same as the impact of the Cypriot government's grab. The personal finance industry has not been slow to point out that the remit change will hammer savers.

On top of that, there are other circumstances conducive to repression: the QE policy and new bank and insurance regulations, are forcing British pension funds to hold more government debt. Meanwhile the side-effect of QE is to heavily suppress market forces in the bond market: so that the government always has a buyer for its debt... which is effectively itself.

Now here's how Reinhart and Sbranica explain the modern version of financial repression:

"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.

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.

While to state that initial conditions on the extent of global integration are vastly different at the outset of Bretton Woods in 1946 and today is an understatement, the direction of regulatory changes have many common features. The incentives to reduce the debt overhang are more compelling today than about half a century ago."

Of course, the British government is not the only one pursuing a combined policy of QE, unstated currency devaluation, the suppression of market forces in the bond market and tacit toleration of high inflation. But it is a signal moment when an Anglo-Saxon economy, wedded to the ideology of inflation targeting for the past 20 years, suddenly begins to "look through" the inflation figures.

There is one missing piece of the jigsaw. To make financial repression work well, Reinhart and Sbranica point out you have to have a sharp inflation spike at the start, preferably into high single digits. This indeed was achieved in the late 1940s: "At the closure of the second great war, we witness a combination of very low nominal interest rates and inflationary spurts of varying degrees across the advanced economies."

Today there are inflationary pressures rising from population growth, competition for energy and natural resources, and from the rising middle class of the Bric countries (Brazil, Russia, India and China). But to spike inflation high, and sharply, would take some kind of crisis.

If some regional power could be induced to close the Straits of Hormuz for a few weeks, that would do it nicely.