Financial Repression

Dr. Krassimir Petrov | Gold Newspaper No. 6 | 2017

The GOAL of financial repression is to channel the financial resources of households into the service of the state. It is mainly accomplished via monetary policies that force interest rates below the natural free-market rate, so that consumers effectively subsidize the borrowing of big government and big business. In its more conspicuous version, the nominal interest rate is driven below the inflation rate, thus offering negative interest rates to savers. It is essentially a hidden inflation tax, an effective transfer of wealth from savers to borrowers, and mainly from households to governments and corporations. The policy reduces the burden of government debt by lowering the debt-servicing cost and inflating the value of the debt. The government gains twice: it pays less now, while tomorrow it pays with “cheaper” money. The policy can be particularly effective at liquidating government debt denominated in a domestic currency. Alternatively, financial repression can facilitate a massive expansion of government debt. This approach characterized the two lost decades of post-bubble Japan and the astronomical expansion of British, U.S., and European government debt after the Global Financial Crisis of 2008.

TOOLS

There are three sets of TOOLS of financial repression, depending on the development of the financial system and the sophistication of the government and population. Poor countries use one set of tools, poorer developed countries (such as Greece, Spain, and Italy) a different set, while rich developed countries employ a wide array of sophisticated tools. Totalitarian fascist and communist regimes also employ remarkably similar tools.

The monumental scholarly work This Time is Different by Reinhart and Rogoff is particularly relevant and highly-recommended as an 800-year history of government debt and defaults. It provides the fundamental insight that, contrary to popular belief and textbook dogmas, investing in government debt is a particularly risky business. The main lesson is that, one way or another, governments always find ways to default on their debts — usually with inflation, whenever possible. The authors broadly classify repression tools in the following five main categories: (1) capping interest rates, (2) government ownership and/or control of banks, (3) high reserve requirements, (4) a captive domestic market for government debt, and (5) capital controls. Each category has its own variety of tools implemented as either monetary policy or as regulations. For example, capping interest rates on deposits was historically implemented as Regulation Q by the Fed. Those interest rate ceilings became very “repressive” during the inflationary 1970s and spurred the growth of money market mutual funds to evade the regulation. Alternatively, in the post-9/11 environment, interest rates were driven to extreme lows entirely by monetary policy, nailing short-term government interest rates down to 1%, and effectively pushing down the whole yield curve to historically low rates. High reserve requirements force commercial banks to buy and hold more treasury securities, thus financing government deficits at lower, subsidized rates. Rules and regulations force various financial institutions such as pension funds into buying treasury securities by limiting risk exposures and requiring a minimum percentage in “risk-free” government securities. The situation can also apply to mutual funds, insurance companies, and commercial banks.

The crucial part of any successful financial repression is the ability of the government to remove alternative safe, high-yielding investments that allow people to protect themselves. When the real return on government debt is negative, investors can protect themselves by holding foreign currencies or gold. Therefore, successful financial repression requires governments to ban foreign currencies and gold. Governments usually impose capital controls to reduce or eliminate the flight of capital that seeks better returns in foreign markets. Alternatives such as hedge funds must be further limited by law to only a few “qualified” investors. The government must also limit the protection from real estate; otherwise, people will simply put their money in land and housing.

Thus, successful financial repression requires a two-pronged approach: (1) eliminating or restricting alternative investments, and (2) forcing individuals and major financial institutions into buying and holding governmental securities.

ARTIFICIAL BOOM

On the surface, lowering interest rates appears especially beneficial to financial markets and the economy. It pushes bond prices higher. Lower interest rates also drive investors into stocks, thus goosing the stock market and igniting animal spirits. Corporations can borrow cheaply, thereby lowering their interest expense and boosting their reported earnings; even better, they can borrow cheap, leverage up, buy back their stocks, and improve financial optics through financial gimmicks. Low interest rates can ignite a real estate boom and a booming economy. Increased government deficits and spending can also contribute to an economic boom. Boom times increase employment and drive wage inflation, keeping workers happy. Who does not love a boom? Pension funds could project 7-7.5% returns during these boom times and keep contributions low.

THE LOSERS

Yet, not all is well with financial repression. There is a much darker side to it. It annihilates savers. Bank depositors get nothing. Money Market Mutual Funds get nothing. Insurance companies get next to nothing, so they have to charge higher premiums. But the real losers of the policy are retirees and pension funds. Retirees are the ones that really need a regular income. They are the ones that cannot take the risk of junk bonds or risky stocks. They are neither rich, nor flexible enough to “diversify” into real estate. They mostly rely on pension funds. Unfortunately, pension funds are the ones most restricted in their investments; they are the ones that must invest most in low-yielding bonds and fixed-income assets. They are the ones limited from diversifying into riskier bonds or riskier stocks; they are the ones that cannot invest in gold or commodities. They are the ones who pay the price for the cheap credit of governments and corporations. They lose more than anyone else, but the ultimate losers are the retirees who must bear the burden of those losses. Because of the extended financial repression, those same pension funds that projected 7% returns barely realized 2-3% over the last decade. Those pension funds were expected to double in 10 years. Instead, they are up 20-30%, which has resulted in an additional 30-40% underfunding over 10 years. Thus, pension payouts must be cut in half just to stay solvent.

Recently, financial repression has gotten a lot worse with the introduction of negative nominal interest rates in 2016. First in Japan and Switzerland, and later on in most low-risk developed countries, over an estimated $7.5 trillion of global government debt has negative yields (Graph 1). It is beyond comprehension: why would anyone buy a negative-yielding bond and guarantee him/herself a loss instead of simply holding cash? Answer: investors buy them because they have to, because they are forced by law. This limitation also means that 2016 marked the lowest returns ever for pension funds across the globe. For example, CALPERS barely returned 0.6%. The New York State pension plan returned just 0.2%.

However, the worst is yet to come. The day of reckoning approaches as interest rates rise. Rising long-term interest rates can devastate bond portfolios. Small increases in interest rates can result in massive losses. On Trump’s Election Day, global interest rates rose enough to wipe out an estimated few hundred billion dollars off bond portfolios. Since the election, global bond markets have lost approximately $1 trillion. Massive losses are piling up at pension funds, and we are only at the beginning.