financial repression back to stay

8/2/2019 Financial Repression Back to Stay

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Financial Repression Back to Stay: Carmen M.Reinhart

As they have before in the aftermath of financial crises or wars, governments and central banks are

increasingly resorting to a form of taxation that helps liquidate the huge overhang of public and

private debt and eases the burden of servicing that debt.

Such policies, known as financial repression, usually involve a strong connection between the

government, the central bank and the financial sector. In the U.S., as inEurope, at present, this

means consistent negative real interest rates (yielding less than the rate of inflation) that are

equivalent to a tax on bondholders and, more generally, savers.

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Figure 1. Gross Central Government Debt as a Percent of GDP: 22 Advanced Economies, 1900- 2011 (unweighted averages)

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Figure 2: Real Interest Rates Frequency Distributions: Advanced Economies, 1945-2011 Treasury bill rates Sources: Reinhart and Sbrancia (2011),

International Financial Statistics, International Monetary Fund, various sources listed in the Data Appendix, and authors calculations. Notes: The

advanced economy aggregate is comprised of: Australia, Belgium, Canada, Finland, France, Germany, Greece, Ireland, Italy, Japan, New Zealand,

Sweden, the United States, and the United Kingdom. Interest rates for 2011 only reflect monthly observations through February.

Enlarge image

Figure 3. Share of Outside Marketable U.S. Treasury Securities plus Government Sponsored Enterprises (GSEs) Securities: End-of-period, 1945-2010

Sources: Flow of Funds, Board of Governors of the Federal Reserve and authors calculations. Notes: The outstanding stock of marketable U.S. Treasury

securities plus GSEs is calculated as Treasury credit market instruments plus GSE issues plus GSE-backed mortgage pools less savings bonds, less

budget agency securities. Outside marketable securities is defined as marketable securities (as defined above) less official holdings by the rest of the

world of US Treasuries and GSEs, less holdings by the Federal Reserve (monetary authority) of U.S. treasuries and GSEs.
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Figure 4. Domestic Bank Holdings of General Government Debt: Greece, Ireland, Portugal, and UK, 2008-2010, end-of-period (as a percent of gross

general government debt) Sources: See Kirkegaard and Reinhart (2011) for individual country sources, International Monetary Fund, World Economic

Outlook. Notes: Holdings of both general government loans and securities. Totals do not include European Central Bank (ECB) bond purchases of the

three troubled sovereigns. These purchases totaling about 76 billion over May 2010- March 2011, account for about 12 percent of the combined general

government debts of Greece, Ireland, and Portugal. Does not include government debt holdings by pension funds.

In the past, other measures also included directed lending to the government by captive domestic

entities (such as pension funds or banks), explicit or implicit caps oninterest rates, regulation of

cross-border capital movements, and (generally) a tighter coordination between governments and

banks, either explicitly through public ownership of some institutions or through heavy moral

suasion by officials.

Central banks in both developed and developing countries are being subjected to complementary

pressures. Emerging markets may increasingly look to financial regulatory measures to keep

international capital out (especially given the expansive monetary policy stance pursued by the

U.S. and Europe). Meanwhile, advanced economies have incentives to keep capital in and create a

domestic captive audience to absorb the financing for the high existing levels of public debt.

Common Cause

Concerned about potential overheating, rising inflationary pressures and the related competitiveness

issues, emerging- market economies may continue to welcome changes in the regulatory landscape

that keep financial flows at home. Indeed, this trend is already well under way. This concern means

advanced and emerging-market economies are findingcommon causein increased regulation and/or

restrictions on international financial flows and, more broadly, the return to more tightly regulated

domestic financial environments.

This scenario entails both a process of financial deglobalization (the reappearance of home bias in

finance) and the re-emergence of more heavily regulated domestic financial markets.

-- Public and Private Debt Overhang: Elevated levels of public debt in the U.S. and elsewhere will

probably be the most enduring legacy of the post-2007 financial crises. For the advanced

economies, public debts had not approached these levels since the end of World War II.

Figure 1 (attached), which traces the evolution of average gross public debt for the 22 advanced

economies from 1900 to 2011 demonstrates the magnitude of the policy challenges now facing

many (if not most) of these countries. However, these numbers significantly understate the

magnitude of the debt surge in recent years by excluding record private borrowing -- particularly by

banks -- which remains a major possible contingent liability of governments.Throughout history, debt-to-GDP ratios have been reduced in five ways: economic growth,

substantive fiscal adjustment or austerity plans, explicit default or restructuring of private and/or

public debt, a surprise burst in inflation, and a steady dose of financial repression that is
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accompanied by an equally steady dose of inflation. It is critical to note that the last two options --

inflation and financial repression -- are only viable for domestic-currency debts (the euro area is a

special hybrid case).

Closed Channels

Some of these channels have been used in combination during historical episodes of debt reduction.

Fiscal adjustment, however, is usually painful in the short run and politically difficult to deliver. Debt

restructuring leaves a troublesome stigma and is also often associated with deep recessions.

Pretending that no restructuring will be necessary doesnt make the debt overhang disappear. For

many, if not most, advanced countries, concerns about those debt burdens will shape policy choices

for many years to come.

In this setting, monetary policy in the advanced economies is likely to remain overburdened for

some time.

Complicating the situation is the fact that the debt overhang isnt limited to the public sector, as it

was immediately after World War II. There is now a high degree of leverage in the private sector,

especially in the financial industry and households. In addition, the recent buildup in external

leverage was greater than in past crises. This debt overhang and the financial fragility it creates are

a common feature of most advanced economies, along with stubbornly high unemployment.

Concerns that higher realinterest ratesand deflation will worsen an already precarious situation will

probably impose added constraints on monetary policy.

-- Negative Real Interest Rates, 1945-1980 and Post-2008: One of the main goals of financial

repression is to keep nominal interest rates lower than would otherwise prevail. This effect, otherthings being equal, reduces governments interest expenses for a given stock of debt and

contributes todeficit reduction. However, when financial repression produces negative real interest

rates and reduces or liquidates existing debts, it is a transfer from creditors (savers) to borrowers

and, in some cases, governments.

This amounts to a tax that has interesting political- economy properties. Unlike income, consumption

or salestaxes, the repression tax rate is determined by factors such as financial regulations and

inflation performance, which are opaque -- if not invisible -- to the highly politicized realm of fiscal

policy. Given thatdeficit reductionusually involves highly unpopular spending cuts and/or tax

increases, the stealthier financial-repression tax may be a more politically palatable alternative.

Bretton Woods

Liberal capital-market regulations and international capital mobility had their heyday before World

War I, when the gold standard was in force. However, the Great Depression, followed by World War

II, put an end to laissez-faire banking. It was in this environment that the Bretton Woods

arrangement of fixed exchange rates and tightly controlled domestic and international capital

markets was conceived.

The result was a combination of very low nominal interest rates and inflationary spurts of varying

intensities across the advanced economies. The obvious results were real interest rates -- whether
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for Treasury bills (see attached Figure 2), central bank discount rates, deposits or loans -- that were

markedly negative from 1945 to 1946.

For the next 35 years or so, real interest rates in both advanced and emerging economies were, on

average, negative. Binding interest-rate ceilings on deposits (which kept real ex- post deposit rates

even more negative than real ex-post rates on Treasury bills) induced domestic savers to

holdgovernment bonds. In addition to the effect ofcapital controls, leakages by investors in search

of higher yields elsewhere were limited because the incidence of negative returns on government

bonds and on deposits was, more or less, a universal phenomenon at this time.

The frequency distributions of real rates for the period of financial repression (1945 to 1980) and the

years following financial liberalization, shown in Figure 2, highlight the universality of lower real

interest rates prior to the 1980s and the high incidence of negative real interest rates.

A striking feature of Figure 2, however, is that real ex- post interest rates (shown for Treasury bills)

for the advanced economies have, once again, turned increasingly negative since the outbreak of

the crisis, and this trend has been intensifying.Real rates have been negative for about half of the observations and below 1 percent for about 82

percent of the observations. This turn to lower real interest rates has occurred even though several

sovereign borrowers have been teetering on the verge of default or restructuring (with the attendant

higher risk premiums). Real ex-post central bank discount rates and bank deposit rates have also

become markedly lower since 2007.

Negative Rates

Critical factors explaining the high incidence of negative real interest rates after the crisis are theaggressively expansive stance of monetary policy and heavy central bank intervention in many

advanced and emerging economies.

This raises the broad question of whether current interest rates are more likely to reflect market

conditions or whether they are determined by the actions of official large players in financial markets.

A large role for non-market forces in interest-rate determination is a central feature of financial

repression.

In theU.S. Treasury market, the increasing role of official players (or conversely the shrinking role of

outside market players) is made plain in Figure 3, which shows the evolution from 1945 through

2010 of the share of outside marketable U.S.Treasury securitiesplus those of so-called

government-sponsored enterprises, such as the mortgage companiesFannie MaeandFreddie Mac.

The combination of theFederal Reserves two rounds of quantitative easing and, more importantly,

record purchases of U.S. Treasuries (and quasi-Treasuries, the government-sponsored enterprises,

or GSEs) by foreign central banks (notablyChina) has left the share of outside marketable Treasury

securities at almost 50 percent, and when GSEs are included, below 65 percent.

These are the lowest shares since the expansive monetary policy stance of the U.S. regularly

associated with the breakdown ofBretton Woodsin the early 1970s. That, too, was a period of rising

oil, gold and commodity prices, negative real interest rates, currency turmoil and, eventually, higher

inflation.
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A similar situation prevails in the U.K., where the Bank of Englands quantitative-easing policies

since the crisis -- coupled with the requirement (since October 2009) that banks hold a higher share

of gilts in their portfolios to satisfy tougher liquidity standards -- have reduced the share of outside

gilts to about 70 percent. If foreign official holdings (by central banks) were included in this calculus,

the share of outside gilts would be considerably lower.

ECB Purchases

TheEuropean Central Banks purchases of the bonds ofGreece, Ireland and Portugal amounted to

about 76 billion euros ($100.9 billion) from May 2010 to March 2011 and account for about 12

percent of the combined general government debts of those three countries.

To summarize, central banks on both sides of the Atlantic (and the Pacific, for that matter) have

become even bigger players in purchases of government debt, possibly for the indefinite future.

Meanwhile, fear of currency appreciation continues to drive central banks in manyemerging

marketsto purchase U.S. (and, increasingly, European) government bonds on a large scale. That

means markets for government bonds are increasingly populated by nonmarket players, calling into

question the information content of bond prices relative to their underlying risk profile -- a common

feature of financially repressed systems.

-- Modern Financial Repression, 2008-2012: Advanced economies face the common policy

challenge of finding prospective buyers for their abundance of government debt. Huge purchases of

such debt by central banks around the world have played a clear role in keeping nominal and real

interest rates low. In addition, the Basel III rules provide for the preferential treatment of government

debt in bank balance sheets.Other approaches to creating or expanding demand for government debt may be more direct. For

example, at the height of the financial crisis, U.K. banks were required to hold a larger share of gilts

in their portfolio. Figure 4 documents how Greek, Irish and Portuguese banks among others have

already increased their exposures to domestic public debt.

Thus, the process where debts are being placed at below market interest rates in pension funds

and other more captive domestic financial institutions is under way in several countries in

Europe.Spainrecently reintroduced a de facto form of interest-rate ceilings onbank deposits.

It is difficult to sort out the exact motivations, but as bank deposits have migrated from the periphery

countries in Europe to Germany and Scandinavia, among others, the amount of disclosure, red tape

and other requirements that are necessary to make such transfers has been on the rise. Although

some of these requirements may be motivated by a governments desire to curbmoney

launderingandtax evasion, the measures also amount, in some cases, to administrative capital

controls.

Similar trends are emerging in Eastern Europe. The pension reform adopted by the Polish

parliament in March 2011 has been criticized by the Polish Confederation of Private Employers,

which said the proposal is intended to hide part of the states debt by grabbing the money of the

insured and passing the buck to future governments. Hungary has nationalized its prefunded
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pension plans and excluded the cost of the reforms from public debt figures. Bulgaria has taken

similar measures.

Faced with a private and public domestic debt overhang of historic proportions, policy makers will be

preoccupied with debt reduction, debt management, and, in general, efforts to keep debt-servicing

costs manageable.

In this setting, financial repression in its many guises(with its dual aims of keeping interest rates low

and creating or maintaining captive domestic audiences) will probably find renewed favor and will

likely be with us for a long time.

(Carmen M. Reinhart, a senior fellow at the Peterson Institute for International Economics

inWashington, is the author, with Kenneth S. Rogoff, of This Time is Different: Eight Centuries of

Financial Folly. Thiscommentarydraws on work withJacob F. KirkegaardandM. Belen Sbrancia.

The opinions expressed are her own.)

Read more opinion online fromBloomberg View.

To contact the writer of this article: Carmen M. Reinhart in Washington at [email protected] contact the editor responsible for this column: Max Berley [email protected].
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