Financial repression revisited

February 8, 2012

At a monetary policy event hosted by Fathom Consulting at the Reuters London office today, former Bank of England policymakers were discussing the pros and cons of “financial repression”.

Financial repression is a concept first introduced in the 1970s in the United States and is becoming a talking point again after the financial crisis, especially with a NBER paper last year written by economists Reinhart and Sbrancia reviving the debate.

In the paper, authors define financial repression as follows:

Historically, periods of high indebtedness have been associated with a rising incidence of default or restructuring of public and private debts. A subtle type of debt restructuring takes the form of “financial repression”.

Financial repression includes directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks.

Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt. Thus, financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation.

Credit Suisse estimates that a decline in interest rates by1% would lead to a fall in the debt ratio by roughly 10% over a ten-year period.

A more comprehensive set of measures — a 1% lower interest rate, a 1% higher nominal growth rate and a 1% primary surplus — reduces the debt ratio by more than 25% over the same period.

However, financial repression clobbers savers: they are forced to live with a period of low, or sometimes negative, rate of real returns because bond yields fall but inflation rate goes up.

At the event this morning, Fathom director Danny Gabay said financial repression did work in the UK in the past but it won’t work this time because of the level of household debt. The average UK household debt is six times higher than before, he says.

Former BoE Monetary Policy Committee members Andrew Sentance and Rachel Lomax were also sceptical.

Sentance said quantitative easing is an emergency policy and it worked the first time round. But  QE2 is not appropriate to rebuild confidence, adding that financial repression is undesirable.

Lomax agreed: “Financial repression is a stealth tax on consumers, imposed by central banks. It’s very convenient for politicians, it’s vaguely opaque, so it’s politically objectionable.”

She did add however that it was hard to see an alternative to ultra-easy policy. “The transmission mechanism for monetary policy is interfered (with) by banks which are impaired. This was the rationale for QE.”

At the end of the event, participants were split on whether financial repression would work, with 51 percent of them saying it would.


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