The “least worst” option?

April 24, 2012

Western governments saddled with mountainous debts will “repress” creditors and savers via banking regulation, capital controls, central bank bond buying and currency depreciation that effectively puts sovereign borrowers at the top of the credit queue while simultaneously wiping out real returns for their bond holders. So says HSBC chief economist Stephen King in his latest report this week called “From Depression to repression”.

Building on the work of U.S. economist Carmen Reinhardt and others, King’s focus on the history of heavily indebted governments applying “financial repression” to creditors arrives at several interesting conclusions. First, even though western governments appeared successful in using these tactics to reduce massive World War Two debts alongside brisk economic growth during the 1950s and 1960s, King argues that the debt was cut mainly by the impressive economic growth and tax revenues during that “Golden Age” – and this was mostly down to the once-in-a-century period of relative peace that involved unprecedented integration and cooperation among western governments also engaged in a Cold War with the Soviet Union. Compared to this boost, the financial repression was a “sideshow”, he reckons.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           To show that, he applies the interest rate and inflation conditions of the 1950s and 1960s to the current US government debt trajectory and then compares the growth scenario back then with the one faced now. The graphic is revealing. So, for repression to work, it needs to generate higher growth first. And despite lower real rates today than in the days of Mad Men, that seems not to be the case.

Instead, King says governments will adopt this repression tactic anyway just to stave off draconian austerity now and prevent a destabilising surge in economy-wide borrowing rates. This will effectively reduce the amount of credit to the rest of the private sector, or at least elevating its cost, while reducing the pressure on governments to cut the debt levels quickly. The net result, then will likely be “persistently lower growth”, whatever your conclusion about the desirability of  state or the market allocation of resources.

And, in the absence of an obvious alternative, repression may also be the “least worst” option, King argues.




“Ultimately, however, we’re likely to be stuck with repression unless we find some other alternative source of growth, whether through, say, new technologies, ingeniously-funded infrastructure projects or mass immigration of people of working age (thus increasing both production and tax revenues). However, in the absence of growth – and with the democratic process valuing the minimisation of short-term pain at the possible expense of long-term gain – repression seems an easy, if ultimately damaging, way of avoiding tough decisions.”

Of course, left to its own devices, the private sector did cause large parts of this problem in the first place. As the US government cut borrowing in the late 1990s (ending the second Clinton administration with a budget surplus), the private sector binged on credit like never before as banks and households cooked up an explosive cocktail of mortgage and asset-backed debts.  If the private sector is now being “crowded out” by government, it was in large part a result of preventing its implosion in the first place. The unwind may sensibly be slow from here then, but it is hard to escape the conclusion that growth will be a casualty.
























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Renihart is exactly right. But there is a darker theory yet: that Fed policy is just part of a government-wide strategy of practicing “financial repression” to escape from the consequences of the debt explosion. The leading expert on financial repression is Carmen Reinhart of the Peterson Institute. She defines it as a situation in which “governments implement policies to channel to themselves funds that in a deregulated market environment would go elsewhere.”

Low or negative real interest rates are among the oldest examples. Call this monetary repression. Reinhart points out that it was practiced on a large scale by governments after World War II. She asserts that it accomplished by stealth the effective cancelation of government debt without resort to orthodox spending and tax policies for which governments knew then and now that they cannot get the electorate’s consent.

A similar debt predicament today implies that monetary and other forms of repression are again on the cards, especially in the United States. Wainwright has attempted to measure it, but estimates of real interest rates and monetary repression are fuzzy and contentious, especially because the government as¬serts control over the method by which inflation is measured.

Nevertheless, the company’s research, estimates that the Fed’s interest-rate policy in 2007-11 has cut the real interest rate from a normal 2 or 3 percent to an aver¬age of minus 7 or 8 percent. That’s a diversion of about ten percentage points a year to the Treasury and other borrowers—just about enough to fund the current budget deficit. Genius…

Luis de Agustin

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