Prepare to be financially repressed
James Saft is a Reuters columnist. The opinions expressed are his own.
Financial repression, the capture by government of capital for its own needs, is coming, if it’s not already here.
If you are a saver, or just rich, for that matter, this means that some of your money will flow to debtors, mostly your government, in a kind of sleight of hand.
Financial repression, which takes many forms, has historically been a popular way for governments to dig themselves out of debt holes, as it can be slow and controlled, unlike a default, and, like the proverbial frog being slowly boiled, is hard for the victims to figure out.
“One of the main goals of financial repression is to keep nominal interest rates lower than they would be in more competitive markets. Other things equal, this reduces the government’s interest expenses for a given stock of debt and contributes to deficit reduction,” economists Carmen Reinhart, Jacob Kirkegaard and Belen Sbrancia wrote in an IMF publication.
“However, when financial repression produces negative real interest rates (nominal rates below the inflation rate), it reduces or liquidates existing debts and becomes the equivalent of a tax — a transfer from creditors (savers) to borrowers, including the government.”
That’s exactly what happened in much of the post-World War II era, and is one of the principal ways nations bailed themselves out of the debts incurred during the conflict.
How does it work?
There are many forms, but keeping interest rates artificially low, either through direct or effective caps is an important component of financial repression. Look no further than QEII for an example of this, but more may be coming.
Both Bill Gross of PIMCO and David Rosenberg of Gluskin, Sheff have warned that the Fed’s next effort at stimulus may come in the form of an interest rate cap of some kind. For example, the central bank may pledge to buy enough of a given maturity of government debt, let’s say the two-year, to keep rates capped at a given yield. That would be both stimulative and quite convenient from a debt management point of view.
Decoupling of interest rates and risk is a noted feature of financially repressed systems. Again, look at QEII as a prime cause, as well as purchases of treasuries by foreign central banks. This is one of the great dangers of financial repression; that in an otherwise lightly regulated market it unplugs the risk alarm bells that investors usually hear. The Chinese property market is a great example of this, as hugely negative Chinese real interest rates prompt speculation in Shanghai apartments.
After all, why keep your money in the bank or in bonds only to see it ebb away?
Note that a negative real interest rate, i.e. one that fails to compensate for inflation, effectively liquidates the underlying debt. That’s a stealth tax on capital holders and does not have to feature high inflation.
Financial repression also often features governments capturing investors, such as by forcing pension funds or banks to hold given amounts of government debt. There have already been great examples in Europe, such as Irish efforts to nobble pension money by forcing it to contribute to government bank bailouts. France has recently put in place measures that unfairly induce pension plans to invest in government debt, as has Hungary.
What is considerably different this time, as opposed to after World War II, is that so much of the debt is privately issued, meaning that it is not just government debt that needs clearing up but masses of private debt. Attempts to apply financial repression to the housing market have so far failed, after having worked only too well for decades. While the Federal Reserve bought up mortgage bonds, and the government massively subsidizes mortgage rates through Freddie Mac and Fannie Mae, this so far has not outweighed the fall in the value of the underlying real estate.
Another main feature of financial repression is closer ties between government and banks, either via ownership or suasion, and tighter regulation. Banks often tend under these circumstances to hold more government debt, and to lend more at home rather than abroad.
Look for all of this to happen in massive amounts if Greece falls out of the euro zone, and perhaps even if it does not.
For capital holders this is all a huge drag. If financial repression works this time, which it may not due to all of that private debt, look for investment in highly indebted companies and vehicles to work well, as theoretically would property. Gold would also outperform, theoretically, so long as investors are allowed to hold it.
The really remarkable thing is how attractive an unjust policy like financial repression looks given the dire alternatives.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)