Developed World in Deep Debt Do-Do

Many nations in the developed world are in deep do-do with their debt levels. On one hand they need growth to earn their way out of their problems while on the other they’re being forced into anti-growth austerity measures by markets concerned about their spiralling interest obligations. It’s a grim position for those of us brought up to expect an unrelentingly rosy economic outlook.

This isn’t a new situation, though. We’ve been here many, many times before and governments have, by design and evolutionary accident, developed many, many ways of dealing with these problems. The cunning thing is that many of these involve stealthily thieving from their own citizens, but done so surreptitiously that, if we’re not careful, we won’t even notice it.

Financial Repression

A paper by Carmen Reinhart and Kenneth Rogoff looked at ways in which governments can use their privileged positions to manage down debt – methods that the authors refer to as “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.”

Governments, for example, can regulate that pension funds must hold certain types of security – which, it might so happen, turn out to be government bonds, which might be quite useful if you have to sell bucket-loads of them in order to keep your finances in good order. However, normally associated with this is one common factor:

“Financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation. Inflation need not take market participants entirely by surprise and, in effect, it need not be very high (by historic standards).”

The pillars of financial repression that the authors list include:

• ceilings on interest rates which can be explicitly legislated for, or can be implicit, through mandated central bank targets for instance
• creation of a captive domestic audience, through blunt measures like exchange controls or more subtle ones like the pension liability issue mentioned above, and
• enforcing more or less direct control of bank lending policies.

All of [the above examples] can be used to draft domestic markets into lending to governments and, accompanied by a bracing dose of inflation, can reduce the real value of that debt – often quite quickly.

Negative Interest

The paper shows that there have been five debt crises over the past hundred years, including the latest one, and the last two, since World War II, have both been accompanied by financial repression. The key to these measures, which are many and varied in nature, are to keep nominal interest rates lower than would otherwise be the case, which reduces the interest payable by governments. If you add in inflation this can lead to effective negative interest rates, and the rapid erosion of the debt mountain.

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A “negative interest rate” is simply where the interest we get on our cash is less than the prevailing rate of inflation. The beauty of these measures, from a politician’s perspective, is that they are not obvious to the general public – as the authors state:

“The financial repression tax has some interesting political-economy properties. Unlike income, consumption, or sales taxes, the “repression” tax rate (or rates) are determined by financial regulations and inflation performance that are opaque to the highly politicized realm of fiscal measures. Given that deficit reduction usually involves highly unpopular expenditure reductions and (or) tax increases of one form or another, the relatively “stealthier” financial repression tax may be a more politically palatable alternative to authorities faced with the need to reduce outstanding debts.”

Money Illusion

Interestingly the paper indicates that real US interest rates have only rarely been as high as 3% since 1945 and were under 1% for over 60% of the time. The use of financial repression was highly effective at reducing debt levels – 2% to 3% a year rapidly makes a difference:

“The UK’s history offers a pertinent illustration. Following the Napoleonic Wars, the UK’s public debt was a staggering 260 percent of GDP; it took over 40 years to bring it down to about 100 percent…Following World War II, the UK’s public debt ratio was reduced by a comparable amount in 20 years.”

[Such public debt ratio reduction] relies on the sleight of hand that lies behind money illusion – the idea that people focus on nominal interest rates rather than real ones. Unfortunately, this seems to be hardwired into people…

If financial repression was in the cards then we might expect to see abnormally low interest rates, stubbornly high inflation rates and governments imposing all sorts of new capital holding requirements on banks and pension funds…Keep an eye open for [such happening]…

Booming and Busting

[It is interesting to note that during] periods of financial repression in developed countries post war the economies of those countries boomed. That’s fine if you’re happy to reduce government debt by impoverishing savers at the expense of borrowers, and even more fine if the government is prepared to take up the slack by offering retirees inflation adjusted pensions. However, if governments are determined to cut back on such benefits as well, then a future booming economy isn’t going to benefit everyone, and it’s every investor for themselves as we all look for safe havens.

How to Invest During Times of Financial Repression

If financial repression was to occur then inflation linked bonds – which are generally expensive anyway – and higher yielding, “safe” equities (whatever those are) along with some gold would probably be about as safe as you could get. What you wouldn’t want to be doing is holding cash or those ultra-safe government bonds for anything other than the very, very short term.

*http://www.stockopedia.co.uk/content/how-sneaky-governments-steal-your-money-63352/

Editor’s Note: The above article has been has edited ([ ]), abridged (…) and reformatted (including the title, some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The article’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.

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