by Carmen M. Reinhart
Op-ed on Bloomberg.com. Reposted with permission.
March 11, 2012
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 United States, as in Europe, 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.
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 on interest 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 United States 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.
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 finding common cause in 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 United States 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, 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.
Figure 1 Gross central government debt as a percent of GDP:
22 advanced economies, 1900–2011 (unweighted averages)
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 accompanied by an equally steady dose of inflation. It is critical to note that the last two option— inflation and financial repression—are only viable for domestic-currency debts (the euro area is a special hybrid case).
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 doesn’t 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 isn’t 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 real interest rates and 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, other things being equal, reduces governments’ interest expenses for a given stock of debt and contributes to deficit 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 sales taxes, 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 that deficit reduction usually involves highly unpopular spending cuts and/or tax increases, the stealthier financial-repression tax may be a more politically palatable alternative.
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 for Treasury bills (see figure 2), central bank discount rates, deposits or loans—that were markedly negative from 1945 to 1946.
Figure 2 Real interest rates frequency distributions:
advanced economies, 1945–2011 Treasury bill rates
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
Sources: Reinhart and Sbrancia (2011), International Financial Statistics, International Monetary Fund, various sources listed in the Data Appendix, and authors’ calculations.
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 hold government bonds. In addition to the effect of capital 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.
Critical factors explaining the high incidence of negative real interest rates after the crisis are the aggressively 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 nonmarket forces in interest-rate determination is a central feature of financial repression.
In the US 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 US Treasury securities plus those of so-called government-sponsored enterprises, such as the mortgage companies Fannie Mae and Freddie Mac.
Figure 3 Share of “outside” marketable US Treasury securities
plus government sponsored enterprises (GSEs) securities: end-of-period, 1945–2010
Notes: The outstanding stock of marketable US 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 US Treasuries and GSEs.
Sources: Flow of Funds, Board of Governors of the Federal Reserve and authors’ calculations.
The combination of the Federal Reserve’s two rounds of quantitative easing and, more importantly, record purchases of US Treasuries (and quasi-Treasuries, the government-sponsored enterprises, or GSEs) by foreign central banks (notably China) 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 United States regularly associated with the breakdown of Bretton Woods in 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.
A similar situation prevails in the United Kingdom, where the Bank of England’s 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.
The European Central Bank’s (ECB’s) purchases of the bonds of Greece, 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 many emerging markets to purchase US (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, 2008–12
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, UK 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.
Figure 4 Domestic bank holdings of general government debt:
Greece, Ireland, Portugal, and the United Kingdom, 2008–10, end-of-period
(as a percent of gross general government debt)
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.
Sources: See Kirkegaard and Reinhart (2011) for individual country sources, International Monetary Fund, World Economic Outlook.
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. Spain recently reintroduced a de facto form of interest-rate ceilings on bank 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 government’s desire to curb money laundering and tax 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 state’s debt by grabbing the money of the insured and passing the buck to future governments. Hungary has nationalized its prefunded 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, policymakers 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.