by Jacob Funk Kirkegaard, Peterson Institute for International Economics
and Carmen M. Reinhart
Op-ed in VoxEu
March 26, 2012
© Peterson Institute for International Economics
In light of the record or near-record levels of public and private debt, debt-reduction strategies are likely to remain at the forefront of policy discussions in most of the advanced economies for the foreseeable future (Reinhart and Sbrancia 2011).
Throughout history, debt-to-GDP ratios have been reduced by:
As coined by Ronald McKinnon (1973), the term “financial repression” describes various policies that allow governments to “capture” and “under-pay” domestic savers. Such policies include forced lending to governments by pension funds and other domestic financial institutions, interest-rate caps, capital controls, and many more. Governments have typically used a mixture of these to bring down debt levels, but inflation and financial repression typically only work for domestically held debt (the euro area is a special hybrid case). In the current policy discussion, financial repression comes under the “macroprudential regulation” rubric.
Most governments would only contemplate default or surprise inflation under truly desperate economic conditions. In Europe, austerity is being pursued, but in the countries that need it most, falling growth tends to offset much of the progress. Little wonder, then, that financial repression is back on the policy menu.
Financial repression, teamed with a steady dose of inflation, cuts debt burdens from two directions:
Here, inflation need not take market participants entirely by surprise and, in effect, it need not be very high (by historic standards).
Financial repression also has some interesting political-economy properties. Unlike other taxes, the “repression” tax rate (or rates) is 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 for authorities faced with the need to reduce outstanding debts.
Would Not Financial Repression by Any Other Name…
We suggest that the combination of high public and private debts in the advanced economies (with the attendant pressures towards creating captive audiences for government debt) and the perceived dangers of currency misalignments and overvaluation in emerging markets facing surges in capital inflows (and, thus, the pressures towards currency intervention and capital controls) interact to produce a “home bias” in finance and a resurgence of financial repression. It is not called financial repression but unfolds in the context of “macroprudential regulation.”
This is materializing worldwide:
The emerging economy controls are meant to counter loose monetary policy in the advanced economies and discourage “hot money,” while regulatory changes in advanced economies are meant to create a captive audience for domestic debt.
More broadly, the world is witnessing a return to more tightly regulated domestic financial environment—referred to in the old jargon as “financial repression.”
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 the 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 (government and private). A recent study by Reinhart and Sbrancia (2011) documents such historical episodes.
Negative Real Interest Rates During 1945–1980 and again post-2008
Liberal capital-market regulations and international capital mobility reached their heyday prior to World War I under the gold standard. However, the Great Depression, followed by World War II, put the final nails in the coffin of 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 degrees across the advanced economies. The obvious results were real interest rates—whether on treasury bills (figure 1), central bank discount rates, deposits or loans—that were markedly negative during 1945–46.
For the next 35 years or so, real interest rates in both advanced and emerging economies would remain consistently lower than during the eras of freer capital mobility before and after the financial repression era. In effect, real interest rates 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. What delayed the emergence of leakages in the search for higher yields (apart from prevailing capital controls) was that 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 (1945–80) and the years following financial liberalization, shown in figure 1, highlight the universality of lower real interest rates prior to the 1980s and the high incidence of negative real interest rates in the advanced economies. Reinhart and Sbrancia (2011) demonstrate a comparable pattern for the emerging markets.
Figure 1 Real interest rates frequency distributions: Advanced economies, 1945–2011
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).
Back to Negative Real Interest Rates
A striking feature of figure 1, 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. Real rates have been negative for about one-half of the observations, and below 1 percent for about 82 percent of the observations. This turn to lower real interest rates has materialized despite the fact that several sovereigns have been teetering on the verge of default or restructuring (with the attendant higher risk premiums). Indeed, in recent months negative yields in most G-7 countries have moved much further out the yield curve (figure 2).
Figure 2 G-7 real government bond yields, February 2012
Sources: Organization for Economic Cooperation and Development and Bloomberg.
In the United Kingdom, United States, Germany, and Canada, negative real rates now include even the ten-year segment of the yield curve and, inside the euro area, even in non-safe haven France negative yields stretch to five years and in crisis-stricken Italy to the two-year segment.
No doubt, a critical factor explaining the high incidence of negative real interest rates in the wake of the crisis is the aggressively expansive stance of monetary policy (and more broadly, official central bank intervention) in many advanced and emerging economies during this period.
“Modern” Financial Repression: 2008–2012
One thing advanced economies do not lack at present is an abundance of government debt, which is accompanied with the attendant common policy challenge of finding prospective buyers for such debt. The role of massive purchases of government debt by central banks around the world in keeping nominal and real interest rates low was already noted above. In addition, Basel III provides for the preferential treatment of government debt in bank balance sheets via substantial differentiation (in favor of government debt) in capital requirements.
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 UK government bonds in their portfolio (see Kirkegaard and Reinhart 2012 for details). Thus, the process where debts are being “placed” at below market interest rates in pension funds and other more captive domestic financial institutions is already under way in several countries in Europe. Spain has recently reintroduced a de facto form of interest-rate ceilings on bank deposits.1
The use of capital controls for emerging markets concerned about destabilizing “hot money” inflows, potential overheating, rising inflationary pressures, and the related competitiveness issues have found far greater acceptance in the international community than at any time since the breakdown of the Bretton Woods system of fixed exchange rates. Many emerging markets have already embarked on various policies with that aim (Kirkegaard and Reinhart 2012).
Implications and Conjecture
As noted, financial repression contributed to rapid debt reduction following World War II. At present, the levels of public debt in many advanced economies are at their highest levels since that time; some of these governments face the prospect of debt restructuring. Furthermore, public and private external debts (which are a relatively volatile source of funding) are at historic highs. It seems probable that policymakers for some time to come will be preoccupied with debt reduction, debt management, and, in general, efforts to keep debt servicing costs manageable. The high and persistent levels of unemployment in many advanced economies in the wake of the crisis add further motivation for central banks to keep interest rates low. In this setting, financial repression (with its dual aims of keeping interest rates low and creating or maintaining captive domestic audiences) will probably find renewed favor and the measures and developments we have described and discussed in this column are likely to be only the tip of a very large iceberg.
Kirkegaard, Jacob F., and Carmen M Reinhart. Forthcoming 2012. The Return of Financial Repression in the Aftermath of the Great Contraction. PIIE Working Paper. Washington: Peterson Institute for International Economics.
McKinnon, Ronald I. 1973. Money and Capital in Economic Development. Washington: Brookings Institute.
Magud, Nicolas, E., Carmen M. Reinhardt, and Ken S. Rogoff. 2011. Capital Controls: Myth and Reality —A Portfolio Balance Approach. PIIE Working Paper 11-7. Washington: Peterson Institute for International Economics.
Reinhart, Carmen M., and M. Belen Sbrancia. 2011. The Liquidation of Government Debt. PIIE Working Paper 11-10. Washington: Peterson Institute for International Economics.
1. Our discussion has focused primarily on Western Europe but similar trends are emerging in Eastern Europe. Pension reform adopted by the Polish parliament in March of this year has met with criticism from employers' federations and business circles. Polish Confederation of Private Employers Lewiatan says the proposal seeks to hide part of the state's debt by grabbing the money of the insured and passing the buck to future governments. The confederation also points out that moving money from pension funds to social security (ZUS) will protect the government from having to change the definition of public debt and exceed financial safety thresholds, but will expose future retirees to losses. Struggling with budgetary pressure at home, Hungary has nationalized its pre-funded pension schemes and excluded the cost of the reforms from their public debt figures. Bulgaria has taken measures in the same direction (see Kirkegaard and Reinhart 2012 for details).