Friday, November 21, 2014

The Age of Financial Repression

TILBURG – Following his re-election, US President Barack Obama almost immediately turned his attention to reining in America’s rising national debt. In fact, almost all Western countries are implementing policies aimed at reducing – or at least arresting the growth of – the volume of public debt.

In their widely cited paper “Growth in a Time of Debt,” Kenneth Rogoff and Carmen Reinhart argue that, when government debt exceeds 90% of GDP, countries suffer slower economic growth. Many Western countries’ national debt is now dangerously near, and in some cases above, this critical threshold.

Indeed, according to the OECD, by the end of this year, America’s national debt/GDP ratio will climb to 108.6%. Public debt in the eurozone stands at 99.1% of GDP, led by France, where the ratio is expected to reach 105.5%, and the United Kingdom, where it will reach 104.2%. Even well disciplined Germany is expected to close in on the 90% threshold, at 88.5%.

Countries can reduce their national debt by narrowing the budget deficit or achieving a primary surplus (the fiscal balance minus interest payments on outstanding debt). This can be accomplished through tax increases, government-spending cuts, faster economic growth, or some combination of these components.

When the economy is growing, automatic stabilizers work their magic. As more people work and earn more money, tax liabilities rise and eligibility for government benefits like unemployment insurance falls. With higher revenues and lower payouts, the budget deficit diminishes.

But in times of slow economic growth, policymakers’ options are grim. Increasing taxes is not only unpopular; it can be counter-productive, given already-high taxation in many countries. Public support for spending cuts is also difficult to win. As a result, many Western policymakers are seeking alternative solutions – many of which can be classified as financial repression.

Financial repression occurs when governments take measures to channel to themselves funds that, in a deregulated market, would go elsewhere. For example, many governments have implemented regulations for banks and insurance companies that increase the amount of government debt that they own.

Consider the Basel III international banking standards. Among other things, Basel III stipulates that banks do not have to set aside cash against their investments in government bonds with ratings of AA- or higher. Moreover, investments in bonds issued by their home governments require no buffer, regardless of the rating.

Meanwhile, Western central banks are using another kind of financial repression by maintaining negative real interest rates (yielding less than the rate of inflation), which enables them to service their debt for free. The European Central Bank’s policy rate stands at 0.75%, while the eurozone’s annual inflation rate is 2.5%. Likewise, the Bank of England keeps its policy rate at only 0.5%, despite an inflation rate that hovers above 2%. And, in the United States, where inflation exceeds 2%, the Federal Reserve’s benchmark federal funds rate remains at an historic low of 0-0.25%.

Moreover, given that the ECB, the Bank of England, and the Fed are venturing into capital markets – via quantitative easing (QE) in the US and the UK, and the ECB’s “outright monetary transactions” (OMT) program in the eurozone – long-term real interest rates are also negative (the real 30-year interest rate in the US is positive, but barely).

Such tactics, in which banks are nudged, not coerced, into investing in government debt, constitute “soft” financial repression. But governments can go beyond such methods, demanding that financial institutions maintain or increase their holdings of government debt, as the UK’s Financial Service Authority did in 2009.

Similarly, in 2011, Spanish banks increased their lending to the government by almost 15%, even though private-sector lending contracted and the Spanish government became less creditworthy. A senior Italian banker once said that Italian banks would be hanged by the Ministry of Finance if they sold any of their government-debt holdings. And a Portuguese banker declared that, while banks should reduce their exposure to risky government bonds, government pressure to buy more was overwhelming.

In addition, in many countries, including France, Ireland, and Portugal, governments have raided pension funds in order to finance their budget deficits. The UK is poised to take similar action, “allowing” local government pension funds to invest in infrastructure projects.

Direct or indirect monetary financing of budget deficits used to rank among the gravest sins that a central bank could commit. QE and OMT are simply new incarnations of this old transgression. Such central-bank policies, together with Basel III, mean that financial repression will likely define the economic landscape for at least another decade.

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    1. CommentedMoritz G€d1g

      What is the point of this article?
      The poor banks are forced to buy government bonds? LOL what else are they going to do? No one is forcing banks to do business.
      "when government debt exceeds 90% of GDP, countries suffer slower economic growth"
      Or is it:
      when countries suffer slower economic growth, government debt exceeds 90% of GDP ?

    2. CommentedNathan Coppedge

      I'm tired of hearing that the "trouble will end soon". And I'm tired of hearing that the solution is to buy more debt. The United States needed to be the wealthiest nation in at least two thousand years to accumulate the GDP that has been lumped into debt-bond structures.

      Because of this kind of ---what is not a mere sensibility--- I find a strong appeal in a kind of double economy, that attempts to make good on informational concepts of currency. I'm surprised that it has not already been officialized by washington. Opposite concepts of currency can be fixed into a reciprocal pattern, benefiting permanent industries. This is bolstered by "ticket currencies" which function in a seperate economic system, which attempts to exact real benefits in buying etc. Maybe that just looks like a new form of inflation, but in a system with fixed reciprocity, this problem might not exist.

    3. CommentedZsolt Hermann

      We simply cannot take out parts of the system and try to solve them in isolation.
      Debt is not a cause it is a necessary servant, accessory to the system we promote.
      The whole constant quantitative growth economic system necessitates going beyond means, otherwise the constant growth cannot be sustained.
      When a child is growing he needs much more calories, energy intake than an adult that is only feeding itself to maintain its regular state.
      We cannot hope for a child to grow if we do not give him constant feed, extra needed for the exponential growth.
      Without debt there is no quantitative growth, without debt the economy would remain on the same level.
      And actually that is the natural state, humanity is beyond the "growing child state", it evolved into a fully matured, global, interconnected network, where further quantitative growth is impossible, the human and natural resources are depleted, they cannot take further exponential growth in a closed, finite system.
      If we want to reduce debt, if we want to correct the human system, returning it to a sustainable state, we have to return to an economic model where we consume goods that are necessary for a modern, comfortable human life, according to everybody's settings and natural desires without the artificially generated, harmful and excessive desires we get from marketing and society pressure today. Such model would put us back in line with available resources, as after all we are part of the natural system, our body and mind is based on natural laws and principles, so without the excessive, over the top brainwashing we would automatically align ourselves with normal needs.
      As always we need to correct the true cause not the superficial symptoms.

    4. CommentedProcyon Mukherjee

      The whole setting reminds one of a scheme where savers willing to save are deterred and investors are forced to hoard cash.

      We have a case here where the middle income group and low income group have the most to lose, as they have an environment where savings is not incentivized whereas they would be left with precious little to guard against when they retire. On the other hand we have those investing in Treasury Bonds who are betting against inflation, because if inflation is factored in they would lose money. The corporate sector on the other hand must hoard cash as it makes no sense to invest in riskier assets.

      I wonder who are the beneficiaries of such a scheme, perhaps the banks, who have a prolonged period of negative real interest rate environment and a continued monetary easing. But not really, as risks would have to be priced soon.

      Procyon Mukherjee