Financial Repression,Inflation & Real Wages
Recent months have seen a lot of discussion of the concept of ‘financial repression’.
Wikipedia provides a good and concise definition of the term. Simply put, financial repression is the use of government policy to direct funds where they otherwise, in a free market, wouldn’t go. When combined with higher inflation it can prove an effective way of reducing government debt.
In a (much cited) 2011 NBER paper Reinhart & Sbranica argued that:
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. In the heavily regulated financial markets of the Bretton Woods system, several restrictions facilitated a sharp and rapid reduction in public debt/GDP ratios from the late 1940s to the 1970s. Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt. Thus, financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation.
In other words a combination of capital controls (to stop funds leaving), explicit (or implicit) caps on interest rates and the direction of bank and pension fund assets into government debt can lead to large amounts of savings being ‘pushed’ into government debt at low nominal yields. When combined with a dose of sustained inflation this leads to negative real interest rates on government debt which erodes the value of that debt over time.
The BBC’s Paul Mason wrote a detailed (and as ever very interesting) post on this last week. He noted that many suspect that ‘financial repression’ might already be underway :
Now consider this: the Federal Reserve’s quantitative easing III tactic explicitly targets the “risk free interest rate” – aiming to set it at a historic low, and thus influencing all related interest rates downwards. It is not (yet) a cap, but it is a way of repressing interest rates.
Then, with much of the European bond market effectively neutralised by the long-term purchase of government debt by the ECB (we are paid not to think about the market value, says one fund manager), you make a large part of the world’s debts difficult to value.
Then you create a euro 1tn fund to buy the debts of Spain, Italy and Portugal and bury them for 20 years.
It is hard to escape the conclusion that “financial repression” – as mooted by Reinhart and Sbranica – is, if not under way, then being pieced together ad hoc out of the anti-crisis measures in Europe.
In the UK, of course, QE acts in a similar manner. Witness last week’s complaints from the NAPF on the effects of the bank’s gilt buying on pensions.
Late last year the think tank Centre Forum released a report by economic historian Nicolas Crafts entitled ‘Delivering Growth Whilst Reducing Debts: Lessons from the 1930s’. This explicitly noted the use of inflation to both stimulate the economy and to reduce debts:
The key to recovery was the adoption of credible policies to raise the price level and in so doing to reduce real interest rates by raising the expected rate of inflation. This provided monetary stimulus even though, as today, nominal interest rates could not be cut further.
The report promoted blogger Hopi Sen to ask ‘Are Liberals embracing the inflation saviour?’
In a time of heavy government involvement in the banking sector (two part state-owned banks in the UK, the Project Merlin Deal), new financial regulation (from Solvency II in insurance to Basel III for banks) and unconventional monetary policy from the major central banks combined with negative real interest rates on much government debt, it is perhaps easy to conclude that ‘financial repression’ is making a comeback.
Morgan Stanley’s senior advisor Alan Taylor provides an interesting counter argument. He argues that negative real interest rates on government debt don’t reflect ‘financial repression’ but are instead simply a result of general fear and uncertainty in financial markets and global shortage of ‘safe’ assets. Nobody is (yet) ‘forcing’ the banks to pile into gilts at negative real rates, they simply are fearful of buying anything else.
Leaving aside the question of whether financial repression is yet occurring, there is a bigger question – could it succeed if it was tried?
Here Paul Mason notes that floating (rather than fixed) exchange rates make the entire notion a lot more tricking than during the post-war period. As, of course, do open global capital markets.
What makes this time different, on a global scale, however, is the reality of floating exchange rates. Countries couldn’t use competitive devaluation under the Bretton Woods system. Now they can.
But I worry there might be another, larger, problem with the use of ‘financial repression’. For it to succeed in lowering the real value of debt requires a reasonably sustained period of high inflation. But if this high inflation isn’t accompanied by rising nominal wages then real incomes will be squeezed and spending reduced.
As Chris Dillow wrote last year, falling real wages put the public finances under pressure.
The 1950s and 1960s, the ‘golden age’ of financial repression, were marked not only by fixed exchange rates and capital controls but also by rising real wages.
The fear is that any sustained upswing in inflation will not be matched by an upswing in nominal earnings (the 2011 pattern in the UK), the resulting squeeze in living standards would depress real spending and hence GDP, undermining any attempt to reduce debt/GDP ratios.
Given this, I’m not sure at all that a period of high inflation would prove the best way to reduce government debt.