Domestic Bonds

Chancellor: Watch out for the return of financial repression


Illustrative photo of US dollar, Swiss franc, British pound and euro banknotes taken in Warsaw on January 26, 2011. REUTERS / Kacper Pempel

LONDON, September 2 (Reuters Breakingviews) – High debt levels require persistently low interest rates. This is the political and economic logic behind the policy of keeping interest rates well below the rate of economic growth. After 1945, this state of affairs, which economists call financial repression, effectively liquidated much of America’s and European war debts. But when the policy was attempted again after the global financial crisis, debt levels continued to rise. In the wake of the Covid-19 pandemic, markets anticipate decades of further financial repression. But they did not take into account its costs or the measures necessary for its operation.

By the end of World War II, US short rates were pegged at less than 1% and the yield on 10-year Treasuries was just over 2%. The Federal Reserve acquired bonds directly from the Treasury Department. US public debt peaked at 120% of GDP. Deposit rates in Western economies have remained negative in real terms for decades. Between 1945 and 1980, this form of financial repression reduced the size of American and British public debts by almost 3% of GDP per year, according to Maria Belen Sbrancia, economist at the International Monetary Fund.

After the Lehman Brothers bankruptcy, the world turned to financial repression once again. In both the United States and Europe, short-term interest rates have remained both below the level of nominal GDP growth and have remained negative in real terms. But as ultra-low interest rates helped American households reduce their excessive debt, corporations and the federal government took advantage of the easy money to sink deeper into the shank. The pandemic has significantly accelerated this process. As a result, US non-financial debt at the end of last year hit a record high of almost three times GDP, according to the Bank for International Settlements. US public debt has returned to its post-war high.

Massive purchases of securities by central banks have eased recent government spending madness. But they also make any hike in interest rates much more expensive. This is because quantitative easing is in effect replacing long-term sovereign bonds with short-term debt issued by the central bank. In the UK, the average maturity of the national debt has fallen to just over four years. This means that a 1 percentage point increase in the Bank of England rate would cost the UK government the equivalent of 0.8% of GDP in additional interest charges. So the political imperative to keep interest rates low has never been stronger.

Investment strategist Russell Napier expects rates to stay below economic growth for years to come. This new episode of financial repression will be accompanied by significantly higher inflation, predicts Napier. After 2008, the Fed’s newly printed money was not used by banks to make new loans. Instead, bank reserves swelled and the money multiplier collapsed. Today, banks are better capitalized and have fewer bad debts. Last year, when Jay Powell’s Fed doubled the size of its balance sheet, much of its new money went straight into the pockets of the public. US banks are currently overflowing with deposits and are eager to lend.

Napier predicts that the money supply will increase by around 10% this year in the United States and Europe, leading to inflation in the order of 4%. If inflation stays at this level and governments control their spending appetite, then financial repression will liquidate public debt at about the same rate as in the post-war years.

It’s not a free lunch, however. Financial repression acts like a wealth tax. Government creditors are the biggest losers. In 1946, a bear market in US Treasuries began and lasted for 35 years. In the post-war decade, British gilts lost around 40% of their purchasing power. In addition, as Napier points out, when credit is no longer allocated on the basis of its market price, governments must assume a greater role. In post-war France, most bank loans were the responsibility of the state. In Britain, companies seeking to raise funds in the City of London had to obtain the approval of a capital matters committee.

To paraphrase John Maynard Keynes, when a country’s capital development becomes a by-product of the political process, the job risks being done poorly. By encouraging inflation and retarding economic growth, financial repression results in stagflation – a term coined by conservative politician Iain Macleod in the 1960s.

Investors appear optimistic about the prospect of negative real interest rates in the indefinite future. They shouldn’t be. Since treasury bills are even more expensive today than in 1945, bondholders face potentially larger losses this time around. Napier recommends that investors replace the fixed income securities in their portfolios with gold, which tends to perform well when interest rates are below inflation.

Stocks are not directly affected by financial repression and performed relatively well after 1945. But after the war, US stocks were extremely cheap, whereas today they are extremely expensive. When bond yields start to rise, stock valuations will likely go down.

Investors in regulated financial institutions, such as life insurers and pensions, are also expected to suffer when the state directs their savings towards politically preferred ends, such as green energy. New regulations may also be needed to prevent companies from using cheap credit for financial engineering. A simple and long overdue reform would be to end the tax deductibility of interest payments for corporations. This would put an end to the era of share buybacks and LBOs.

Financial repression is associated with capital flight, as investors seek to escape the loss of capital in their home markets. The Bretton Woods international monetary system, which operated after the war, allowed capital controls that trapped domestic savings. Any return of capital controls would give investors another headache.

But perhaps the greatest risk is that the current experience of financial repression is unleashed. Under financial repression, investors look like the proverbial frog that is slowly boiled to death. High inflation, on the other hand, is the fire under the pot whose scorching heat is felt immediately and from which there can be no escape.

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Editing by Rob Cox and Marjorie Backman

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