Chancellor: Beware financial repression’s return
LONDON, Sept 2 (Reuters Breakingviews) – High debt levels require permanently 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 a large chunk of American and European war debts. But when the policy was attempted again after the global financial crisis debt levels continued rising. In the wake of the Covid-19 pandemic, markets are anticipating decades more financial repression. But they haven’t factored in either its costs or the measures required for it to work.
At the end of World War Two, U.S. short-term rates were pegged at below 1% and the yield on 10-year Treasuries at just over 2%. The Federal Reserve acquired bonds directly from the Department of Treasury. American public debt peaked at 120% of GDP. Deposit rates in the western economies remained negative in real terms for decades. Between 1945 and 1980, this form of financial repression reduced the size of U.S. and UK public debts by nearly 3% of GDP a year, according to Maria Belen Sbrancia, an economist at the International Monetary Fund.
After Lehman Brothers’ bankruptcy, the world turned once again to financial repression. In both the United States and Europe, short-term interest rates were kept both below the level of nominal GDP growth and remained negative in real terms. But while ultralow interest rates helped American households reduce their excessive debts, corporations and the federal government took advantage of easy money to get more deeply into hock. The pandemic dramatically accelerated this process. As a result, U.S. non-financial debt at the end of last year reached a record high of nearly three times GDP, according to the Bank for International Settlements. America’s public debt has returned to its post-war high.
Massive securities purchases by central banks facilitated the governments’ recent spending splurge. But they also make any interest rate hike far more costly. That’s because quantitative easing, in effect, involves replacing long-dated sovereign bonds with short-term debt issued by the central bank. In the United Kingdom 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’s rate would cost the UK government the equivalent of 0.8% of GDP in extra interest costs. So the political imperative to maintain low interest rates has never been stronger.
The investment strategist Russell Napier expects that rates will be kept below economic growth for years to come. This new bout of financial repression will be accompanied by significantly higher inflation, Napier predicts. After 2008, the Fed’s newly printed money wasn’t used by banks to advance new loans. Instead, bank reserves ballooned, and the money multiplier collapsed. Today, banks are better capitalised 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. U.S banks are currently overflowing with deposits and eager to lend.
Napier predicts that the money supply will grow this year by around 10% in the United States and Europe, resulting in inflation in the region of 4%. If inflation stays at this level and governments control their urge to spend, then financial repression will liquidate the public debt at roughly the same pace as in the post-war years.
This is no free lunch, however. Financial repression acts as a closet wealth tax. Government creditors are the biggest losers. In 1946, a bear market in U.S. Treasuries commenced that lasted for 35 years. In the post-war decade, UK gilts lost around 40% of their purchasing power. Furthermore, as Napier points out, when credit is no longer allocated according to its market price, then governments must assume a greater role. In post-war France, most bank lending came under the state’s purview. In Britain, firms seeking to raise money in the City of London required approval from a Capital Issues Committee.
To paraphrase John Maynard Keynes, when the capital development of a country becomes a by-product of the political process, the job is likely to be ill done. By encouraging inflation and retarding economic growth, financial repression ends in stagflation – a term coined by the Tory politician Iain Macleod in the 1960s.
Investors appear sanguine about the prospect of negative real interest rates for the indefinite future. They shouldn’t be. Given that Treasuries are even more highly priced today than in 1945, bondholders face potentially greater 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 trail below inflation.
Equities are not directly hurt by financial repression and did relatively well after 1945. But after the war, American stocks were extremely cheap, whereas today they are extremely expensive. When bond yields start to rise, equity valuations will probably come down.
Investors in regulated financial institutions, such as life insurers and pensions, are also set to suffer when the state directs their savings toward politically preferred ends, such as green energy. New regulations may also be required to prevent companies from using cheap credit for financial engineering. One simple and long overdue reform would be to end the tax deductibility of interest payments for corporations. That would bring the era of share buybacks and leveraged buyouts to a close.
Financial repression is associated with capital flight, as investors seek to escape the loss of capital in their domestic markets. The Bretton Woods international monetary system, which operated after the war, authorised capital controls which trapped savings at home. Any return of capital controls would provide investors with yet another headache.
But perhaps the greatest risk is that the current experiment with financial repression runs amok. Under financial repression investors resemble the proverbial frog that is slowly boiled to death. High inflation, on the other hand, is the fire beneath the pot whose scorching heat is felt immediately and from which there can be no escape.
Follow @Breakingviews on Twitter
Editing by Rob Cox and Marjorie Backman
Reuters Breakingviews is the world’s leading source of agenda-setting financial insight. As the Reuters brand for financial commentary, we dissect the big business and economic stories as they break around the world every day. A global team of about 30 correspondents in New York, London, Hong Kong and other major cities provides expert analysis in real time.
Sign up for a free trial of our full service at https://www.breakingviews.com/trial and follow us on Twitter @Breakingviews and at www.breakingviews.com. All opinions expressed are those of the authors.