Financial Repression: A Solution To The U.S. Government Debt Problem?

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by: Disruptive Investor

The term financial repression was introduced in the literature by the works of Shaw (1973) and Ronald McKinnon (1973).

According to a more recent paper (March 2011), "The Liquidation Of Government Debt" (Carmen M. Reinhart and M. Belen Sbrancia), financial repression is a subtle type of debt restructuring.

Historically, periods of high indebtedness have been associated with a rising incidence of default or restructuring of public and private debts. A subtle type of debt restructuring takes the form of "financial repression." 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 of government debt. Thus, financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation.

According to the same paper, the pillars of financial repression have been identified as:

Explicit or indirect caps or ceilings on interest rates, particularly (but not exclusively) those on government debts.

Creation and maintenance of a captive domestic audience that facilitate and direct credit to the government through capital account restrictions, exchange controls and institutions that hold government debts in their portfolios.

Other common measures associated with financial repression are direct ownership of banks or extensive management of banks and other financial institutions.

This article looks into the current phase of financial repression in the U.S., and its implication on government debt, inflation and asset classes.

At the onset, I am convinced that the U.S. is in a period of financial repression, as policymakers have been implementing measures discussed in the pillars of financial repression.

There is an indirect cap on treasury bonds through the bond purchase program, which has been recently extended. Record low yields on long-term government bonds have been a direct result of the bond purchase program.

Further, it is increasingly evident that there are more local buyers of U.S. government debt after the crisis. The monetary authority (Federal Reserve) and individuals are amongst the largest buyers of U.S. treasury post-crisis. I had discussed this aspect in one of my earlier articles.

There is no case of the government sector owning large banks. However, the policymakers have focused on extensive management and oversight of banks and other financial institutions.

These factors make it evident that policymakers in the U.S. are using the strategy of financial repression to control government debt in the country.

The policymakers have also been resorting to inflation targeting, and financial repression necessitates a steady dosage of inflation. This further underscores the point that financial repression is being used as a method to reduce the debt to GDP levels.

The timing of the discussion seems apt, as the debt level for advanced economies has surged after the financial crisis. In all the previous instances of high debt, a period of deleveraging has ensued, with events of default, financial repression, inflation and hyperinflation.

The chart below gives the periods of surge in debt in advanced and emerging economies over the last 100 years:

(click images to enlarge)

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If history has to repeat itself, the world will witness defaults, financial repression and inflation over the next decade.

As mentioned above, I am of the opinion that the U.S. will witness financial repression and inflation over the next decade. With projected deficits of USD10 trillion over the next 10 years, the phase of financial repression might be associated with much higher inflation than witnessed in previous instances of repression.

One of the ways of deficit reduction through financial repression is explained in the "Liquidation Of Government Debt" paper as:

One of the main goals of financial repression is to keep nominal interest rates lower than would otherwise prevail. This effect, other things 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, this also reduces or liquidates existing debts. It is a transfer from creditors (savers) to borrowers (in the historical episode under study here -- the government).

The financial repression tax has some interesting political-economy properties. Unlike income, consumption, or sales taxes, the "repression" tax rate (or rates) are 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 to authorities faced with the need to reduce outstanding debts.

Policymakers in the U.S. have been successful in this form of financial repression with negative real interest rates.

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On the flipside, invisible taxation has eroded the purchasing power of individuals.

The problem arises when a decline in interest payments and liquidation of existing debt (through repression tax) is more than offset by continued deficit spending.

In the current scenario, deficits are likely to be above USD1 trillion for the next few years. With meaningfully high deficits, financial repression punishes households through invisible taxation and through a weak currency.

Therefore, the success of financial repression is questionable in an environment of continued deficit spending.

Having said this, policymakers in the U.S. have been successful in keeping yields at lower levels, along with a steady dose of inflation. I am not talking about the reported inflation numbers. For a typical household, inflation has been around 5% in the U.S., with food, energy, healthcare and higher education costs rising.

However, if a steady dose of inflation is not enough to liquidate the massive debt, the U.S. has another option, as explained in the Reinhart and Sbrancia research paper.

We have argued that inflation is most effective in liquidating government debts (or debts in general), when interest rates are not able to respond to the rise in inflation and in inflation expectations. This disconnect between nominal interest rates and inflation can occur if:

(NYSE:I) the setting is one where interest rates are either administered or predetermined (via financial repression, as described); (II) all government debts are fixed rate and long maturities and the government has no new financing needs (even if there is no financial repression the long maturities avoid rising interest costs that would otherwise prevail if short maturity debts needed to be rolled over); and (NASDAQ:III) all (or nearly all) debt is liquidated in one "surprise" inflation spike.

I am of the opinion that "surprise inflation spike" is one of the options for U.S. policymakers in order to liquidate debt at sometime in the future. I am not suggesting a period of hyperinflation.

However, it would be not surprising to see high double digit inflation in the US in the next five to 10 years with the sole purpose of liquidating debt. I had discussed the prospects of high inflation in one of my earlier articles in details.

The problem with a steady dose of inflation, surprise inflation and artificially low interest rates is that it punishes the savers and the middle class. Further, a steady dose of inflation creates a prolonged period of invisible taxation, lowering the standards of living and purchasing power for an average household.

From that perspective, a better option to get out of the inescapable debt trap would be to default directly and not default through inflation. However, this is certainly not the option policymakers would want to implement.

Therefore, consumers and investors can expect steadily rising inflation over the next decade. From an investment perspective, investors need to beat inflation in order to retain their purchasing power.

I would personally look at investing in equities in times of high inflation. Global equity diversification is necessary in order to ensure relatively robust returns. Gold and silver would also be an automatic choice for the portfolio. In line with this, I would consider exposure to the following ETFs:

SPDR S&P 500 (NYSEARCA:SPY) ETF - The ETF gives exposure to the S&P 500 index, with ETF returns generally corresponding to the price and yield performance of the S&P 500 Index. The ETF has a low expense ratio of 0.09% and is a good index investing option.

SPDR Gold Shares (NYSEARCA:GLD) ETF - The ETF seeks to replicate the performance, net of expenses, of the price of gold bullion. The ETF has an expense ratio of 0.4%, with net asset holdings for the fund at USD65.26 billion

iShares Silver Trust (NYSEARCA:SLV) - The ETF seeks to reflect the price of silver owned by the trust, less the trust's expenses and liabilities. The ETF has an expense ratio of 0.5%, with net asset holdings for the fund at USD8.78 billion

Vanguard MSCI Emerging Markets ETF (NYSEARCA:VWO) - The ETF seeks to track the performance of a benchmark index (MSCI Emerging Markets Index) that measures the investment return of stocks issued by companies located in emerging market countries. With a low expense ratio of 0.2%, the ETF is a good option to consider exposure to emerging market equities, which should outperform developed market equities in the long term

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.