Financial Repression: The Unintended Consequences Of Saving The Sovereign

Includes: AGG, DIA, QQQ, SPY, UDN, UUP
by: Lewis Spellman

What's new has often been lived before, but sometimes it's not pretty. Presumably that's what Clarence Darrow meant when he said, "History repeats itself, and that's one of the things that's wrong with history."

It is becoming increasingly clear that developed-world countries will attempt to go down a path followed before by governments facing similar debt loads … and it's not pretty. In this case it's not a wartime debt rollover, but a combination of lofty promises made to provide a social net to a burgeoning population demographic. This follows years of fiscal sloppiness both here and abroad derived from an attitude best expressed in the infamous and thoughtless words of Dick Cheney, "Debt doesn't matter." Well, Dick, it does.

With the U.S. and many other sovereign's debt levels reaching or exceeding the 100% ratio to GDP, governments are in a mad scramble to line up financial resources to keep the debt thing afloat.

Europe (Greece in particular) continues to be the poster child for the illusion that a government can keep itself going by leaning on its citizens and others to create bailout funds, or by changing the accounting, regulatory or legal rules, or by engaging in other funny-money schemes. Europe has just concluded the 16th summit of its leaders in less than two years to solve the euro debt problem once and for all - and all they do is create more debt (the ESM permanent fund) to solve an over-indebtedness problem.

Some of these efforts have brought a temporary reprieve from financial meltdown, but they do not provide a meaningful adjustment process to regain prosperity or debt sustainability. Basically, the horse is out of the barn. There is now so much debt and so many additional scheduled debt commitments that austerity on the rest of the budget will not contain the debt problem.

It would almost be an amusing soap opera if we, the spectators in the audience of this high-theatre drama unfolding in the daily financial tabloids in both Europe and the U.S., could sit back and enjoy the comedy, but unfortunately the bottom line is the actors in the comedy will soon be passing the hat around the audience - at first for voluntary contributions and later for mandatory contributions to the cause.

Moreover, we the audience will ultimately need to ante up less in direct contributions (whatever form of taxes you care to name), but more so in the loss of our income base and market value of wealth. All of this begins with the redirection of scarce capital to finance governments at terms favorable to the debtor government. When that is not enough, next comes the systemic raiding of banks and private resources to finance government debt.

Given the lack of will by the government actors in this soap opera to stop the entitlement game made by previous irresponsible governments, it appears that we will soon be learning the ultimate cost of attempting to keep the entitlement promise. The promise will not be delivered, but we will go down trying.

The cost of trying is not calculated in terms of the present value of the unfunded entitlement liabilities or in the cost of escalating government debt service that we can directly measure. Rather, the cost will be in the more difficult to calculate income, output and wealth losses as a result of a country's undersupplied and misdirected capital resources. In the environment of attempting to keep the faith in entitlements, income flows and job growth occur at a diminished rate. The economic engine is stuck in low gear when a higher priority is given to financing the sovereign rather than the private sector.

All of this goes by the name of financial repression, a term that has resurfaced in the economic-financial policy lexicon in the last months and is becoming chic in the financial policy press. It's a term that I am familiar with in that my Ph.D. Chairman, Professor Edward S. Shaw, along with Professor Ron McKinnon of Stanford University, invented it as an explanation of why the Less Developed Countries were less developed for about five decades. Now we get to view it in living color as the nightly news shows us how it is being applied to and affecting the developed economies of the world.

The idea of financial repression presented to me as a graduate student didn't resonate then, but it does now as I view it and its side effects. It sometimes takes a while for ideas to sink in, and because history is repeating, I get to watch it live the second time - or the third, or however many times it's been around. What needs to be understood is that financial repression is the unintended consequence of government efforts to suck private capital resources at favorable terms into the financing of government debt. It could just as well be called economic repression because that is what results.

While the general objective for a debt-stressed government is to induce or coerce the buying of its debt, it also needs the buying to take place at a cost the government can afford - not just zero, but even below zero. This occurs when the real interest rate (the nominal rate paid less the inflation rate) is held in negative territory. The cost becomes negative in real terms when a positive inflation rate depreciates the bond's real value to a greater extent than interest is paid to the holder of the debt.

To pull this off requires a cooperative central bank to create the negative real rates. It's been quite amazing how the "independent" central banks - made independent to provide checks and balances to prevent reckless government spending sprees - have been co-opted to play an essential role in financial repression. They do so by providing a negative real interest rate for governments by both targeting simultaneously both near-zero nominal rates of interest on government debt and a positive inflation rate.

Given this perspective it should be little surprise that the Fed has recently extended its near-zero nominal interest rate forecast (target) through 2014 and talk of another round of QE is alive both here and in Europe on top of all the others that have occurred in the last three years. While this cheapens government finance at the expense of the holders of the government debt, it also provides disincentives to save and accumulate capital for private uses, hence our near-zero saving rate.

A government's central bank is its first line of defense in maintaining its ability to pay entitlements. The second line of defense consists of the banks and financial institutions that are coerced to hold greater proportions of government debt in the name of rising liquidity and capital requirements - but with almost zero nominal rates earned on this sizable asset class, they pay virtually nothing for deposits. Hence the banking system and financial institutions in general are also offering negative interest rates on deposits and are in a state of shrinkage, allocating smaller and smaller proportions of their portfolios to the private sector.

We the people will be the third line of defense as the government crams its debt down the throat of the unsuspecting and the unwilling. This generally takes the form of voluntary programs for debt purchases, as the WWII-era poster above suggests. Later this will be accomplished through a mandatory program, with mandatory purchases in the form of swapping "risky" private assets in an IRA for "secure government debt" to finance a private retirement. This has just occurred in Hungry and Poland, and that discussion has been launched in the U.S. and is contained in the Annual Report of the White House Task Force on the Middle Class (p. 27).

But what do depressing government bond yields do to non-government financial prices? As discussed in my previous post Liquidity and Asset Bubbles: How Long Will the Dam Hold, the lowest interest rates in U.S. history promote a carry trade that finances the purchase of higher quality debt and higher quality dividend-paying equities that investors hope will survive a sovereign meltdown. By extending the time period of its zero interest rate policy out to three years, the Fed reduces the funding risk of the carry trade and ramps it up further.

There is substantial financial buying power to be spread out: the Fed and the ECB's liquidity transfusions of operation twist, on top of swap financed lending to euro banks, on top of LTRO, on top of another LTRO in the works, and ad hoc ECB direct sovereign purchases, and now with just plain old out-and-out QE3 rumored to be on its way. Furthermore, QEs are also in operation with the BofE and the BofJ and other central banks concerned that capital flight to their currency will undercut their terms of trade. Hence, there is global impetus for central bank buying and money issuance in large numbers as depicted in the accompanying figure.

The equity price run up the last few months is fun while it lasts, but ultimately and fundamentally, if the government interest rate anchor for the financial markets is reduced to a rate that does not reflect its risk, and if further price distortions are introduced into the pricing of equity so that P/Es become transparently unsupportable by fundamentals (if anyone remembers what that is anymore), then expect to see investors seek to place their capital elsewhere.

If the government then attempts to head that off with capital outflow restrictions and more mandatory funneling of capital to the government's cause, then we are into a full-fledged financial and economic repression. Europe is certainly much closer to that than the U.S., but if there is a buyers strike of government debt here (China has removed itself from accumulating Treasuries), it will eventually repress the economy here as well. We will be no different than the LDCs that self-inflicted decades of pain, as explained by professors Shaw and McKinnon, and history will indeed have repeated.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.