As if on cue, Federal Reserve Chairman Ben Bernanke signaled he would take further action to keep interest rates low the day a new study on “financial repression” predicted the tactic. Financial repression, by which governments channel money to themselves, is not going away any time soon.
In a speech on Tuesday, Bernanke buoyed markets with his call for “continued accommodative policies,” which is Fed-speak for another round of monetary easing.
The same day, Jacob Funk Kirkegaard and Carmen Reinhart published a paper looking at what they called financial repression in historical context. The term, coined by the Stanford economist Ronald McKinnon in 1973, has gained new popularity in the current economic crisis through research by Carmen Reinhart, cited often by the Pimco bond manager Bill Gross. Reinhart is co-author with Ken Rogoff of the 2009 bestseller This Time is Different: Eight Centuries of Financial Folly.
The paper by Kirkegaard and Reinhart, both fellows at the Peterson Institute for International Economics, says there are five ways nations have adopted to deal with debt. These include economic growth, austerity, default, “surprise” inflation and financial repression combined with inflation. The authors say that default and surprise inflation are undertaken in “truly desparate economic conditions” and that with austerity, as shown in Europe right now, “falling growth tends to offset much of the progress.”
Consequently, financial repression, which “allows governments to ‘capture’ and ‘under-pay’ domestic savers” is back in favor. The tactic, combined with steady inflation, works to cut debt through low nominal rates that reduces debt-servicing costs, negative real interest rates that erode the nation’s debt-to-GDP ratio and effectively act as a tax on savers.
In that regard, the authors show that the negative real rate savers get in the U.K., U.S., Germany and Canada has climbed so far up the yield curve as to now encompass 10-year bonds. In the U.S., for example, the real (i.e., after-inflation) return on 2-year bonds is -2.5%; on 5-year bonds it is -1.8%; and on 10-year bonds it is -0.6%. Two-year bondholders in the U.K. are getting a -3.1% real interest rate.
While low rates serve to transfer capital from savers to borrowers, both government and private, the authors argue that stealth repression and inflation are politically safer and less visible than unpopular spending cuts or tax hikes conducted in the political arena.
In the current crisis, the authors say real rates in advanced economies have been negative about one-half of the time, and below 1% in 82% of all observations, and this despite the fact that “several sovereigns have been teetering on the verge of default or restructuring (with the attendant higher risk premiums).”
These governments awash in debt are managing to find buyers for their bonds. One method to accomplish this is the government itself buying the bonds; a more direct approach, and possible portent of future trends, is the requirement the U.K. imposed on its banks at the height of the crisis to maintain a large share of domestic bonds in their portfolios. “Thus, the process where debts are being ‘placed’ at below-market interest rates in pension funds and other more captive domestic financial institutions is already under way in several countries in Europe,” Kirkegaard and Reinhart write.
The authors conclude that efforts both to keep rates low and to create or maintain “captive” audiences for government debt “are likely to be only the tip of a very large iceberg.”