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Financial repression comes and goes [ClearOnMoney]
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Commentary

Financial repression comes and goes

19 Mar 2012 by Jim Fickett.

Politics will always be politics, and governments will always welcome opportunities to place their debt at below-market rates. However one current manifestation of extreme government policies, namely negative real rates, is unlikely to remain in place for the long term.

Almost a year ago I provided a synopsis (History suggests forced subsidies from savers will be used to reduce government debt) of a paper by Carmen M. Reinhart and M. Belen Sbrancia on “financial repression”, the practice of governments placing government debt with savers at artificially low rates. Much of the material from the Reinhart and Sbrancia paper has been recycled a few times since then, for example in Financial Repression Redux, a June 2011 article in Finance and Development, and in a Bloomberg article a week ago entitled Financial Repression Has Come Back to Stay.

This last article starts out characterizing financial repression somewhat ambiguously, then makes a parallel between the current situation and a period of 35 years' duration in the past, and then suggests that financial repression will endure for a long time:

As they have before in the aftermath of financial crises or wars, governments and central banks are increasingly resorting to a form of “taxation” that helps liquidate the huge overhang of public and private debt and eases the burden of servicing that debt.

Such policies, known as financial repression, usually involve a strong connection between the government, the central bank and the financial sector. In the U.S., as in Europe, at present, this means consistent negative real interest rates (yielding less than the rate of inflation) that are equivalent to a tax on bondholders and, more generally, savers. …

Figure 1 (attached), which traces the evolution of average gross public debt for the 22 advanced economies from 1900 to 2011 demonstrates the magnitude of the policy challenges now facing many (if not most) of these countries. [The figure shows that gross government debt across advanced economies is now at a very high peak similar to that following World War II) …

The frequency distributions of real rates for the period of financial repression (1945 to 1980) and the years following financial liberalization, shown in Figure 2, highlight the universality of lower real interest rates prior to the 1980s and the high incidence of negative real interest rates. [A histogram shows that real rates on short term government debt in advanced economies were negative about half the time during the period 1945-1980.] …

[Currently …] Faced with a private and public domestic debt overhang of historic proportions, policy makers will be preoccupied with debt reduction, debt management, and, in general, efforts to keep debt-servicing costs manageable.

In this setting, financial repression in its many guises (with its dual aims of keeping interest rates low and creating or maintaining captive domestic audiences) will probably find renewed favor and will likely be with us for a long time.

So the gist of the argument is, (1) in the last hundred years there have been two extreme peaks in government debt, 1945 and 2012, (2) following the 1945 peak, there was a period of 35 years when real rates were negative about half the time, (3) expect more of the same now.

I do accept the argument that extreme levels of debt are now widespread, and politicians will be pushed to extreme solutions. That is the main reason why I think all investors should be preparing for the possibility of high inflation.

But the way this argument is couched makes it sound as if negative real rates are likely to be a semi-permanent feature of the financial landscape. That conclusion, however, is not supported by the historical record. The original Reinhart and Sbrancia paper shows, in figure 2, the average real rate in treasury bills, averaged across advanced economies. Rates were, indeed, sharply negative 1945 to 1953, but then were positive for many years thereafter. Here are real rates on US 1-year treasuries, back to 1954 (the extent of historical data available from the Fed):

Note that real rates were positive most of the time 1954-1974, and that the extreme negative real rates of 1979-80 were balanced by extremely high positive real rates over the next few years.

Do not doubt that the politicians will be looking for all possible ways to hide debt and reduce its carrying cost. But stay flexible and don't count on any particular outcome in treasury yields.

The main thing for investors to keep in mind are (1) do, indeed, worry about the real long-term value of dollars and bonds, and continue to shift money into real assets like resources and stocks, and (2) don't count too much on the particular way you think the future may work out; take advantage of the opportunities as they come.