Macroeconomists generally divide into two camps: the followers of the classical-liberal Friedrich Hayek and those who favour the teachings of John Maynard Keynes. For much of the financial crisis and the long recession that has followed, the Keynesians and their economic prescription of fiscal and monetary stimulus have held sway. But high government debt levels have prompted markets in Europe and politicians in the US to rebel. For policymakers this leaves a dilemma.
None of the available options looks attractive. Hair-shirted Hayekian austerity and tax rises are unpopular. Outright default or debt restructuring are humiliating and rarely forgiven by electorates. Hyperinflation destroys debt but history teaches us that it comes with unpredictable and generally disastrous social and political consequences. Faced with an unpalatable menu of policy choices there is increasing concern that another course will be taken: financial repression.
Put simply this involves keeping real interest rates (policy rates minus inflation) negative over time to inflate away debt. It is a policy that the character Fagin from the musical version of Oliver Twist would recognize: it transfers wealth from the pockets of creditors (savers) to those of debtors (governments).
A recent paper shows that financial repression was a remarkably effective mechanism for reducing the debts incurred during the Second World War*. In both the UK and US the post-war debt burden was halved in about 15 years. This was achieved without runaway inflation. Even in the years of most debt destruction, inflation was typically below 5%.
Should (or could) such a policy be pursued now? Taking money from savers cannot be done without some impact on demand. However, this is likely to be a more lagged effect than traditional Hayekian cuts. The attraction of financial repression is that it is a stealth tax. Few would vote for it, but they would not be asked to. Currently, financial repression is being pursued whether by accident or design. Real interest rates are strongly negative in the UK and US (–4% and –3.55% respectively).
In fact, real interest rates are negative out to 10 years and more in both countries. This suggests the stealthy element of this tax on savings is passing bondholders by. In the short term this might be justified by the extraordinary impact of the crisis on markets and investor psychology. But economic orthodoxy argues that in the long term the pursuit of financial repression will not succeed.
Two reasons
There are two main reasons. First, we live in an open global economy where money flows easily across borders. This is quite unlike the economy following the Second World War and the creation of the Bretton Woods system. If it became known that it was government policy to inflate away debt, the bond market vigilantes would force yields to rise. Debt costs would increase and any short-lived benefit from higher inflation would disappear.
Secondly, central banks now have independence and explicit mandates to pursue price stability. But interest rates are not the only channel through which policy can direct funds into government bonds.
Currency controls under the Bretton Woods system effectively meant that pension funds and other investors were forced into a home-country bias. Regulation, accounting standards and the vogue for asset/liability matching have latterly combined to ensure many defined contribution schemes now have a similar bias toward bonds. UK pension fund holdings of equities are at the lowest level for more than 30 years. The demands of Basle III and Solvency II are similarly compelling banks and insurers to hold greater quantities of government debt.
The purposes of pension reserve systems in France and Ireland have blurred to such an extent that they now look props for their own treasury departments. Meantime the Federal Reserve, Bank of England and European Central Bank have all been active in secondary bond markets, expanding their balance sheets to varying degrees.
The share of marketable Treasury securities not owned by the Fed and other official institutions, principally Asian central banks, has fallen to its lowest level since the collapse of Bretton Woods in the early 1970s. With the eurozone periphery being pushed to the brink it would be ridiculous to claim that the bond vigilantes have been entirely neutered. But the direction of travel is away from completely free markets where capital can flow to wherever the best returns are.
There is another distortion. If the low-growth, high-debt countries of the developed world are unattractive to investors it clearly makes sense to overweight emerging markets. The trouble is that policymakers in emerging markets have been bleating about hot money causing asset price bubbles. Some, such as China, have always had strict capital controls. Others, notably Brazil, are introducing them.
Bond bulls should beware. Real rates can stay negative even if nominal rates rise a long way from historically low levels. The period of financial repression between 1946 and 1981 coincided with the longest bond bear market in US history. Having embraced Keynes and briefly dabbled with Hayek, governments might decide a dose of Faginomics is the least bad next option: "You’ve got to pick a pocket or two, boys, you’ve got to pick a pocket or two."
* The Liquidation of Government Debt, Carmen Reinhart and Belen Sbrancia, NBER Working Paper 16893; http://www.nber.org/papers/w16893
Andrew Capon has won multiple awards for commentary and journalism on markets, investment and asset management. He welcomes comments from readers and can be reached at amcapon@btinternet.com