Austerity and default aren’t turning out to be popular policies in the West. In the US they are barely mentioned in a remotely constructive way. Here we have the kind of austerity that involves both spending and debt continuing to rise, as the debt figures out this week have shown. In the likes of Greece, the people won’t stand for austerity and the politicians won’t stand for default.
Good news, then, that there is another way out – what academics call “financial repression” and the rest of us call “ripping off savers”. It involves keeping the cost of government debt low and eroding the value of that debt by using a mix of policies to keep interest rates lower than inflation. For short-term rates this is easy: central banks just keep the base rate lower than inflation. For longer-term rates it is tricky, but never beyond the wit of even the average Treasury official – it’s simply a matter of forcing investors to hold their money in government debt. The more they are forced to invest, the higher they push the price of sovereign bonds. This drives down the yield on those bonds, and hence long-term interest rates.
This isn’t new. Financial repression got us out of the bind of the debt we accummulated during World War II. A National Bureau of Economic Research paper by Carmen Reinhart and M. Belen Sbrancia refers to the period between 1945 and 1980 in America and Britain, when “the liquidation of debt via negative real interest rates” amounted to 3%-4% of GDP on average per year, or 30%-40% over each decade. The policy effectively inflated the debt away.
How do you push investors into government debt? Easy. You impose rules that force pension funds to allocate more assets to government debt (better to “match their assets and liabilities”). You keep short-term rates low and print your own money to buy long-dated government bonds. You change capital adequacy ratios for banks so they’ve no choice but to buy more bonds. If all this sound familiar, it is because they are all already well underway.
Finally, you can cap interest rates (as the Federal Reserve did from 1941 to 1951) and put in place exchange controls such as those last seen in the UK in the 1970s. In 1975, says CLSA’s Russell Napier, you weren’t allowed to buy foreign currency: you had a choice of investing “in UK industry under Tony Benn” or taking “a negative real yield on gilts”. That’s real financial repression. Will we see such controls again? In some form, probably yes. As the FT’s Gillian Tett notes, the longer the rows over debt restructuring, fiscal reform and austerity go on, the sooner full-on financial repression will come to be seen as “the least of all evils” – by everyone. Expect low nominal interest rates to be with us for some time. And expect those low rates to continue to be accompanied by inflation.