by Andreas Hoffmann and Holger Zemanek*
Over the last two years Carmen Reinhart and Belen Sbrancia have published a series of papers on financial repression and its historical role in financing government debt. They show that throughout the Bretton Woods period governments in many advanced economies repressed financial markets to liquidate the high levels of debt that had been accumulated by the end of World War II.
During this period, low policy rates reduced debt servicing costs. Financial repression raised the attractiveness of government bonds relative to other investments. Inflation liquidated government debt. The authors report an annual debt liquidation effect for, e.g., the US and UK government debt of about 3 – 4 percent of GDP (Reinhart and Sbrancia 2011).
Today government debt levels in many countries are comparable to those after the Second World War II! After all, good politicians do not need a World War. There are plenty of other ways to spend. But in the light of the European debt crisis, governments are feeling the need to correct the spending-revenue misalignments in order to make debt-service sustainable.
Because economic growth remains sluggish and there is opposition to austerity, central banks are again urged to take on special roles! Low interest rates and central bank interventions reduce debt-servicing costs.
In the US, the Federal Reserve purchases government bonds to drive down bond yields. As a consequence, long-term interest rates for US-Treasury securities have significantly declined. Compared to the effective debt-service interest rate from 2008 (after the initial crisis reactions), the fall in yields reduced US debt service by 3 to 4 percent of total government revenues – about one percent of GDP in 2011 and 2012 (Hoffmann and Zemanek 2012).
The European Central Bank purchased government bonds of struggling countries on the secondary market (by the end of 2011: 210.5 Billion Euro) to bring down bond yields. The interventions by the ECB led to significant reductions in sovereign bond premia of euro area crisis countries (Link). Recently, the ECB even announced an unlimited government bond purchasing scheme, which might even imply government yield caps (Reuters 2012).
The German government is an – perhaps unintended – beneficiary of the crisis measures. At least in the short run, the ECB prevented a collapse of the financial system. Recapitalization costs are – let us say – foregone.
Second, the capital flight from South to North caused a steady decline in German government bond yields. Consequently, the 10-year yield has declined below 1.5 percent by September 2012. The 1-year yield turned negative! Compared to the effective debt-servicing rate in 2008, the government saved about 2 percent of government revenues p. a. on debt service in 2011 and 2012 – almost one percent of GDP (Hoffmann and Zemanek 2012).
Given that central banks help cut government spending, balancing the budget should have become easier in both the US and Germany. Obviously, such policies have other consequences as well. William White (2012) summarizes them with a focus on the US. But (to many) that is another story. Why worry now? One problem at a time! In the long run, and so on..
*University of Leipzig, Germany, the views are those of the authors