by Andreas Hoffmann
Government debt levels in many advanced economies, especially in Southern Europe, in the US and in Japan, have reached peacetime records. People are worried and rightly so: C. Reinhart and K. Rogoff have provided evidence that elevated debt-to-GDP ratios may contribute to stagnation or even debt crises. As austerity policies are unpopular with voters and growth remains rather sluggish, Reinhart and Rogoff suggest that governments might have to consider other options to reduce debt-to-GDP ratios. Debt should be liquidated via financial repression. It’s how governments typically dealt with high levels of debt in history, they say. This time is not different.
Financial repression is an umbrella term originally referring to policies that impede the proper functioning of capital markets. Since governments typically pursue such policies to achieve fiscal goals, the term “financial repression” is mostly used to mean policies that artificially raise the attractiveness of holding government bonds relative to other investments to lower government borrowing costs. Modern financial repression can take the form of macro-prudential policies, in which government bonds receive preferred treatment (e.g. capital requirement regulation), bond yield caps that are guaranteed by central banks (“Whatever it takes policy?”) or captive regulation (for instance by forcing pension funds to hold a large portfolio of government bonds). Lower yields make debt-servicing easier. If central banks add a dose of inflation and bond yields turn negative in real terms, government debt is liquidated; i.e. the real value of debt is reduced.
Debt liquidation via financial repression may seem like a good idea to politicians that have a hard time in cutting spending or bringing on structural reforms that would allow the economies to prosper again. But financial repression is also dangerous.
I can think of at least three reasons why engaging in financial repression would put a drag on growth. First, financial repression distorts financial markets. Second, when governments mess with money, they tend to breed protectionism and conflicts. And third, there would be international repercussions from financial repression that make things worse. Let’s look at them one by one:
Financial Distortions and Growth
Ronald McKinnon’s Money and Capital in Economic Development (1973) was among the first works to analyze the role of well-functioning capital markets in economic development: McKinnon suggested that developing countries suffered from a so-called “intervention syndrome”. In the 1950s and 1960s, governments in many developing countries insulated their economies to engage in import-substitution strategies. To finance their “ideas”, governments repressed financial markets. Capital controls, interest rate caps and credit rationing policies forced savers and banks to provide cheap funding to the government and its affiliated businesses. Repressive policies undermined the ability of capital markets to channel available funds from savers to those investors with the best investment projects. The interest rate lost its functions. The resulting financial distortions prevented the full utilization of resources and assets available in the economies. The consequences of interventions in capital markets seemed to make necessary further interventions in other markets. Economic development stagnated.
Monetary Nationalism and Globalization in History
Benn Steil and Manuel Hinds outlined in a fascinating essay, Money, Markets and Sovereignty, that the (ab)use of monetary sovereignty by governments for their own benefit is historically associated with international conflicts, crises and protectionist measures. By contrast, periods in which money was, by and large, shielded from government influence, and in which monetary policy was less concerned with governments’ fiscal situations were more conducive to international trade and finance and, consequently, global prosperity. From this perspective, our age of globalization seems at odds with the policies suggested by the debt liquidationists.
Obviously most economists that have recently come out in favor of repressive policies to liquidate debt are not considered opponents of free trade or the free movement of capital. But even if the advanced countries did not impose restrictions on capital outflows and trade, the emerging markets might eventually impose capital inflow controls. If long-term yields or deposit interest rates in the advanced economies were pushed into negative territory to liquidate debt, financial flows to the emerging markets would accelerate and global financial volatility would rise. We have already seen some of this when the Fed’s target interest rate reached the zero-bound. Low interest rates in the US triggered substantial portfolio shifts toward the developing and emerging markets. To stem the surge in financial inflows policymakers in emerging markets felt the need to raise reserve requirement ratios or reintroduce capital controls. Negative nominal interest rates in the US, Europe and Japan would not leave the rest of the world unaffected.
Beware of Financial Repression: This time is not different!