Are we all Debt Liquidationists now? … No!

by Andreas Hoffmann

A growing number of economists suggest that governments in highly indebted countries should consider liquidating debt via financial repression. In other words, they want governments to intervene in financial markets and push government borrowing costs below the rate of inflation to erode the real value of debt. In a previous post, I argued that financial repression is dangerous and a drag on growth. This post explains why we can be hopeful that, despite a rise in popularity, the debt liquidationists will not succeed in putting their ideas to work. Debt liquidation via financial repression would necessitate far-reaching regulation or drastic measures, both of which seem unlikely in the US.

Some history

To promote the idea of financial repression and underpin its success in liquidating debt in advanced economies, C. Reinhart has repeatedly pointed to the decline in debt-to-GDP ratios during the Bretton Woods period. Many people have fond memories of the Bretton Woods episode. We might, therefore, wonder if we could easily repeat that success story.

Looking at US data for the post-WWII period we learn that debt-to-GDP ratios declined most rapidly until the mid-1950s. In fact, debt-to-GDP ratios halved, falling from 122 percent in 1946 to 66 percent in 1955. That is impressive. And Reinhart is right, financial repression was at work. US bond yields were capped and capital controls were still binding. However, at the time, Bretton Woods was still dysfunctional and plagued with payment and convertibility problems. Financial markets were underdeveloped and the level of international trade was low.

That’s not the world we live in today. Do we want those days back? Probably not. But economists referring to this historical episode to support the case for financial repression seem to propose just that.

Following the Fed-Treasury Accord of 1951, which allowed the Fed to phase out yield caps (installed under Roosevelt to finance the war), US bonds saw one of the longest bear bond markets in history (Sylla and Homer 1996, 3rd ed., pp. 366-367). After 1955, real interest rates were positive and growth picked up. When current account convertibility was restored in Europe in 1958, the Bretton Woods system began working properly. However, the corresponding increase in international trade undermined the effectiveness of capital controls and contributed to financial development. GDP growth rather than inflation held debt-to-GDP ratios within limits from the late-1950s up to the late 1960s. Debt liquidation had stopped.

The debt liquidationists face a problem

Because of financial liberalization and because the scope of financial markets and investment opportunities has widened substantially since the 1980s, it is even harder to implement financial repression today. Note that although the balance sheet expansions of central banks and the prolonged period of low interest rates seem to benefit governments by reducing debt-servicing costs, inflation remains remarkably low in many highly indebted countries (Italy, Greece, Japan, even the US). Moving the real yields of Italian or Greek government debt into negative territory to repeat the post-war debt liquidation scenario would necessitate substantial regulatory efforts and even more aggressive monetary policy interventions.

When the going gets tough, ..

.. K. Rogoff takes things a few steps further. In his latest book, The Curse of Cash, he promotes to ban cash. Rogoff is, of course, a brilliant economist. He feeds the reader with rather convincing arguments. You may want to ban cash to shrink the underground economy: in illegal prostitution, illegal drug trade, extortion or corruption cash is king. It may be considered a once in a lifetime coincidence that Rogoff’s ideas for taking on the underground economy would also allow central banks to deal with the debt burden in exactly the way he had proposed in numerous papers: Cash is a substitute for deposits. Banning cash would allow monetary authorities and banks to set negative nominal interest rates if needed. And Rogoff wants them as low as possible to liquidate debt.

Debt liquidationists everywhere

These days many economists consider negative real interest rates desirable, e.g., to cope with the so-called secular stagnation. Not surprisingly, Rogoff’s proposal hit a nerve. To be sure, Rogoff tends to argue against the notion of secular stagnation. But if we followed his idea to ban cash, monetary policy could break through the lower zero-bound of nominal interest rates when inflation is low, to stimulate the economy or create inflation. If the natural interest rate was negative as suggested by L. Summers, P. Krugman and others that believe in secular stagnation, a negative fed funds target rate might be necessary. Negative real interest rates would also benefit government finances. A weird coalition of debt liquidationists is in the making.

What to expect?

Because there is opposition to a further strengthening of financial regulation – even in the White House, people favoring debt liquidation via financial repression in the US have to come up with rather drastic ideas. It’s unlikely these more radical measures will be put to work. It seems that unless the fiscal situation of the US worsens substantially only the Fed might be ready for action. Let’s hope it won’t.

In the EMU, however, the never-ending debt crisis provides incentives to politicians of all sorts to go the other way. EU governments favor additional captive regulation if this allows liquidating debt of highly indebted countries. They are scared of receiving bills (they would have to present to the public) when losses from bailouts materialize. To prevent visible losses and provide, e.g., the Greek government with some fiscal space, (ESM) loan maturities were extended. In addition, so-called prudential regulation is viewed more favorably: the Commission even plans to introduce a financial transaction tax.

As long as the US and the UK do not engage in aggressive financial repression to liquidate the debt in real terms, it is unlikely that European politicians will be willing to go all the way. That’s reason for some hope.

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