Financial Repression as a way out of Government Debt
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Government debt was very high throughout the world before the pandemic, and is spiraling even higher during it. Les Nemethy, a former World Banker, asks how governments can manage or reverse the massive amounts of debt post-COVID.
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There are a number of options for us to look at. Below, I outline three, before focusing on one in particular.
• Trigger rapid economic growth: This helps reduce debt levels as a percentage of GDP, making debt levels more manageable. However, economists typically associate high levels of debt with stagnation (due to large numbers of “zombie” companies, etc.), making rapid growth unlikely. Hence it is unlikely that rapid growth in GDP can be relied upon as a standalone measure to reduce the debt/GDP ratio.
• Default or restructuring: Bluntly speaking, not a pretty option. A default on government debt may financially destroy retirees and other segments of the population. This is generally not a voluntary option on the part of governments, which may, nevertheless, be forced to restructure or default where a sudden rise in interest rates on debt denominated in foreign currency creates a situation of default.
• Financial repression: This is a term coined by two Stanford economists in 1973. It is the likeliest choice for most governments, because default or restructuring is politically unpalatable. (The severity of the financial repression might be moderated if some GDP growth can be achieved). The remainder of this article will discuss this final option.
Financial repression involves government, in some way shape or form, clawing back wealth from individuals or corporations, to pay down debt or create additional collateral behind the debt.
It has been associated with rapid reductions of government debt in the past. For example, between 1945 and 1955, the United Kingdom’s national debt was reduced from 216% to 138% of GDP, according to International Monetary Fund data. Similar trends were observed in the United States, using a combination of financial repression and GDP growth.
In the past, there has been no lack of creativity on the part of governments as to forms of financial repression. Here are some examples:
• Artificially low interest rates: This may be achieved by various measures, such as caps on interest rates, or a more modern version, a term we have got used to since the 2008 financial crisis, quantitative easing (QE), where yields are manipulated downwards. This creates a massive transfer of wealth from savers to borrowers (including governments). Artificially low interest rates were the primary method of financial repression during the aforementioned post World-War II era.
• Debasing currency: The Romans, for example, put less and less silver and gold into their coins over the centuries. Very rapid increases in broad money supply is the modern version of currency debasement. Governments may (or may not!) use this additional money to pay down debt.
• Asset confiscation: In 1933, the United States confiscated gold in the hands of private citizens.
• Confiscating bank deposits: The Government of Cyprus, for example, confiscated approximately 48% of uninsured bank deposits in 2013.
• Expropriation of private pension funds: Examples of this include Argentina and Hungary, who used the funds to pay down national debt. In 2011, the Hungarian government nationalized the second private pillar of the pension fund system, providing the state with additional budgetary revenue equivalent to 9.5% of GDP.
• Capital controls: In China, there has been multi-decade restrictions on buying foreign assets which continue into the present. This alters the supply/demand relationship for government debt, allowing the Chinese government to borrow on far more competitive terms that in a liberalized capital market. Due to low interest rates, people need to put aside more money to reach their desired retirement nest egg. In effect, this is a mechanism for forced savings at a reduced rate of interest, creating a windfall for borrowers, including government.
• Government control or regulation of financial institutions: For example, requiring them to hold a higher percentage of government bonds, as the United Kingdom did during the 2010 recession. Another example is the Basel III requirements demanding banks to hold higher levels of sovereign debt to meet solvency ratios. Once again, this alters the demand/supply relationship for government bonds, suppressing interest rates.
The above is but a partial sample of financial repression measures. As you can see, financial repression is alive and well in today’s world, and with the mountain of global indebtedness rising, is likely to become even more common.
One of the frequently acknowledged effects of financial repression is to increase the inequality of income distribution. As discussed in the Chinese example, inflating away the national debt puts an enormous burden on vast swaths of the population who hold bonds to save for retirement, while indebted entrepreneurs and corporations benefit from low interest rates, making them substantially wealthier.
This article might be considered as a general introduction to financial repression. Several of my subsequent articles will deal with what I consider to be special cases of financial repression, such as bail-ins and revaluing gold reserves. Financial repression will remain a hot topic over at least the coming decade. As investors, you will need to develop strategies to protect against it to conserve your net worth and portfolio.
Les Nemethy is CEO of Euro-Phoenix (www.europhoenix.com), a Central European corporate finance firm, author of Business Exit Planning (www.businessexitplanningbook.com) and a former president of the American Chamber of Commerce in Hungary.
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