Financial Repression?

2012 February 20
by SJ Leeds

Today, I want to discuss a slightly different idea.  Normally, we always say that we’re eventually going to see cuts in the entitlement programs and we’re going to increase tax revenue.  (I believe that both will eventually happen.)  But, there’s another option that will help to reduce our much-watched debt-to-GDP ratio.  It’s referred to as financial repression and it’s largely based on the idea of forcing low or negative real interest rates (negative real rates occur when inflation is higher than the interest rate) to exist.


Before we get to the idea of financial repression, lets start with some quick background info.  Our debt-to-GDP ratio is now over 100% (if you include our debt to the “trust funds”.  Two factors can drive the debt-to-GDP ratio higher:

1. primary budget deficits; and

2. when the interest rate is greater than GDP growth


Note: the primary budget deficit measures how much we overspend (compared to tax revenue), but it excludes interest expense.  That’s why we have to factor in the second factor.  Assume the primary budget was neither a surplus nor a deficit – the debt-to-GDP ratio would change depending on whether the debt grew faster (because of the interest expense) or the GDP (denominator) grew faster.


Cutting the deficit is going to be difficult.  In a recent speech, Fed Chairman Bernanke said that even after economic conditions have returned to normal, we’ll still face a sizable structural budget gap.  He suggested that if we get to full employment by 2017, we’ll still be running a deficit of 4% per year.


Assuming that our politicians don’t have the moral ability to do the right thing, what can we do to minimize the possibility of our debt-to-GDP ratio exploding?  If we’re not going to cut the deficit (factor one above), we need to (at a minimum) address factor two.  In other words, we need to maintain low interest rates.  Otherwise, our debt-to-GDP ratio will explode.


Recently, I read a paper titled, “The Liquidation of Government Debt” by Carmen M. Reinhart and M. Belen Sbrancia.  It was dated March 2011.  They described the idea of financial repression – where governments reduce their debt-to-GDP ratio by keeping interest rates low and forcing investors to buy government debt.  It’s even better if we have negative real rates (i.e., inflation is higher than interest rates) – think of it as paying back a low-interest-rate loan with dollars that are worth less.


When I read this paper, it was hard to not think about what the Fed is already doing.  The fact that the FOMC is saying that the Fed funds rate will stay near zero through the end of 2014 is astounding.  That’s three more years!  (Are you impressed with my math skills?)  Is that simply pessimism about the economy or is it the Fed trying to anchor expectations – so they can promote negative real rates?  It seems to be working right now.  If you buy short-term bonds, you’re getting a negative yield.  You may be getting a negative yield even if you buy a ten-year Treasury.


Of course, the Fed has a major problem if they are trying to impose financial repression.  Our debt is short term.  The average maturity of our debt is approximately five years.  So, you would think that investors would demand higher rates as the government refinances.  In order to avoid this, the Fed has to break the connection between inflation and interest rates.  They’ve been successful at doing this for the past few years.  We’ll see if they can do this in the future.  But, the bottom line is that it’s reasonable to expect the Fed to try to keep rates low for a long, long time.  So, you need to think about how that will affect you.  Negative real rates punish savers and reward borrowers.  As others have said, “we punish the virtuous and reward the sinners.”


Have a great week.

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