Financial repression

This phrase has suddenly started appearing in economic research, and will probably do so more frequently in the coming months. Its origin is a Bank for International Settlements working paper co-authored by Carmen Reinhart and Belen Sbrancia, economists well enough known to merit attention. So what is it all about?

Financial repression includes directed lending to governments by captive funds such as pension and insurance funds, artificial caps on interest rates, restrictions on capital flows and a generally tighter connection between government and banks. Some or all of these devices have been used in the past to reduce the level of government debt to GDP, particularly in the two decades after the Second World War. Many countries reduced the level of their outstanding debt by a significant amount over a 10 to 20 year timeframe through these techniques, assisted by moderate levels of inflation.

Two of the alternatives to financial repression listed in the paper are clearly unpalatable: default, and “a burst of high inflation”. Two further alternatives are either impractical or politically unattractive: economic growth, which is slipping away further into the future, and austerity plans involving years of unpopular policies with the risk of a deflationary depression. For these reasons, financial repression seems the default option to Reinhart and Sbrancia.

Some of its elements are already being implemented. eurozone bail-outs involve contributions from government-controlled pension funds. Bank and financial regulation allocates lower risk weightings to government debt, giving it a systemic subsidy despite current events. Interest rates are being held below the rate of inflation by central banks, lowering the cost of borrowing for most governments to artificially cheap levels.

But will it work this time? To do so will require private individuals to continue with an unquestioning belief in the soundness of their paper currencies. In the wake of Bretton Woods, when there was a gold exchange standard underpinning the dollar, together with higher levels of national patriotism, the might of the dollar was never questioned. Instead, we now have a US dollar-standard with substantial levels of foreign ownership of government debt and an increasingly sceptical public. This suggests that financial repression would probably bring on a currency crisis.

Reinhart and Sbrancia are not recommending financial repression, but they are right to point out its attractions to governments in financial difficulties. It is, in the cliché often used today, a description of the various means of kicking the can down the road. This is something governments have been doing for a long time: it has generally worked in the past, so they are almost certain to assume it will work again now.

However, economic and financial problems are rapidly mounting. Today’s situation is very different from the end of WW2 with all that destructive spending replaced by people rebuilding for the future, as they did in the 1950s and 1960s. Instead, our systemic and economic problems are leading to yet more deterioration in government finances. No amount of financial repression can fix that.