It's a way for the government borrower to manipulate markets to hold down the cost of financing its debt. This is accomplished with negative interest rates as well as by encouraging the purchase of government debt by non-market participants, including the Federal Reserve.
What's the underlying reason behind government created financial repression? Well, it avoids the necessity to take unpopular actions in the short term. Accordingly, financial repression acts as an indirect substitute for economic growth, spending cutbacks, tax increases, inflation and even defaults on the public debt.
Stated in simple terms, financial repression techniques help a government liquidate its public debt burdens through the counterintuitive combination of negative interest rates and high government borrowings. At the same time as negative interest rates are in place, additional funds are made available to the government through government debt purchases by both government agencies and other non-market borrowers.
In essence, the government relieves itself of a portion of its debt obligations when it causes real interest rates to be less than zero. In a true market environment, rates would never be negative. Lenders wouldn't make loans and agree to get back less than they loaned initially. That would make no sense.
With respect to the government borrower, however, negative interest rates are an attractive way to liquidate the inflation adjusted public debt and reduce annual deficits at the same time.
So when public debt is high, as is the case today, these negative rates can "save" a government hundreds of billions of dollars in interest expense, at least during the short term. Over the long term, however, interfering with the free market is never a good idea. It sends the wrong signals to government, investors, individual citizens and politicians. And the longer it continues the more harmful its results can be.
Let's take a very simple example of the free market compared to financial repression.
Free Market -- If real interest rates (nominal minus inflation) are a normalized 2%, and if inflation is assumed to 2%, we would expect the interest rate on risk free borrowings to be 4%. That would provide a 2% real return to the investor.
Financial Repression -- Due to Federal Reserve actions, current rates on government borrowings are roughly zero, or 2% less than inflation. Hence, negative interest rates of ~2% prevail.
That's a difference of 4% in inflation adjusted terms.
Accordingly, financial repression is great for the borrower. As a result, heavy borrowers such as governments frequently embrace both financial repression and the resulting negative real interest rates on their borrowings.
On the other hand, free market participants obviously don't welcome these artificially created interest rates. Thus, market investors will tend to stay away from investing in government bonds.
That's where friendly government persuasion or coercion often enters the picture. Such maneuvers by government in the form of higher liquidity requirements for banks or no reserve requirements for government debt act to favor government debt issuance or purchase. Similarly, implicit or explicit caps on interest rates and securities transaction taxes and the like are other examples of government actions which encourage government borrowings as well.
So when a government buys government bonds it can liquidate its public debt through negative interest rates. In addition, the placement of its non-market oriented government debt often "crowds out" market investors.
But financial repression only works in the short run. In the long term, the market will prevail. That said, the long term can take a very long time to reassert itself.
In simple terms, today's ultra-low interest rates enable the government to service and even liquidate its real debt at the same time. It does this by making lower interest payments than would be required if the free market were allowed to work its magic. Such a market distortion can't continue indefinitely.
The 'Financial Repression' Trap was written by a former Federal Reserve governor and warns about the long term dangers of government intervention to keep interest rates lower than the market would otherwise dictate. It says this:
"Financial repression is sometimes the effect of policy even if it is not the intent. It manifests itself, for example, when policy makers react more forcefully to declines in asset prices than to increases. Price increases tend to be treated with benign indifference. But declines often lead policy makers to respond with force, deploying fiscal stimulus and monetary accommodation. Market participants then conclude that governments have their backs.
Consider the fiscal trajectory of the United States. However well-intentioned, the Federal Reserve's continued purchase of long-term Treasury securities risks camouflaging the country's true cost of capital. Private investors are crowded out of the market when the Fed shows up as a large and powerful bidder. As a result, the administration and Congress make tax and spending decisions—with huge implications for our standard of living—with heightened risks around future funding costs.
As measured against the administration's budget, every one-percentage-point increase in interest rates above the current baseline would translate into another $1 trillion of debt service over 10 years. And with financial repression at play, we risk missing early warning signs from markets that our debt burden is intolerable.
Efforts to manage and manipulate asset prices are not new. But history provides little comfort that these practices work. Interfering with market prices occasionally buys time, but rarely do policy makers seize the window of opportunity to enact structural reform. Financial repression embeds the wrong incentives—obfuscation begets delay, and a robust recovery becomes unattainable.
The path to prosperity requires taking the long road. It requires policy reforms that make the economy less reliant on the preferences of government and more responsive to the market. That means prioritizing long-term growth over fleeting market stability, and giving precedence to structural reforms over temporary stimulus and market manipulation. Financial repression is a tactic that may help get us through the week or month or year. But it will come at a substantial cost to our long-term prosperity."
Thus, one key point concerning financial repression is that when interest rates are negative, the artificiality of government debt servicing costs and the consequence of enabling politicians to avoid addressing the nation's long term financial problems can be quite harmful. That will happen if often painful decisions about fiscal responsibility are postponed indefinitely.
For example, let's assume that current interest rates are 4% lower than market rates due to financially repressive government policies. Assuming that's true, in ten years our nation's normalized fiscal situation could be $4 trillion worse than current expectations. And the current projections are bad enough!
Thus, if we choose to boost the economy in the short term by keeping real interest rates at artificially low levels, that's only an appropriate choice if doing so doesn't prevent us from taking the perhaps painful but necessary steps to get our long term financial house in order.
Therefore, it's up to the citizens to keep a close watch on both the short and long term effects of government policies and their lasting effects.
Tomorrow's right around the corner.
Thanks. Bob.
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