Financial Repression - The goose and the MaxiMin principle
"The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing" Jean Baptiste Colbert (1619-83), Finance Minister du Roi Soleil
One of the "file rouges" and my personal pre-occupations during the current financial & sovereign debt crisis has been : no "exit" road map is available or to phrase it more bluntly : no way we are gonna come out of this crisis the normal way. The thought came up when I read Rogoff/Reinhart "This time is different ?" about 3 years ago. Looking at their charts and main conclusions, it seemed to me that the size of the current problem is so gigantic that a realistic textbook outcome is of the table. This conviction was enhanced when the IMF and OECD brought forward studies and simulations on post-crisis normalization. When even taking into consideration their rather optimistic assumptions on growth, budget surpluses and inflation going forward, it seems that the developed world would reach pre-2008 sustainable debt levels (not only public but also private !!) somewhere around the year 2030. The fact that this optimistic scenario is to no extend acceptable for politicians, should lead us - or at least me - to conclude that our great leaders are going to solve this issue in a non-text book fashion. And the last couple of days/weeks, we have seen some form of expression going into that direction with the blog sphere picking up a Reinhart part II exposé published by the IMF mid last last year : Financial repression is most likely back on the agenda. And with financial repression I refer to the Colbert quote on top : How to implement policy measures - some form of stealth tax - over a considerable period of time without the hurting the tax base too much or with the tax base not even being aware they are being ripped off ?
The starting point remains the original Rogoff/Reinhart analysis where the 90% threshold of public debt/GDP seems to be a hinge moment throughout history. It's a kind of moment of truth because trend growth breaks down and the debt issue can't be solved any more by generating sufficient growth escape velocity. One way to solve this is by means of default (haircuts, coupon delay etc). There are other ways and so comes in the next graph (Reinhart 2011) which has recently become very popular :
After WWII, we came at the same crossroads and were faced with the same challenges. And as you can see from this graph, it took the developed world about 3 decades to skim the debt/GDP ratio by 70% points without defaults. It was accomplished by a healthy dose of financial repression spread over time with the following ingredients (the sheep shearing manual) :
1) inflation ; now this is not straightforward because inflation usually comes in with a cost as well, this in terms of higher interest rates and higher risk premia (real interest rates move up as well). But it’s a basic ingredient for successful financial repression but requires some additional help (cfr infra). And for negative real yields to be a part of normal life for a considerable time, the regulator has to step in (cap interest rates)
2) Involuntary funding or obligatory/mandatory legal requirements for certain players in the market to hold a certain minimum amount of specific debt instruments.
3) Capital controls : the government has to make sure that certain investment are retained domestically so that inflation and negative interest rates can do their work in terms of savings’ destruction. Or like Reinhart puts it more poetically: financial repression requires the creation and maintenance of a captive domestic audience. Something which also comes into consideration are transaction taxes on certain assets like equities or the prohibition on gold transactions.
Are there similarities between the Post WWII situation and the post 2008 situation ? Sure.
1) In order to establish negative real interest rates – and this on a persistent basis – you need to formally cap interest rates. After the war, the US introduced regulation Q to prevent the payment of interest on checking accounts and to put a cap on the interest payment on savings’ accounts. Today we already have something of this kind by zero-interest rate monetary policy going global and central bank manipulation of the yield curve : eg FED operation Twist trying to control the long end of the yield curve resulting in negative interest rates across all maturities. In case this doesn’t work out, the regulator will surely step in.
2) Involuntary funding or you appoint the so-called Chinese volunteers. By this we mean that the government will impose “quality” reserve requirements upon banks, insurance companies, and most likely pension funds as well. Now this will be sold to the public under the argument of justice : he who has done the harm in terms of causing the financial crisis, will pay for it by holding assets (government bonds) yielding negative real interest rates. Make no mistake however because financial institutions can maintain profit margins by shifting the burden to the retail client and saver. So the hidden stealth tax is most likely to fall upon joe six-pack, meaning you and I. The central bank in the mean time will continue to function as the lender of the last resort while private financial institutions will function as buyers of the first resort with respect to government bonds
The result looks like the following
From the study by Reinhart, it seems that the US and the UK were capable of reducing their debt by 3 to 4% yearly, this by a combination of financial repression and inflation. In the case of Italy and Australia – more inflation prown – the same medicine reduced the outstanding debt by some 5% of GDP in the years after WWII. That's quite a yearly liquidation effect indeed.
Apart from the evidence we already have - eg the ECB LTRO operations and the artificial market manipulation of interest rates by central banks - there are other signs :
1) The UK Treasury and Bank of England recently came into the news on 2 occasions. First of all, there was the issue to launch a 100 year bond @ 3,5%-4%. Very recently, we had the speech of Mervin King and other BoE member comments stating the following : When the time comes for us to reduce the size of the central bank’s balance sheet, we’ll find out that it will be a lot easier than expanding it in the first place…After expanding it by 325 bio £, the Treasury is now paying interest to itself (BoE). That makes no sense. May be we should “cancel” the gilts ? (Note : We assume that this last statement refers to banks under Basel III having to "fortify" their balance sheet and hence be obliged to buy the gilts from the bank of England ?)
2) Last weekend, Turkey’s government came up with the following plan : all the people who still have physical gold stashed somewhere, are kindly invited to voluntarily hand over their gold to the central bank in exchange for a certificate. An the teaser here would be that the certificate would be bearing interest.
3) Confiscation took place under other forms like the nationalization of pension schemes which recently occurred in Poland and Hungary. These operations fall under “swapping risky private assets for secure government debt"
So financial repression and all forms of steath tax will avoid consecutive rounds of budgetary austerity. It will create inflation and most likely asset inflation as well. But there is another interesting angle to this situation which makes it different from WWII. We now live in a world with free floating exchange rates as in contrast to the 1946-1971 Bretton Woods system of fixed exchange rates. So even if you can’t do or don’t want to do financial repression, you are forced in the end to repress other countries under the form of trade wars and currency wars : sounds familiar no, these days ?