Tallahassee, FL 1/6/12 (StreetBeat) -- In their 2009 book This Time is Different: Eight Centuries of Financial Folly economists Carmen Reinhart and Kenneth Rogoff argued that high debt to GDP ratios usher in extended periods of low growth; always have and, they assume, always will. Last year Reinhart, in collaboration with M. Belen Sbrancia, wrote a BIS/IMF working paper that can be looked upon as a coda to her book on sovereign debt. The paper, The Liquidation of Government Debt, explains the ways in which countries with extremely high debt to GDP ratios attempt to unwind them. Among the strategies that have historically been employed is “financial repression”, something the authors describe as “a subtle type of debt restructuring”.Reinhart and Sbrancia say there are five ways that too high debt/GDP ratios have usually been reduced. The first three are obvious: economic growth, austerity, and default or restructuring. The last two may be the most important, but are less straight forward and in the author’s opinion have been “largely overlooked in the literature and discussion on debt reduction”. The final two strategies are: “a sudden surprise burst in inflation” and “a steady dosage of financial repression that is accompanied by an equally steady dosage of inflation”, which Reinhart and Sbrancia think accounted for at least half of the post World War II debt adjustment in the US and UK. They say financial repression was the norm “for advanced economies during the post World War II period and in varying degrees up through the 1980s.”
So what is financial repression? Last month FT Alphaville described how Reinhart and Sbrancia define it; “Financial Repression, means limits on interest rates and the direction of lending to the government by a captive domestic audience, say the authors. This can be the result of subtle (e.g. through ceilings imposed by the central bank on commercial bank lending rates) or less subtle (e.g. state ownership of banks) policies. For example, the authors cite Regulation Q, which capped interest rates on savings deposits, and the ‘forced home bias’ regulation on portfolios under the Bretton Woods arrangements. Anything, really, that uses a domestic audience to keep nominal rates lower than they otherwise would be in order to erode the real value of government debt. (Hence why it’s most potent with a burst of inflation.) When real interest rates are negative this equates to a transfer from savers/creditors to borrowers, which in the authors’ case is the government.” In a nut shell, it is a strategy that forces the market to buy government bonds at interest rates that are below the prevailing rate of inflation for an extended number of years. The inflation rate does not necessarily have to be high, nor does the gap between the yields and inflation have to be wide for strategy to be effective. As Gillian Tett explained in a recent article in the Financial Times, “But since asset managers and banks continued to buy those bonds at unfavourable prices, this implicit, subtle subsidy from investors helped the government to cut its debt pile over several years” after the second world war.
It is clear that because of today’s extremely high debt to GDP ratios there is heightened interest in the concept of financial repression. In the FT article I cited above Gillian Tett mentions some examples that may not necessarily indicate a resurgence of financial suppression as a debt reduction strategy, but that certainly walk, squawk and look just like it. For the first time ever time ever the Bank of Tokyo Mitsubishi had more Japanese government bonds in its balance sheet than it did corporate or consumer loans; “Yes, you read that right,” writes Tett, “at an entity such as Bank of Tokyo Mitsubishi, it is now the government—not the private sector—that is grabbing most credit, as the bank gobbles up JGBs, notwithstanding rock-bottom low rates.” In addition she adds, “In Europe, Nicholas Sarkozy, French president, indicated this month that he was keen for banks to use their EU489 billion European Central Bank bonanza to purchase more euro zone government bonds. Asset managers in places such as Spain and Ireland are now facing pressure to acquire more sovereign debt, or quasi sovereign bonds, as debt pressures bite there. More subtly, British banks are being required to buy more sterling bonds, as a result of regulatory reform. Even in the US, government officials and bank leaders have recently taken to muttering that American banks have an unusually low holding of US government bonds, by international standards. The unspoken assumption, then, is that as western debt levels rise, banks and asset managers’ holdings of state debt will grow too—never mind that western sovereign debt is looking riskier by the day.”
Reinhart and Sbrancia concluded their historical review of sovereign debt to GDP ratio reduction with a view of the present day. “To deal with the current debt overhang, similar policies to those documented here may re-emerge in the guise of prudential regulation rather than under the politically incorrect label of financial repression. Moreover, the process where debts are being ‘placed’ at below market interest rates in pension funds and other more captive domestic financial institutions is already under way in several countries in Europe. There are many bankrupt (or nearly so) pension plans at the state level in the United States that bear scrutiny (in addition to the substantive unfunded liabilities at the federal level). Markets for government bonds are increasingly populated by nonmarket players, notably central banks of the United States, Europe and many of the largest emerging markets, calling into question what the information content of bond prices are relatively to their underlying risk profile. This decoupling between interest rates and risk is a common feature of financially repressed systems. With public and private external debts at record highs, many advanced economies are increasingly looking inward for public debt placements. While to state that initial conditions on the extent of global integration are vastly different at the outset of Bretton Woods in 1946 and today is an understatement, the direction of regulatory changes may have common features. The incentives to reduce the debt overhang are more compelling today than about half a century ago. After World War II, the overhang was limited to public debt (as the private sector had painfully deleveraged through the 1930s and the war); at present, the debt overhang many advanced economies face encompasses (in varying degrees) households, firms, financial institutions and governments.”
So, has financial repression returned, or is it in the process of returning? There are skeptics on this matter. Alan M. Taylor is a Senior Advisor at Morgan Stanley and a professor at the University of California at Davis. He wrote a critique of the Reinhart/Sbrancia paper that was included with their BIS/IMF report. As the FT Alphaville reported recently; “Taylor observes that the drops in the real rate observed by Reinhart and Sbrancia may not be examples of financial repression after all but of investor fear and …a shortage of safe assets. He writes that ‘in recent years’ we’ve seen T-Bill yields go negative not because of any sinister policy motive but because investors preferred to pay for the benefit of holding safe assets.” In his critique Taylor argues, “I think this is potentially a big issue for the paper—history shows that when uncertainty shocks hit, real rates always drop, and this is indicative of investor fear, and is not a reliable symptom of financial repression. For example, we have low real rates now (T-Bill rate minus CPI inflation rate < 0 for an extended period). Are we in a financial repression episode since 2008? Not really. We are in an ongoing era of uncertainty, with investors still in a flight to safety. Whilst some potential for financial repression lurks in changes in rules that are set to arrive in the future (e.g., new liquidity standards for banks under Basel or national rules) we are not there yet.”
Whether it is repressed or not, this aspect of the financial system is sure to get an exhaustive airing throughout the coming year, making “financial repression” a piece of jargon worth knowing about in 2012.
What Taylor sees as a shortage of safe assets is what I have described in this space as causing a flight to quantity. A sharp decline in private sector credit creation in the last couple of years, in addition to the fear of default by Europe’s periphery, has pushed investors into US Treasuries and German Bunds as never before. This has in turn created a vicious cycle; a shortage of safe assets means that there is also a shortage of acceptable collateral. This situation is further exacerbated by an increase in the use of collateralized lending that has proliferated because of the debt problems that are at the root of the shortage of safe assets to begin with. So this has engendered a sharp decline in the velocity of rehypothecation.
Oops, I think we have just stumbled upon 2012 Jargon, part 2.
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