http://www.widepr.com/press_release/15256/dynamic_wealth_management_headlines_the_great_repression.html
OF THE many unpleasant legacies left by the economic crisis the mountain of sovereign debt may prove hardest to erode. Across the rich world, debt levels approaching 90% of GDP are now common. Indebted governments face an unenviable menu of options. Growing their way out of trouble will prove difficult as economies deleverage. Austerity, a second and unappetising choice, can easily choke recovery. Defaults are seen as a last resort. Politicians are searching for an easier way.
There is another model. Following the second world war many countries reduced debt quickly without messy defaults or painful austerity. British debt declined from 216% of GDP in 1945 to 138% ten years later, for example. In the five years to 2016, by contrast, British debt as a proportion of GDP is expected to drop by just three percentage points despite a harsh austerity programme. Why was it so much easier to cut debt in the immediate aftermath of the war?
Inflation helped. Between 1945 and 1980 negative real interest rates ate away at government debt. Savers deposited money in banks which lent to governments at interest rates below the level of inflation. The government then repaid savers with money that bought less than the amount originally lent. Savers took a real, inflation-adjusted loss, which corresponded to an improvement in the government’s balance-sheet. The mystery is why savers accepted crummy returns over long periods.
Related topics
* Bond markets
* Government bonds
* China
* United States
* Government and politics
The key ingredient in the mix, according to a recent working paper* by Carmen Reinhart of the Peterson Institute for International Economics and Belen Sbrancia of the University of Maryland, was “financial repression”. The term was first coined in the 1970s to disparage growth-inhibiting policies in emerging markets but the two economists apply it to rules that were common across the post-war rich world and that created captive domestic markets for government debt.
The exchange-rate and capital controls of the Bretton Woods financial system kept savers from seeking high returns abroad. High reserve requirements forced banks to lock up much of the economy’s savings in safe asset classes like government debt. Caps on banks’ lending rates ensured that trapped savings were lent to the sovereign at below-market rates. Such rules were not necessarily adopted to facilitate debt reduction, though that side-effect surely didn’t go unnoticed. The system was ubiquitous, reducing pressure on governments to abandon it.
Repression delivered impressive returns. In the average “liquidation year” in which real rates were negative, Britain and America reduced their debt by between 3% and 4% of GDP. Other countries, like Italy and Australia, enjoyed annual liquidation rates above 5%. The effect over a decade was large. From 1945 to 1955, the authors estimate that repression reduced America’s debt load by 50 percentage points, from 116% to 66% of GDP. Negative real interest rates were worth tax revenues equivalent to 6.3% of GDP per year. That would be enough to move America’s budget to surplus by 2013 without any new austerity programme.
The same conditions of instability that produced the post-war system of repression are again at work. Banks’ reserve requirements are rising in the wake of the financial crisis. Regulators like Britain’s Financial Services Authority are mandating that banks boost their holdings of safer government bonds for liquidity reasons. The new Basel 3 rules on bank capital still privilege government debt over other assets, nudging holdings toward sovereign debt despite the possibility of below-market returns. Interest rates hint at a return to post-war conditions, too, according to the Reinhart-Sbrancia sample of advanced economies. From 1981 to 2007 real interest rates were almost always positive. Since then they have been negative about half of the time.
More desperate governments are going further still. Ireland has raided its national pension reserves to help meet financing needs. European leaders are considering a textbook example of repression to postpone a reckoning on Greece’s debt. European banks are under state pressure “voluntarily” to roll over or reprofile their holdings of Greek government debt.
Emerging markets had more buttoned-down financial systems to start with. China, the world’s second-largest economy, is the financial system’s arch-represser. Tight controls over the banking system and strict limits on capital movements enable China’s leaders to hold down the value of its currency. An implicit tax on Chinese savers keeps down government borrowing despite hefty state expenditures.
Don’t hold it in
Politicians are sure to find bits of the post-war model appealing, despite the distortions to investment decisions it entails. Fortunately, the financial world is a far more liberal, multipolar place than it used to be. The Bretton Woods system fractured amid the inflationary pressures of the 1970s, around the time the rich world embarked on a three-decade process of financial liberalisation. Capital now flows quickly and easily around the world in search of high returns. New regulations in the West have done little to change that. China, too, is easing its financial controls. It is difficult to imagine how the genie of liberalisation can be stuffed back into its lamp.
Nor is repression alone enough to solve debt woes. Inflation is necessary too, and the example of Japan suggests that ageing societies may prefer to sacrifice the young to a long period of slow growth rather than erode the savings of older voters. Most importantly, governments must stop adding new debt. Even in a financially repressed system austerity is not entirely avoidable. Most economies must still cut their debts the hard way.
