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In the seven years leading to the financial crisis, debt loads in the Western economies ascended to unprecedented levels. In the United States, the combined debt of government, nonfinancial businesses, and private households soared from 183% of gross domestic product (GDP) to 225%. In Europe, it climbed from about 206% to 227%.1
While consumers and the financial sector have since scaled back their borrowing, the gross debt owed by the U.S. government has continued to climb, recently surpassing 100% of GDP. Not everyone agrees that this is unsustainable, but some believe it poses a risk not only to the economy but also to national security, making debt reduction imperative.2 In a paper for the International Monetary Fund, economists Carmen Reinhart and M. Belen Sbrancia argue that the most likely route to achieving this will be via inflation, assisted by the return of "financial repression."
Repressive policies that capped interest rates and strong-armed private parties into buying government bonds were used after World War II to reduce war debts, the authors argue, and these measures short-changed savers and investors in the process. Similar policies may soon be employed again, they say, and, in fact, some measures are already in place. But do the Federal Reserve's interventions amount to financial repression, or merely monetary policy? And is regulatory reform repressive, or necessary to make the banks safer? Sharing their insights on this controversy are Lord Abbett Partners Rob Lee, Director of Taxable Fixed Income, and Walter Prahl, Director of Quantitative Research.
Financial Repression: A Stealthy Tax?
Not all means of shrinking a debt burden are equally viable, according to Reinhart and Sbrancia, who recently addressed the topic in their paper, "The Liquidation of Government Debt."3 Austerity is challenging because budget-cutting and tax-raising policies put politicians' careers at risk. Default is off the table because most countries want to avoid that stigma, which makes future borrowing more expensive. Reducing debt relative to GDP by boosting GDP is less feasible because heavily indebted countries find generating growth especially difficult.4
That leaves inflation or, more likely, a combination of that and financial repression, say the authors. Financial repression involves imposing policies that cap interest rates and make holding government debt mandatory for certain investors, lowering the government's borrowing costs.
If these policies produce nominal interest rates that are below the rate of inflation, real rates become negative. When this happens, the size of the debt shrinks in real terms, something the authors refer to as the "liquidation effect."
With negative real rates, a government can shrink liabilities rapidly. Reinhart and Sbrancia estimate that in the United States, real rates were negative during half of the years between 1945 and 1980. And in the first 10 years after World War II, "liquidation years" (see Table 1) cut the debt-to-GDP ratio from 116% to just 66%.5
Source: Carmen M. Reinhart and M. Belen Sbrancia, "The Liquidation of Government Debt," November 2011.
* Liquidation years are years in which real interest rates were negative.
Reinhart and Sbrancia, by applying the negative real interest rate to the outstanding debt, estimate that for the United States, the "financial repression tax" contribution equaled 2.3% of GDP and 13.4% of tax revenues annually between 1945 and 1980 (see Table 2). This reduced the debt/GDP ratio much faster than economic growth alone would have.
Source: Carmen M. Reinhart and M. Belen Sbrancia, "The Liquidation of Government Debt," November 2011.
A primary advantage of combining inflation with financial repression is stealth. "Unlike income, consumption, or sales taxes, the 'repression' tax is determined by factors such as financial regulations and inflation performance, which are opaque—if not invisible—to the highly politicized realm of fiscal policy," said Reinhart. "Given that deficit reduction usually involves highly unpopular spending cuts and/or tax increases, the 'stealthier' financial-repression tax may be a more politically palatable alternative."6
Financial Repression or a Flight to Safety?
But citing periods of negative real yields as evidence of financial repression is problematic, according to Walter Prahl, Lord Abbett Partner & Director of Quantitative Research. Calculating real, inflation-adjusted yields after the fact is easy: subtract the rate of inflation from the nominal yield. Calculating real yields on a forward-looking basis is more difficult because it requires estimating the future rate of inflation.
When investors purchase a government bond or put money in a savings account, they don't know for certain whether the interest rate they receive will be positive after the inflation rate is subtracted. They learn the rate of inflation only after the fact. So, "To say that investors during this period of repression were willing to accept negative yields is to know something now about inflation that investors at the time didn't know," Prahl said.
In other words, the negative real yields cited by Reinhart and Sbrancia may be more an indication of investors' inaccurate inflation estimates than of government repression.
Another likely explanation for negative yields is fear. Uncertainties today have led investors to accept negative yields (or what they suspect will be negative yields) on savings accounts, money market funds, and Treasury bills. Similarly, investors in the late 1940s/early 1950s and 1970s—periods when real yields were negative—may have preferred this to the possibility of greater losses on other investment options, Prahl explained.
And investors then had many reasons to seek safe havens, according to Alan Taylor, an economist with Morgan Stanley. The late 1940s and early 1950s saw the beginning of the Cold War and the eruption of the Korean War. The devastation of the Great Depression was also still fresh in many minds. In the 1970s, uncertainty arising from the Vietnam War, Middle East conflicts, oil shocks, terrorism, and economic instability provided reasons to flee to safety. "History," said Taylor, "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."7
Financial Repression or Merely Banking Reform?
Reinhart and Sbrancia document the policies they say were used to impose financial repression after World War II. These include those that cap interest rates and force private parties to hold government debt, among others.
In the United States, Regulation Q, for example, limited the interest rate that could be paid on savings accounts, and it prohibited paying interest on checking accounts. This relieved banks of the need to invest in risky assets to earn returns that were high enough to pay elevated, uncapped rates. That also allowed the banks to put more of their funds into safer investments, such as government bonds. So, Regulation Q had the effect of creating more demand for government bonds, which helped to keep the rates on those bonds low.
Governments can also put restrictions on the flow of capital out of the country, say the authors, limiting the investment options of individuals and institutions. And rules can be imposed that require pension funds and other large investors to hold at least some government debt. In addition, in circumstances where a central bank is not independent from the government or has only limited independence, interest rate targets are also used.
But calling post–World War II policies repressive appears to be an overreach, said Prahl. In the case of Regulation Q, the authors imply that it was pro-mulgated to encourage banks to hold government securities. But Regulation Q was adopted 12 years before the war's end, as part of New Deal banking regulation. And it was intended to address the stability of the banking system, not the size of the government's debt.
"There were a lot of reasons for Regulation Q," Prahl said, "but one thing you can say unambiguously is that it was not adopted to force people to hold government debt, because it was adopted at a time when, relatively speaking, there was no government debt."
Financial Repression in Disguise?
Full-fledged financial repression may reemerge in the future, and in some ways it is already here, say the authors, pointing to the Fed's large purchases of Treasury securities via quantitative easing (QE) and "Operation Twist."8 Media reports, subsequently, have confused true financial repression with mere central bank policy.
Financial repression means something more than that, according to Prahl. "Lowering short-term rates is intended to make it costly for investors to be risk-averse at a time when we need people to be investing," he said. "But that is not financial repression. That's just monetary policy."
As Prahl noted, with true financial repression, "the general idea is that it is a kind of forcing of private parties to hold government debt. It implies an element of compulsoriness, or at least making alternatives so unattractive that there's no point in holding anything other than government debt."
The term arose as a way to describe the kinds of policies that typically arise in developing countries. When fiscal conditions become so bad that investors refuse to buy a government's debt, the government sometimes resorts to extreme measures to force it on private parties.
Although the U.S. government faces severe budget difficulties, this is clearly not the case with Treasury securities. Investors have not yet balked at those—quite the opposite, in fact. "What is more absurd," said Prahl, "than the notion that the U.S. government is struggling to find some mechanism to place its debt? Every day we're placing debt without difficulty at very low yields around the world. Everybody wants our debt."
So, quantitative easing and Operation Twist were not implemented because of a lack of buyers. Yields on government debt are low largely because Treasuries are still considered a safe haven worldwide. And the purpose of the Fed's interventions has been to keep interest rates down to stimulate the economy.
Observers can fault Fed chairman Ben Bernanke's reasoning, Prahl said, but they can't seriously argue that he's generating inflation in order to reduce the debt. "That's clearly not the policy objective of Bernanke or the FOMC [Federal Open Market Committee]." To suggest otherwise is "too conspiratorial."
The authors, however, aren't averse to suggesting that government deception is likely. In fact, they write that repressive policies "may reemerge in the guise of prudential regulation [emphasis added], rather than under the politically incorrect label of financial repression."9
But suggesting that future regulation designed to make the banking system safer could really be just a means of forcing banks to hold government debt clearly places the authors outside the mainstream of economic opinion. Moreover, it appears to be an attempt to delegitimize much-needed banking reform, said Prahl. Few on either the political left or right believe banking regulation is unnecessary; the debate now is over the form it should take. "The notion that in a post–Lehman world we don't actually have any worries about making the banks safer is, frankly, misguided," Prahl said.
Financial Repression or a Beautiful Deleveraging?
To argue that true financial repression is not occurring is not to say that it is outside the realm of possibility. It's possible that the fiscal difficulties could deteriorate further and cause investors to back away from Treasuries. Certainly, proposals by China and others for a new reserve currency to replace the dollar are not a good sign. But to describe today's environment as financially repressive appears to be premature, at best.
Ray Dalio, the well-regarded head of hedge fund firm Bridgewater Associates, views the current environment, with its numerous Fed interventions, negative real yields, and debt reductions, much differently. He has compared the current deleveraging episode with those of the past, and he sees something other than financial repression. He sees a "beautiful deleveraging."10
A deleveraging, he says, can be inflationary or deflationary, and ugly or beautiful. Achieving a beautiful one requires balancing the forces of deflation against the forces of inflation.
Shrinking debt in relation to GDP can occur via default, austerity, and debt monetization (i.e., money creation by a central bank for the purpose of purchasing government debt).11 The role played by each is critical. Too many defaults and too much austerity can lead to deflation. Too much debt monetization can lead to runaway inflation. The key is to achieve equilibrium.
Essentially, a "beautiful" deleveraging requires a central bank to provide increased liquidity. It does this by "lending against a wider range of collateral (both lower quality and longer maturity) and buying (monetizing) lower-quality and/or longer-term debt." If done in the right amounts, this generates positive economic growth, despite the depressive effect of defaults and austerity.
Rob Lee, Lord Abbett Partner & Director of Taxable Fixed Income, believes that Dalio's take on the post-crisis environment is about right. "Bondholders and savers are suffering as a result of lower yields, but I generally agree that it has been a beautiful deleveraging," Lee said. "And I thank Bernanke for that. He cut rates aggressively, and has done multiple quantitative easings."
Future debt reduction could also be supercharged by a more robust economy, said Lee. "As Dalio points out, there are various ways to get out of a debt problem," he said. "We could, for example, have stronger economic growth. There are developments out there in the economy, such as shale gas or the renaissance of American manufacturing, which could spur stronger growth."
In the past (see Table 3), deleveragings—whether deflationary or inflationary—have often been much more traumatic. The early years of the Great Depression, for example, involved more defaults and more economic contraction than the U.S. economy has seen since the 2007–08 crisis. Similarly, the inflationary deleveraging during Germany's Weimar Republic of the 1920s included some of the worst hyperinflation of the twentieth century, which many believe ultimately contributed to the rise of Nazi Germany.
Source: Bridgewater Associates.
Unlike these unfortunate episodes, the current deleveraging qualifies as “beautiful” because it has avoided both serious deflation and runaway inflation. But Dalio warns that the process can go from beautiful to ugly “after a long time and a lot of stimulation that is used to reverse a deflationary deleveraging.” In other words, the current deleveraging qualifies as beautiful—so far.
Thinking Positive in a World of Negative Real Yields
Today's investing environment—whether it qualifies as financial repression or a beautiful deleveraging—means that assets in short-term, low-yielding options are earning negative real yields. Interest rates, which have been at historically low levels since December 2008, are expected to stay that way until at least late 2014, and inflation continues to run between 2–3%.
In this situation, the choice for investors is no mystery, according to Lee. Assuming the Fed's policies continue to be stimulative, investors who are relying heavily on lower-yielding investments are vulnerable to negative returns and would do well to consider a change.
"I think the Fed is telling you exactly what you should invest in," Lee said. "It's making it painful to be in a money market fund. It's making it painful to be in a Treasury bond fund. So, the Fed is telling investors to sell at least some of the lower-yielding assets and take on a little more risk. The Fed is not suggesting that investors need to buy the riskiest assets. But it is saying, 'Take on some risk.'"
—Reported by Ron Vlieger
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Longer-term debt securities are usually more sensitive to interest rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated debt securities may be subject to greater risks than higher-rated securities. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements. No investing strategy can overcome all market volatility or guarantee future results.
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