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Financial Repression Fast Becoming a Reality
The concept of financial repression has been on the edge of investors’ minds for a while. It ought to move to the centre, for it is becoming a reality.
In essence, the process involves governments using their muscle to force down the real value of their debt. It can take many forms, but they boil down to two.
First, governments push down real interest rates, with or without the help of rising inflation. Second, they oblige domestic institutions such as banks or pension funds to soak up government debt at those lower rates.
To see this starting to happen, consider the UK — not because it is unique, but because it illustrates both parts of the phenomenon. Take interest rates first.
At present 10-year UK gilts yield 2.4 per cent, some way below retail price inflation of 3.9 per cent. It is always possible that inflation will fall. But it is worth recalling that the average UK rate over the past decade has been over 3 per cent.
Negative real interest rates are an important feature of repression. While it is not strictly essential for rates to be negative — they need only be lower than a country’s growth rate — it speeds the process along.
The US scholars Carmen Reinhart and Belen Sbrancia have calculated that in the period 1945-80 — when governments were liquidating the debts built up in the Second World War — real yields on Treasury bills in the advanced economies averaged minus 1.6 per cent.
There are, of course, various reasons for UK gilt yields being negative at present. But a big one is quantitative easing, whereby the government has forced yields down by buying up almost a third of the total gilt stock.
Again, there are various good reasons for this policy. But one characteristic of financial repression, as Reinhart and Sbrancia put it, is “a pervasive lack of transparency.”
That is, it tends to be a covert byproduct of measures which are otherwise benign. If it could be done overtly, after all, governments could simply raise taxes or slash spending and have done with it.
There are occasional exceptions, such as the US government’s conversion of short-term debt in 1951 into 29-year unmarketable bonds. But that episode is instructive, since another key to repression is to push the maturity of debt further out.
Last week’s news of UK government plans to issue gilts with maturities of 100 years or more is therefore relevant. No one will be obliged to buy them, but they will give the government more elbow room in the matter of inflation.
Inflation does not aid repression if a government has to borrow in the near future — that is, if inflation is already in the price. But the average maturity of UK gilts is an unusually long 14.5 years.
So come the day that the UK’s finances are back in primary balance, the inflationary door will be wide open. From a policy standpoint, not to take advantage of that might seem positively remiss.
So to the second part of the process — the dragooning of financial institutions. The most obvious element of this is regulatory pressure on the banks to buy sovereign debt.
Again, note the ostensibly benign purpose. It is of course sensible to make banks hold low-risk liquid assets. But the fact that many sovereign bonds are neither of those things is a clue to the wider agenda.
Next, the pension funds. I wrote recently about how the UK government is pushing local authority pension funds to invest in infrastructure — that is, to divert funds to projects the central government might otherwise have to pay for.
A starker illustration is the pension fund of the Royal Mail. It is now confirmed that as soon as permission is secured from the European Commission — expected by the end of this month — the UK government will take over the fund’s L28 billion of assets and L32 billion of liabilities.
The assets will then be sold to pay down government debt. There is apparently some debate over whether the proceeds should go on infrastructure — that is, capital projects — or current spending. But after a year or two, who will know the difference?
The liabilities, meanwhile, will vanish off the government’s balance sheet. That is, no doubt, fiscally imprudent. But as the pensions consultant John Ralfe points out, it makes little practical difference, since the central government stands behind the Royal Mail and local authority pension funds already.
What are the nation’s savers to do about all this? Beyond steering clear of gilts at any price, not a lot.
Ultimately, the only question about debt is who pays for it — the borrower or the lender. This way, governments hope, that reality will pass unnoticed.