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Financial repression is here and may be helpful
“The existence of civilisation presupposes the repression of powerful instinctual urges.” The words are from Sigmund Freud’s “Civilisation and its Discontents.” The father of psychoanalysis was not concerned with the discontents of investors, but his insight might be applicable to the instinctive urge to maximise profits. Sometimes a little financial repression can help make the economy more civilised.
Financial repression is the name economists give to the various ways that governments encourage or force investors to buy sovereign debt at unattractive prices. Economists Carmen Reinhart and M. Belen Sbrancia have identified three varieties: First, caps on interest rates keep down government borrowing costs. Second, rules that encourage the purchase of government bonds artificially increase demand. These include limits on cross-border capital flows and requirements that banks and insurers hold large quantities of supposedly risk-free government paper. Finally, governments can take direct control of investment by financial intermediaries. Hungary’s recently-nationalised pension funds are increasing their investment in government debt.
All these techniques allow governments to borrow at a lower cost and in larger quantities than they could in a totally free market. With a little help from inflation, governments can even pay back less than they borrow in real terms. Reinhart and Sbrancia calculate that the average real short-term interest rate paid by U.S. government between 1945 and 1980 was -3.5 percent.
In economic terms, such negative rates are the equivalent of a default. But while absolute non-payment wreaks havoc on the financial system — the great lesson of the Great Depression — banks and other leveraged institutions have less trouble dealing with the erosion of value through financial repression. And at least in some countries, many citizens seem to prefer to pay the government through hard-to-calculate losses in the financial system than through quite visible taxes.
The modern history of financial repression has three chapters. The first lasted as long as the Bretton Woods agreements, which were signed at the end of the Second World War and collapsed in the early 1970s. Capital controls were the norm and repression was rife. So was civilisation — many nations enjoyed two decades of low inflation, low unemployment, and rapid GDP growth. But in some countries financial repression brought more pain than gain. Argentines, for example, were unhappy about the government’s real interest rate, which Reinhart and Sbrancia calculate at -16 percent.
The second chapter began when the 1960s spirit of individual freedom hit the financial world. It took a while, but from 1980 onwards, government controls on rates and investment strategies were considered suspect. A financial Freud could have predicted the result. The instinct of blind greed triumphed over reason. It all ended in a global financial crisis.
The third chapter, which is just beginning, promises more repression. The renewal is hidden by the legacy of the years of financial freedom. Central banks and regulators are reluctant to follow politicians’ orders. Capital controls are still considered anathema in most countries. When the president of France recently recommended that euro zone banks use cheap funds from the European Central Bank to buy government bonds, he was slammed.
But governments still call most of the shots. So repression is blooming, just under new names and with some interesting excuses. The central bankers who set negative real overnight rates in Europe and the United States may believe they are promoting growth, but the effect is to lower government borrowing costs. Investors cannot escape. Real rates are low almost everywhere and regulators will not allow too many bets on higher-yielding alternatives.
Similarly, when central banks buy government debt with newly printed money or when prudential regulators require banks to hold larger buffers of liquid government debt, they artificially increase demand — and depress yields. More traditional direct techniques of repression may also be making a comeback. Italy has recently seen a campaign for patriotic bond-buying.
Such artifices may appal devotees of totally free financial markets, but they are less damaging than more natural alternatives. Government defaults are disastrous and more fiscal austerity might spark another recession. Investors should hesitate before complaining about meagre yields in the new era. Financial repression could even have a civilising influence.