Financial Repression

When a country finds itself in the same situation as that of the U.S. – too much debt – there are basically three ways to resolve the situation:

  1. Get lucky. That is, if the country is lucky enough to grow their way out of the debt by having a healthy economy with low unemployment and a steadily rising GDP, the country could easily pay its debt over time.
  2. Default. The country simply refuses to pay its debt.
  3. Financial Repression.  Inflating the country’s monetary system to the degree in which the debt becomes relatively meaningless.

So far, the U.S. economy has not shown significant improvement in employment and GDP growth, so option #1 is out. A default would be too unpopular for politicians wishing to keep their offices of power. So even though option #2 would be beneficial long-term, it’s off the table as well.

In the middle of 2011, Bill Gross, managing director of PIMCO, referenced a paper on Financial Repression written by Carmen Reinhart and revealed his fund was going short U.S. Treasuries.  Since that time, the fund has lost value due to this call because the U.S. Treasury market bubble has still not burst.  But Mr. Gross was not wrong – perhaps his timing was off.  The U.S. is indeed embarking on some form of Financial Repression in order to address its debt burden.

So, what is Financial Repression?

Simply put, the goal for the U.S. under this strategy is to sustain a modest level of inflation.  For example, if a 4% inflation level can be kept up over a period of 10 years, with compounding, half the debt can be melted away.  Of course, the U.S. Federal Reserve will not publicly state that rate, but instead declare the target of around 2%. Nevertheless, the inflation rate doesn’t have to be that high, just kept consistent over time.

According to Reinhart’s paper, there are 3 mechanisms which serve to sustain a certain level of inflation.  The first is caps on interest rates. With rates at or near zero, it’s rather obvious the Fed has been successful in keeping rates low. And in mid September, 2011, the Fed initiated Operation Twist, which rolled maturing short-term bonds into new long-term bond purchases having the affect of pushing longer term interest rates lower.

The second mechanism is to ensure there’s a market for U.S. bonds – that is, make sure someone is available to buy the securities on offer by the Treasury. With interest rates so low, this is a difficult task. The Fed was supposed to be the buyer of last resort. But recently, they’ve overtaken China as the largest holder of U.S. debt. However, during the bail-outs of 2008, the banks received a lot of money in order to keep their capital ratios up. So far, that money has been parked in accounts at the Fed earning some interest. When called upon, these banks will use that money to buy U.S. Treasuries.

The third mechanism is to have capital controls in place that ensure there is no banking competition. All the banks in the system are banks in line with the Federal Reserve System.  There can’t be any rogue banks out there deciding not to play the Treasury game as planned.

Under this strategy, the U.S. government debt can be inflated away. But there are losers in this game. First, people who save their money see their savings eaten away – they get little to no interest on their savings and as inflation rises, the value of their money decreases.  Second, those purchasing the Treasuries lose as well for the same reason – low interest rates. Understood in this manner, the inflation sought under Financial Repression is a hidden tax.

Another interesting point Reinhart makes in her paper is that in order for Financial Repression to work in the long run, investment in gold needs to be discouraged or even prohibited. Investors cannot have any alternatives, but to invest in the target securities. But thankfully, that’s not the case today.  People are able to buy gold and silver and thus protect themselves from this inflationary strategy.



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