Financial Repression is a term that has become popular in the last two years. You have probably seen or read about it in the media. Before 2011, the term was relegated to high level economic textbooks. That all changed in April 2011 when economists Carmen Reinhart and Belen Sbrancia published: The Liquidation of Government Debt.[1] You might recall that Carmen is co-author with Ken Rogoff of This Time is Different which was the seminal work on 800 years of sovereign defaults.

The new paper is the seminal paper on Financial Repression (FR). It formalized what many economists and investors were thinking. It explained the historical precedent and outlined what advanced economies can expect going forward.

The definition of FR from the paper
1) Explicit or indirect caps or ceilings on interest rates, particularly (but not exclusively) those on government debts.

2) Creation and maintenance of a captive domestic audience that facilitated directed credit to the government.

3) Direct ownership of banks or extensive management of banks and other financial institutions.


The essence of the paper is that developed economies had high ratios of debt/GDP after World War 2. The paper reviews 28 counties in the post WW2 period. FR is a more subtle way of reducing sovereign (government) debts. You might have heard a few comments recently about high government debts in the US.

FR works by creating low or negative “real” interest rates. Real rates are the advertised aka nominal interest rates minus the inflation rate. By having negative real rates, the government has a chance to slowly devalue their sovereign debt. It is purposely a slow, gradual process. Yoda thinks it is similar to slowly boiling frogs. FR is a subtle form of defaulting on sovereign debt. Instead of a dramatic single event like refusing to pay bond principal/interest, the average bond owner hardly notices how he is losing money.

You might not know the statistics on US real interest rates from 1945 through 1980.

Real rates <=0% in 25% of the years
Real rates <=1% in 64% of the years
Real rates <=2% in 89% of the years

These are actually ~better numbers than for all of the other countries listed in the paper. They had more years with less than 0% real rates compared to the US.
FR WAS successful in reducing the debt/GDP. In the US debt/GDP was 116% in1945 and 66% in 1955. The paper calculates that debt/GDP would have been 141% had FR NOT been implemented.

The paper has a lot more details, data and graphs if you are interested.

Why should you care about FR?

1) The US is already experiencing FR. The Federal Reserve has forced negative real rates. The Fed is also buying a good portion of the newly issued treasury debt. The US has very strong control over the TBTF banks, even though they were not nationalized.

2) You might ask how long FR lasted according to the paper. The average number of years was 22.

3) Let’s do the math. The latest FR started in 2008. If the average holds true, it will last until 2030.

4) We are dealing with financial constraints that are 100% out of our control. The Fed has demonstrated the ability to force negative real rates longer than many people thought possible, Yoda included. The group of “bond vigilantes” that can force higher sovereign interest rates seems to be in hiding. Maybe they went extinct after the 1970’s. With the Fed influencing interest rates over the full range of maturities, they have the upper hand over any bond vigilantes that have been hidden in bunkers for the last few decades.

5) With the Fed buying a lot of the newly issued Treasury paper, we do not really know the outside demand at those interest rates.

6) ONE NEW POINT, WHICH MIGHT BE ON THE WAY. As part of the reforms on money market funds, there is a possible win-win situation for FR. IF money market funds hold sovereign debt, they are immune from all of the proposed, onerous solutions that the SEC has proposed. Onerous is what the money market managers like Fidelity and Vanguard call the proposed regulations. If you hold only government paper, you will NOT have to

a) Have floating net asset values instead of being fixed at one dollar
b) Keep a reserve of funds, like 5% ready for immediate redemption

This would be a comprise that the managers would probably prefer, as distasteful as it is. It also provides a ready source of funds to soak up even more sovereign debt.


7) Yoda’s opinion is that the nominal case forecast should be for FR through 2030. Let’s assume this is way too long and FR only lasts through 2020. That means we will have 8 more years of FR.

8) The Fed is incrementally moving towards FORMALIZING FR. Have you noticed that the expiration of ZIRP keeps getting pushed out? Originally it was going to end in one year, then two years, then three years and now they are “guaranteeing” ZIRP to beyond 2015. This begs the question if they really don’t know how long it will last or if they are reluctant to publicly announce it? Can you imagine Ben coming out and saying: “We plan to maintain ZIRP probably through about 2030? Check back every 5 years or so and see how it is working.”

9) Obviously, there are implications on preferred investment strategies that will perform better under FR. I will publish that as a separate post if there is any interest.

As you might suspect, there is a lot more to the FR story. There are many papers that have been written about it since the original paper in 2011. I dramatically edited the FR story down. You might get a different interpretation if you read all of the papers. Or maybe your eyes will glaze over and you go into a cataonic state. I don’t know.

Thanks,

Yodaorange



[1] Reinhart and Sbrancia paper The Liquidation of Government Debt
http://www.imf.org/external/np/seminars/eng/2011/res2/pdf/cr...

Great post, Yoda.
I am feeling somewhat like a poor pitiful genius looking at those 6.5% long call preferreds.
I am most interested in your take on pfd. strategies under the assumption we may not live to see positive real interest rates.

9) Obviously, there are implications on preferred investment strategies that will perform better under FR. I will publish that as a separate post if there is any interest.

There is plenty of interest right here.

Please publish. ASAP.

:-)

Thanks, Yoda. Very interesting.

I have been using the lack of the Fed's constraints on foreign currency/equity markets for extracting return that was not available in the US. It is fortunate for me that, while many (most?) US multinational firms take investing outside the US for granted, most American individual investors don't. If this became popular I would think that constraints on funds leaving the country would be put into place.

Fortunately, most Americans feel that it is somehow unpatriotic, possibly illegal and certainly distasteful (not to mention neurotic considering their perception of the strength of the US economy and how rickety everyone else's is perceived to be) for someone to ship their real American dollars abroad and trade them for Monopoly money.

Can't seem to get enough of this (the song, that is) :-)
http://www.youtube.com/watch?v=rkRIbUT6u7Q

Jeff

The kids at home (well, ages 61 and 54) don't understand what this means:

2) Creation and maintenance of a captive domestic audience that facilitated directed credit to the government.

Thanks in advance for any explanation.

9) Obviously, there are implications on preferred investment strategies that will perform better under FR. I will publish that as a separate post if there is any interest.




Color me 'interested'.


Thanks,
Jim

Have you noticed that the expiration of ZIRP keeps getting pushed out? Originally it was going to end in one year, then two years, then three years and now they are “guaranteeing” ZIRP to beyond 2015. This begs the question if they really don’t know how long it will last or if they are reluctant to publicly announce it?

The Fed announced earlier this week that interest rates will remain unchanged until unemployment goes below 6.5 percent and if inflation is projected to be no more than 2.5 percent. Link to the announcement:

http://www.federalreserve.gov/newsevents/press/monetary/2012...

"The kids at home (well, ages 61 and 54) don't understand what this means:

2) Creation and maintenance of a captive domestic audience that facilitated directed credit to the government."

I'm obviously not Yoda, but I understood this as a reference to things like Japanese citizens who purchased JGBs with their savings even though there really isn't a rational reason to own JGBs. Similarly, Treasury rates went down when the S&P downgraded US debt during the last debt ceiling debates, and in some European countries (e.g., Denmark) government bonds have negative rates.

I think all of these are examples of captive domestic audiences that don't really have better options than government bonds, and so they continue to pile in even though it doesn't really make sense. As a result, the governments are allowed to run up way more debt than they should be allowed to accumulate under normal financial conditions.

"9) Obviously, there are implications on preferred investment strategies that will perform better under FR. I will publish that as a separate post if there is any interest."

I'm very interested too. If possible I would also be interested to find out what happens when financial repression ends. For example, do the assets that people piled into during financial repression (e.g., stocks with large dividends) suffer when financial repression ends? My guess is they will lose value, which is why I'm reluctant to invest in these companies, but this is just speculation on my part.

Thanks in advance (and thanks for all your great posts; I read every one).

For example, do the assets that people piled into during financial repression (e.g., stocks with large dividends) suffer when financial repression ends?

Yes, they do.

And that's why Financial Repression will not end so long as the Fed can keep it in place.

Only an irresistible force could cause financial repression to end (something not likely to be encountered by a Fed that can print unlimited amounts of digital cash at whim).

If the Fed enters the market for any asset class, then the Fed sets the price, because it doesn't cost them anything to overpay.

Period.

The Fed can drive up the price of anything (or, by selling/dumping assets, they can drive down the price of anything - gold, for instance).

Financial repression in the current circumstances is permanent.

That is solely in my humble opinion, of course.

In reality, I defer to Yoda - who actually knows a thing or two.

;-)

Dallas Federal Reserve Bank President Richard Fisher commented on Financial Repression yesterday. He made an appearance on CNBC to discuss the Fed's announced plans to keep ZIRP active until unemployment reaches 6.5%.

Richard said that the fed currently has the “Hotel California Monetary Policy.”

Referring to Fed policy he said the Fed could "check out anytime you like, but never leave."

Richard is very blunt that he and others argued against the current policy but were not able to sway the majority. You might note that all of the FOMC members and Fed Bank Presidents get to speak equally even if they do not currently vote on policy.

Maybe we can get Richard to do a posting on the FED’s financial repression policy!

BTW, Richard is a little disingenuous when he talks about the Fed’s dual mandate of inflation and unemployment. It is common knowledge that the Fed has added a third mandate which is to NOT let the stock market drop too much. It is bad for consumer confidence which hinders GDP growth. At least that is the Fed’s story line and they are sticking to it.

You can listen to the interview on CNBC:

http://www.cnbc.com/id/100314376


Thanks,

Yoda

Funny interview. Joe Curren equates the Fed's latest actions more to the "roach motel". You can check in but you can never leave. Seems about what they're doing to me.

Question I have is how does the Fed's new $85B policy equate to an incentive for companies to hire? Companies like low interest rates so if they hire rates go up. That's a disincentive.

Thanks Yoda.

yoda

Excellent. A thing that is even more insidious is if Treasuries are paying high rates, but inflation is even higher (as in the late 1970s and early 1980s so that "real rates" are still negative). I always thought that you couldn't keep ahead of inflation by buying Treasuries. I was recognizing Financial Repression without knowing it.

It is why I went to buying stocks early in my career, eventually concentrating on increasing dividend stocks. Early in this century, I got smoked out and started buying commercial bonds (for me, apparently over as our last GE bonds are called) and preferred stocks (still open to this).

Much to my surprise, we have a callable CD paying 3.25% that is listed at a more than 4% premium! You may not beat inflation with CDs but they are one of the few places where you can get your principal back when you need it.

Another form of financial repression is the official inflation rate which I suspect is considerably less than nearly everyone's personal inflation rate. And the politicians want to jimmy it some more to make it even lower to lower the inflation adjustments to social Security, Federal endowments, and the like.

brucedoe

Thank you for recommending this post to our Best of feature.

And the politicians want to jimmy it some more to make it even lower to lower the inflation adjustments to social Security, Federal endowments, and the like.

Bears repeating 'cause it's true.

Financial Repression... Federal Reserve

Initials match... coincidence?

Well, yeah. :o)

It just struck me, and I thought a little humor might help the medicine of the vision of the next "x" years go down.

I agree that the Fed policy of maintaining low interest rates "until <6.5% unemployment" doesn't seem like a great policy. Hmmmm... let me rephrase that. It's a great policy if you're a politician with an appetite for rampant spending. Not so much if you're a saver trying to make a return on your savings.

Best regards,
Kathie