Gillian Tett’s perceptive article on financial repression has got a lot of people in the markets very worried. The term has an ominous ring to it. Like the term “inflation tax”, it sounds like the kind of underhand policy option which might appeal to governments because it enables them to reduce debt without the victims actually noticing any pain, at least for a while. And that is exactly what it is. But however tempting it might be to go down this path, governments might find it a difficult option to pursue in present circumstances.
Financial repression occurs when governments force investors to hold assets (often government debt) at interest rates which are lower than would exist in the free market. Combined with a policy of moderately high inflation, this can result in artificially low real government bond yields, which have the effect of reducing the government debt burden through time. Carmen Reinhart and Belen Sbrancia have recently written an outstanding historical account of how financial repression was used in the decades after World War II to reduce US and UK government debt ratios which had risen to 216 and 116 per cent of GDP respectively during the war.
For the decade after 1945, these two countries raised 4-6 per cent of GDP each year from what amounts to a financial repression “tax” (FRT), and this halved their debt ratios, relative to the levels they otherwise would have reached, by 1955. With present day governments running out of other attractive options to control the recent explosive rise in public debt ratios, Gillian Tett says that the possibility of deliberately introducing financial repression is being seriously considered in government circles in the US and Europe. And Bill Gross of Pimco, among others, is clearly quite alarmed by this.
Should governments do this? And, if so, can they do it?
On the first of these questions, there is one obvious advantage to this route, which is that it might be more politically feasible than raising traditional taxes, or cutting public services. If it is considered essential to reduce public debt ratios, this might be one of the few ways, other than default or restructuring of debt, of actually getting the job done. After all, that is why it has been done in the past. But actually it is just another form of taxation, which would work rather like a wealth tax applying only to government bonds. Therefore, to make the economic case for the FRT, proponents need to show that it would be less harmful, in terms of its impact on economic efficiency and income distribution, than other ways of reducing government deficits.
I have not seen any serious attempts to do this. The FRT would certainly introduce some very serious distortions into the efficient allocation of capital in the economy, which would reduce economic growth in the medium term. Money would be forcibly siphoned to low returning government bonds, away from other more productive uses, which would inevitably be damaging to investment and growth in the long run.
Furthermore, taxing people’s pensions (which is what the FRT amounts to) would reduce the wealth of the personal sector, and sooner or later this would curtail the growth of aggregate demand. Maybe this would take longer to work through than it would in the case of raising other taxes and, if so, the immediate multiplier effects of the cuts in the budget deficit might not be as large with the FRT as would be the case with traditional fiscal tightening. But eventually any such advantage would probably evaporate.
Next, would the FRT actually be feasible in present circumstances? In contrast to the post-war period, when many countries operated capital controls and when financial systems had become highly regulated, today’s open capital markets make it more difficult to operate a policy of financial repression.
In past discussions of the “inflation tax”, economists have argued that it is in fact fairly difficult to inflate away public debt. As soon as markets realise that this is being contemplated, bond yields will rise, making it more expensive to refinance existing debt when it matures. This rapidly eliminates the advantages bestowed by higher inflation.
Under financial repression, domestic investors would be required to hold onto their government bonds at low yields, so their holdings of debt could be inflated away. But what about foreign holders? If foreigners own a high proportion of a country’s debt (as they do in the case of the US), it would be exceedingly difficult to force them to continue holding the debt at low interest rates while a policy of raising the inflation rate is being pursued. Chinese holders of US Treasuries would probably run for the doors under such a policy. This would simply increase the need for a higher FRT to be imposed on US citizens, which would increase the political pain.
Finally, there is the question of how the central banks could be persuaded to pursue a policy of moderately high inflation for a decade or more. I doubt if the Fed would do this under its present mandate, which is to attain the maximum level of employment consistent with stable prices. It is one thing for the Fed to buy government bonds in an environment of undesirably low inflation. To buy them in order to artificially force down bond yields in an environment of rising inflation is quite another. If governments want central banks to co-operate with a plan to introduce financial repression, they would have to come out in the open, and change the mandates of the Fed, ECB and Bank of England. I find this hard to imagine, except in an extreme crisis.
I am therefore not persuaded that the use of financial repression to reduce government debt ratios is either desirable or feasible. At least, I hope not.
