Are governments engaging in financial repression? Do all roads lead to inflation?

More from the excellent Russell Jones at Westpac. A brilliant little must-read that resonates with my medium term views:

If the government debt which accumulated during the course of World War One and the two deflationary decades that followed was essentially resolved by outright default, explicit restructurings and the forcible conversion of domestic and external debt (together with the odd dose of hyperinflation), it was a combination of financial repression and moderate inflation which did much of the hard work in the wake of World War Two. The Bretton Woods system of fixed exchange rates, which operated from 1945 until the 1970s, was sustained by a web of trade and capital controls, while governments also only dismantled their war-time structures of domestic financial sector regulation in a slow and piece-meal fashion. In the meantime, with policy-makers more closely focused on the maintenance of full employment than hitherto, persistent, if rarely virulent, inflation became very much the rule rather than the exception. Hence, real interest rates were kept low, indeed below real GDP growth, if not negative. An NBER paper by Carmen Reinhart and Belen Sbrancia suggests that between 1945 and 1980, real rates were below zero 25% of the time in the US, 47.8% of the time in the UK and almost half of the time in Australia. In this way, debt service costs were constrained and the real value of debt was eroded.

For the decade after 1945, public debt liquidation through the combination of outright financial repression and inflation is estimated at an average of 6.3% of GDP per annum in the UK, 4.5% of GDP per annum in the US and 6.2% of GDP per annum in Australia. These three countries exited the war with government debt ratios of 116% of GDP, 216% of GDP and 144% of GDP respectively, yet by 1955 they had been reduced to 66.2%, 138.2% and 66.3%. And, of course, the mixture of financial repression/inflation continued consistently to reduce public debt burdens in the 1960s and 70s, such that they became of relatively little consequence to policy makers.

Back to the Future?
Today, following the fallout from the Global Financial Crisis, and especially given aging population structures, public sector debt burdens are clearly once again at the forefront of the policy debate. This, therefore, begs the question of whether or not inflation and financial repression are re-emerging as the weapons of choice to address this issue? After all, casting an eye over recent events in Europe, the enormous political and social costs of more orthodox fiscal consolidation strategies are all too obvious.

Clearly, the world is a very different place to 1945. Globalisation has been an over-riding theme of the last three decades. Markets are more open and the reliance on international capital controls has diminished sharply, especially outside of the developing world. Central banks are more independent, while their policy priority today is more commonly the control of inflation rather than the maintenance of full employment, to the extent that they are typically formally mandated to target some definition of relative price stability. What is more, OECD populations have become used to the benefits of more stable prices. For inflation to play the sort of role in reducing public indebtedness it enjoyed in the 40s, 50s, 60s and 70s, central banks would need to lose some of their independence and/or see their mandates adjusted.

But there is already evidence that this is beginning to happen. The blurring of fiscal and monetary policy since 2007 has resulted in some de facto loss of central bank autonomy, while a number of commentators, not least Nobel laureate Paul Krugman and IMF Chief Economist Olivier Blanchard, have publicly put the case for the introduction of temporarily higher inflation targets. What is more, it can be argued that some central banks are no longer so religiously wedded to their mandated inflation goals. Instead, they are taking a more holistic approach to policy at a time when financial sectors are fragile and there is a need for deleveraging not just in the public sector, but right across their economies. Consider, for example, the fact that OECD headline inflation has run above the 2% target prescribed by most central banks for considerably more of the last five years than it has been under it. The Bank of England has been perhaps the most egregious miscreant, but even the Bundesbank is now apparently more open to inflation running above 2%, albeit as a means to facilitate competitiveness convergence within the Eurozone. The fact is that the mathematics of debt dynamics mean that a little extra inflation can go a long way towards easing a country’s burden of liabilities.

What of the other aspects of financial repression? The reality is that it is not hard to find evidence that financial sectors have become more tightly controlled and that macroprudential frameworks have been skewed in a direction that helps governments to fund their deficits. Mechanisms for the placement of government debt in pension funds are increasingly common. Basel III, meanwhile, provides for the preferential treatment of government debt in bank balance sheets via substantial differentiation (in favour of government debt) in capital requirements.

Then, of course, there is the fact that the sovereign markets are increasingly populated by non-market players, as unconventional monetary policies and variations on the theme of quantitative easing have become common place.

Against this back this background, as demonstrated in the chart on the front page, we find that very low or negative real interest rates have once again increasingly become the norm and these traits are observable not just at the short end of the yield curve, but for longer dated maturities as well.

But there is a further aspect to modern financial repression and that is the synergistic actions of some emerging market policy makers. The extremely loose stance of OECD monetary policies has encouraged a growing fear of currency misalignments, overvaluations and the inflationary pressures resulting from “hot money” inflows in the non-OECD world. This in turn has encouraged a trend towards fx intervention and capital controls that has been consistent with greater home bias in investment decisions in the developed world.