Reducing Sovereign Debt through Financial Repression

Pruning the United States’ massive (and growing) debt down to a manageable size will not happen overnight, and a paper by Carmen Reinhart and Belen Sbrancia outlines the measures the U.S. government might employ (based upon historical precedent both in this country and elsewhere) to accomplish that task. Collectively, these measures are referred to as "financial repression" (FR). The specifics of FR have taken different forms in each of the economies where the techniques have been used, but they shared four characteristics: 1) inflation; 2) governmental control of interest rates to guarantee negative real rates of return; 3) compulsory funding of government debt by financial institutions; and 4) capital controls. We briefly discuss each point below.


1) Inflation. A deeply indebted government is likely to be tempted to reduce its debt by inflating its national currency. The rate does not have to be high so long as the government is patient, but the higher the rate of inflation, the more effective FR is at quickly reducing a nation's debt problem.

To eliminate debts incurred during WWII, the United States and Great Britain used the combination of inflation and other FR techniques to reduce their debts by an average of 3 to 4 percent of GDP per year. Given the magnitude of the debt this time around, a substantially higher rate of inflation than that experienced between 1945 and 1980 might well be necessary.

2) Negative Real Interest Rates. In theory, a government cannot inflate away its debt because the free market would demand higher interest rates to compensate for that higher rate of inflation. In practice, however, government regulations have often limited the maximum interest rates that could be paid. E.g., Regulation Q was used in the United States to prevent the payment of interest on checking accounts and to cap interest rates on savings accounts.

Regulation Q was largely phased out in the 1980s, but government control of short-term interest rates in the United States has been near absolute during the last decade. The Federal Reserve has openly used its power to keep U.S. interest rates (and hence debt service payments) as low as possible. There is no need for explicit interest rate controls so long as the Federal Reserve is able to maintain control. However, if the Fed begin to lose control (as we have been predicting it will), interest rate controls could return to the U.S. financial landscape.

As an aside, we note that investors in U.S. Treasury Bills (maturities of less than 1 year) are currently receiving negative real returns. Nominal rates ranged from 0.01 to 0.27 percent on 1-month to 1-year T-bills between 8 May and 8 June. Regardless of the inflation measure (implicit GDP deflator, CPI or PPI) all of these yields are negative in real terms. We believe this situation is due to the current uncertainty in global markets. Investors are willing to accept negative real returns rather than risk even larger losses in more volatile markets. Some of that sentiment seems to be changing, however, as China recently grabbed headlines when it was announced it had reduced its T-bill holdings by 97 percent from the peak in May 2009.

3) Involuntary Funding. In this step, the government imposes reserve or "quality" requirements on financial institutions that make holding substantial amounts of government debt mandatory -- or at least establishes overwhelming incentives for financial institutions to do so. Such requirements might be billed as mandating "financial safety" instead of the more accurate description of mandating the making of investments at below market interest rates to help overextended governments recover from financial difficulties.

4) Capital Controls. In addition to ongoing inflation that eats away the value of everyone's savings as well as the value of the government's debts, there is another necessary ingredient to FR: in Reinhart and Sbrancia's words, the "creation and maintenance of a captive domestic audience" -- i.e., mandatory participation.

In this step, the government employs techniques to prevent savers (or at least their money) from fleeing the country while systematically and deliberately destroying the purchasing power of their savings. These techniques might include explicit capital and exchange controls or other, subtler methods like tax and regulatory incentives for institutions and individuals to keep their investments "domestic."

Lest one be tempted to think financial repression is nothing but a far-out conspiracy theory, Mohamed El-Erian believes it is a distinct possibility. "It is a world where several governments in advanced economies, and the United States in particular, opt for financial repression and mild inflation as the major way to accommodate their deteriorating debt dynamics," El-Erian wrote in a report published on the firm's website. Such a situation may occur now because almost four years since the start of the financial crisis, "the world has seen little meaningful reduction in the size of the excess liabilities accumulated" beforehand, El-Erian said. "Rather than be addressed in a convincing manner, most of the excess liabilities have simply been shifted around the system, and importantly to public balance sheets and taxpayers."

Our perception of financial repression is that its tactics are likely to be employed gradually and over the long term. Of more immediate concern is how the markets will respond when the Fed ends its quantitative easing program at the end of June. Are the private sector and/or foreign governments going to be in a position to pick up where the Fed leaves off in terms of buying Treasuries (assuming Congress lifts the debt ceiling so more debt can be created)? We doubt it, in light of the realization that the Fed has been buying between 75 and 85 percent of the Treasuries offered since the end of 2010. The implications of such a scenario are that, with the largest buyer of Treasury debt sitting on the sidelines and no other parties able (or at least willing) to plug the gap left by the Fed's departure, interest rates might finally turn higher as bond prices fall from lack of demand.