Financial repression: Then and now

"Rich nations worldwide have a problem with debt. In the past, such problems have been dealt with by several tactics, including 'financial repression'. This column explains how the tactic works and documents its resurgence in the wake of the global and Eurozone crises.

In light of the record or near-record levels of public and private debt, debt-reduction strategies are likely to remain at the forefront of policy discussions in most of the advanced economies for the foreseeable future (Reinhart and Sbrancia 2011).
Throughout history, debt-to-GDP ratios have been reduced by:

• Economic growth.
• Fiscal adjustment and austerity plans.
• Explicit default or restructuring of private and public debt.
• “Surprise” inflation.
• Steady financial repression accompanied by steady inflation.

As coined by Ronald McKinnon (1973), the term “financial repression” describes various policies that allow governments to “capture” and “under-pay” domestic savers. Such policies include forced lending to governments by pension funds and other domestic financial institutions, interest-rate caps, capital controls, and many more. Governments have typically used a mixture of these to bring down debt levels, but inflation and financial repression typically only work for domestically held debt (the Eurozone is a special hybrid case). In the current policy discussion, financial repression comes under the “macroprudential regulation” rubric.
Most governments would only contemplate default or surprise inflation in truly desperate economic conditions. In Europe, austerity is being pursued but in the countries that need it most, falling growth tends to offset much of the progress. Little wonder, then, that financial repression is back on the policy menu.
Financial repression, teamed with a steady dose of inflation, cuts debt burdens from two directions:

• Low nominal interest rates reduce debt servicing costs.
• Negative real interest rates erode the debt-to-GDP ratio (it is a tax on savers).

Here, inflation need not take market participants entirely by surprise and, in effect, it need not be very high (by historic standards).
Financial repression also has some interesting political-economy properties. Unlike other taxes, the “repression” tax rate (or rates) is determined by financial regulations and inflation performance that are opaque to the highly politicised realm of fiscal measures. Given that deficit reduction usually involves highly unpopular expenditure reductions and/or tax increases of one form or another, the relatively “stealthier” financial repression tax may be a more politically palatable alternative for authorities faced with the need to reduce outstanding debts..."

at http://www.voxeu.org/index.php?q=node/7767