Are we entering the early stages of financial repression?
Carmen Reinhart wrote in April of 2012:
Periods of high indebtedness have historically been associated with a rising incidence of default or restructuring of public and private debts. Sometimes the debt restructuring is more subtle and takes the form of “financial repression”. Consistent negative real interest rates are equivalent to a tax on bond holders and, more generally, savers. In the heavily regulated financial markets of the Bretton Woods system, a variety of financial domestic and international restrictions facilitated a sharp and rapid reduction or “liquidation” of public debt from the late 1940s to the 1970s. The restrictions or regulatory measures of that era had their origins in what would now come under the heading of “macroprudential” concerns in the wake of the severe banking crises that swept many countries in the early 1930s. The surge in public debts that followed during the Great Depression and through World War II only made the case for stable and low interest rates and directed credit more compelling to policymakers.
Reinhart outlines several necessary conditions for financial repression to occur:
- The domestic banking sector holds a large share of the public debt. In the future, this may be the result of macroprudential policy and banking rules that rely on banks holding "safe-assets".
- It only works if a large share of the debt is held domestically, because otherwise, foreign governments would be able to influence interest rates and interest rate volatility.
- Nominal interest rates are less than the rate of inflation.
- Incentives to follow a policy of financial repression are highest when public and private debt levels are high.
The Federal Reserve System formally committed to maintaining a low interest rate peg on government bonds in 1942 after the United States entered World War II. It did so at the request of the Treasury to allow the federal government to engage in cheaper debt financing of the war.
What does financial repression mean for bond markets?