Why Financial Repression Will Fail: Part I

247Bull.com Editor: Ron Hera’s two part article provides some excellent insight into the destructive nature of the western world’s policy of financial repression. He also examines another very important point, which is that the causes of the financial crisis have not been addressed and therefore heightened systemic risks still remain. Ron’s article includes some superb analysis, though thanks to the huge number of new ships being launched, the Baltic Dry Index (BDI) is still a broken economic indicator.

Excessive leverage and risk in the financial system, e.g., using customer funds to speculate, never ends well.  Stock market crashes, bank and investment firm failures or economic recessions are all potential consequences.  Following the failure of the United States to regulate over the counter (OTC) derivatives and the repeal of the Glass-Steagall Act,U.S.banks became the largest financial business entities in history.  The U.S. real estate bubble, sub-prime lending and mortgage backed securities (MBS), along with unregulated OTC derivatives, then lead to bank insolvencies, a historic stock market crash and a near collapse of the global financial system.

Central banks and governments intervened to prevent systemic collapse but governments were saddled with enormous debts due to bank bailouts, lost tax revenues and massive social welfare costs.  Rather than systemic collapse, and perhaps another Great Depression, the post crisis period came to be characterized by (1) market interventions, (2) direct government control over the economy, and (3) ongoing monetization by central banks.  Longer term solutions that would have allowed a return to putatively free markets failed to emerge and government debt, particularly in Europe, became a crisis in its own right.

Measures that began as emergency interventions became routine suggesting a new economic paradigm.  In the new paradigm, big banks, politicians and academics would decide what market outcomes, e.g., bankruptcies, interest rates or bond yields, would be permitted, as well as when to apply accounting rules, regulations and laws.  Despite increased centralization of decision making and greatly expanded powers, however, policymakers were unable to repair the financial system.  Instead, mounting government debt led to de facto financial repression.

Financial repression occurs when governments channel funds into their own sovereign bonds in order to reduce debt levels through mechanisms such as directed lending, caps on interest rates, capital controls, debt monetization, or by other means.  Economist Carmen M. Reinhart, et al., brought the term back into popular usage in 2011 after a long hiatus.  Past examples of financial repression include several South American countries, such as Argentina.  The promise of financial repression is that it will hold down government borrowing costs and reduce government debt levels, but critics argue that financial repression merely targets the producers of society, i.e., the middle class, and therefore harms the economy.

The Liquidation of Government Debt, Carmen M. Reinhart and M. Belen Sbrancia (NBER 16893, 2011)

The Liquidation of Government Debt, Carmen M. Reinhart and M. Belen Sbrancia (NBER 16893, 2011)

Debt monetization, which can be a tool of financial repression, destroys savings while a zero percent interest rate policy (ZIRP), which reduces government borrowing costs, deprives savers and pensioners of interest income and can lead to inflation.  What is more important, however, is that financial repression prevents capital formation.  Of particular concern in the U.S. is the link between capital formation and new business creation, which is primarily a middle class phenomenon.  The vast majority of corporations in the U.S. are small businesses and they account for the majority of jobs.  By preventing capital formation, financial repression short circuits the engine of new business creation, increases unemployment and threatens to bring down the middle class.

Governments cannot supply entrepreneurship or innovation in the marketplace, nor can they effectively replace savings (genuine capital derived from surplus production) or private investment with bank credit or with public funds, which represent debt and a transfer of wealth, respectively.  The deployed capital, inventions, products and services of new businesses drive innovation, fuel competition, provide jobs and increase the wealth of society.  In contrast, financial repression can only produce economic stagnation and result in a net loss of wealth to society.

Crisis and Consequence

Substantially as a consequence of the financial crisis and global recession, Europewas engulfed in a sovereign debt crisis characterized in the European periphery by austerity measures and Great Depression levels of unemployment.  In the U.S., the real estate collapse and stock market crash represented a direct loss of household wealth while bank bailouts represented a transfer of wealth from proverbial Main Street to literal Wall Street.  Deficit spending, debt monetization and the Federal Reserve’s purchases of MBS and U.S. Treasury bonds expressed a radically inflationary monetary policy and, although much of the money is idle in the banking system, the overall increase in the supply of U.S. dollars is concerning.

Despite the 2008 financial crisis, global recession and inflationary policies, confidence in the U.S. dollar, the U.S. stock market, the U.S. federal government and the U.S. economy remained largely intact.  Inflationary policies reduced certain risks, such as the risk of a deflationary collapse, and increased liquidity from central bank monetization lifted financial markets, but the effects were only temporary.  Confidence was also boosted in Europe by the European Central Bank’s (ECB) outright monetary transactions (OMT) program and in the U.S. by the Federal Reserve’s quantitative easing III (QE3) program.  InEurope, the risks of sharply rising sovereign bond yields, sovereign defaults and the potential breakup of the euro were muted by OMT while European leaders putatively moved toward a permanent solution, such as a fiscal union.  Thanks in part to the Federal Reserve’s ZIRP and ongoing “operation twist,” U.S. Treasury yields remained near historic lows.

On the surface, the fallout of the 2008 financial crisis was effectively managed, but the basic causes of the crisis were never addressed.  The lines between depository institutions and securities firms, erased in the U.S. by the final repeal of the Glass-Steagall Act in 1999, were not restored and the U.S. Financial Accounting Standards Board’s (FASB) mark-to-market rule was never reinstated.

Although bank capital ratios have improved, leverage remains excessive, bank balance sheet assets remain troubled and economic conditions have deteriorated compared to the pre-crisis period.  Banks deemed “too big to fail” in 2008 have become bigger and the gross credit exposure associated with high risk OTC derivatives is roughly as large as it was before the financial crisis.  By the end of 2013, the Federal Reserve’s balance sheet will have exceeded $3.4 trillion.  At the same time, the U.S. federal government faces a so-called “fiscal cliff.”

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>