The 2nd Edge of Modern Financial Repression
Manipulating Inflation Indexes to Steal from Retirees & Public Workers
Financial Repression is the academic term for how governments can pay down enormous debts by forcing interest rates below the rate of inflation, and then systematically confiscate the purchasing power of their citizens' savings over time, while keeping people from being able to escape or defend themselves. It is a hidden form of investor wealth confiscation and redistribution with a very long track record of "success", that is as effective in its own way as taxation. In my previous article, "Financial Repression: A Sheep Shearing Instruction Manual", I reviewed the policies used by advanced economies between 1945 and 1980 to successfully slash over 70% of the amount of government debt relative to economic output. This strategy is posted on the IMF website and is drawing international attention among government policymakers and economists for very good reason – it's what actually worked for the governments the last time around, and how they dodged default or hyperinflation.
However, while parallels exist, the current crisis is very different from the post-World War II government debt crisis. By the end of 1945, the war was over, and the challenge was how to pay down past debts that had been racked up but were no longer being incurred. Conversely, the main problem this time around still lies in the future, with the United States, Europe and others having made long-term entitlement promises that dwarf the current deficits.
For Financial Repression to have a chance in the current environment, the governments of the world must employ not just the strategies of the past, but even more powerful strategies to deal with a fast oncoming future crisis that is far larger than the post World War II crisis. From the perspective of a government that is in financial crisis mode, with no end in sight, there is a powerful mathematical advantage to deploying a double-edged strategy which devastates the financial security of millions of retirement investors by slashing both the value of their savings (the first edge) and the value of their pensions and/or Social Security payments (the second edge). The effects of the implementation of this strategy can already be seen all around us.
Destroy the value of money over time - like the last time, only faster this time around. Like the last time, keep interest rates below the rate of inflation - which, by no coincidence, also happens to be the history of interest rates over the last decade. But even more crucially - hold down beneficiary payouts and prevent them from keeping up with inflation. That is, impoverish retirees and workers whose salaries are inflation-indexed a little more each year. Use time combined with the power of exponential mathematics to put the squeeze on investors, public sector workers and retirees simultaneously. With retirees and future retirees - who had deferred gratification and responsibly invested to offset the loss of future retirement benefits - getting the double impoverishment squeeze of 21st Century Financial Repression from both directions (and with stock investors being hurt even worse than fixed income investors, as discussed in the conclusion to this article).
There are solutions, but investing for financial repression is a Third Path, which is quite distinct from 1) the all-or-none currency meltdown strategies that implode absent a meltdown, and 2) the more conventional investment strategies. Ideally, an investor should deploy a strategy that can handle any or all three scenarios: one that survives and even thrives during and after a currency meltdown, and one which also not only survives but even prospers in Financial Repression (or combinations of meltdown and repression) - but while still doing fine if those scenarios end up not being as severe as many now anticipate.
Historic Financial Repression & Its Powerful Return
The most important thing that we need to understand about Financial Repression is that it works. The graph below shows that historically, as a result of war debts, the developed nations of the West owed about as much in total public debt outstanding compared to their economies in 1945 as they do right now. By 1980, more than 70% of that debt was gone, as a percentage of the size of the national economies.
The graph was derived from the data in an influential paper by Carmen Reinhart and M. Belen Sbrancia, which has been circulated by the International Monetary Fund to decision-makers on a global basis. What the paper shows is how it's done: how the developed nations of the world took seemingly impossible debt burdens and brought them down to a manageable level. Below is a link to my analysis of this traditional first edge of Financial Repression, in which I discuss the way traditional investment strategies are devastated by the governments' deliberate tilting of the investment playing field.
Should you wish to also read the much longer original paper by Reinhart and Sbrancia, below is a link to the paper on the IMF website:
What was done – even if it was never described that way in the newspaper headlines or in the investor education books and columns – was that the governments used paper currencies that were prone to inflation, instead of the precious metals-backed currencies that were the norm before the 1930s. They also deployed a network of rules and regulations to create a playing field in which savers and financial institutions were pretty much forced to invest their money at interest rates that were below the rate of inflation. Each year as inflation destroyed part of the value of money, the real (inflation-adjusted) value of the governmental debt burden fell along with the value of money. Each year, inflation also destroyed part of the value of the nation's savings - with much of those savings being either directly invested in government debt, or indirectly, through accounts at financial institutions that were forced to heavily invest in government debt. Savers were effectively given no choice but to watch the purchasing power of their savings fall each year as government debts were paid down by inflation.
Financial Repression is a form of wealth confiscation and redistribution that is in some ways as effective as taxation - but the government never directly calls it that. It never appears in the budget (directly), and while it is dependent on a comprehensive network of laws and regulations - none of those go through the legislature with a stated intention of creating Financial Repression. So while the economic net effects are similar to a huge and comprehensive set of investor taxes being used to pay down the national debt, the "taxes" are never a campaign issue because voters and investors don't understand what is happening - they only feel the results. The form of wealth confiscation is inflation rather than cash payments, and while the enormous benefits which flow to the government are entirely real, the overwhelming majority of those whose wealth is being confiscated will never fully understand what is happening, as there are no checks being written, and it never appears on a tax return. This makes Financial Repression a hugely successful strategy from a governmental perspective.
Even though the academic term fell into obscurity for about three decades, Financial Repression is not just an artifact of the historic past. Indeed it has returned stronger than ever. To see the evidence: consider what you pay for food, energy, healthcare, education and many of the other essentials of life. As we all know, the cost for these resources has been rising at an annual rate that is much higher than the puny-to-nonexistent interest rates that we have been earning in our collective money market funds and savings accounts.
Now in a theoretical free-market, investors would force interest rates up to adjust for current inflation as well as for future inflationary expectations. This competing academic theory that governments can't use inflation to pay down debts has wide acceptance among many commentators. However, it flies in the face of what actually happens in the real world, as shown not just with the experience of the last ten years, but also from 1945 to 1980. The point of Financial Repression from a governmental perspective is that there is no free market with regard to interest rates; instead the government uses its vast powers to effectively force a negative return on savers. Much more information on the recent and current experience can be found in my article "Cheating Investors As Official Government Policy", linked below.
The Oncoming Global Crisis & Governments' Need For Wider & More Aggressive Repression Policies
As mentioned in the overview, while the ratios of overall government debt levels to the size of the economies are roughly comparable between the years 1946 and 2011, there is a major difference which makes things far worse this time around. In 1946, the war was over, the massive deficits had stopped, and it was a matter of paying down debts already in place.
This time, the worst of the crisis still lies ahead of us instead of being behind us. What grips the developed world in the early 2010s is a sovereign debt crisis, the essence of which comes down to the governments having promised to pay far more to certain sectors of their societies than they have the tax revenues or even the economic resources to actually pay for. And as shown by numerous studies - which go back for decades - the worst is still ahead of us.
The amount by which future government expenditures are likely to exceed future government tax revenues in the United States (under the current structure) is estimated to be somewhere in the range between $62 trillion and $200 trillion (with some estimates being in present value form and others not). Now officially, the US government merely has the staggering sum of $14 trillion in debt outstanding. But, that is using a government definition of debt, which is Treasury obligations only, rather than all of what the government has promised to pay in the future. If a corporation were to use that kind of selective accounting - people would go to jail for fraud.
If we take the approach that the newspaper USA Today did, which was to treat the government like a corporation and report on the total by which its total future obligations rose in a year, then during 2010 (as illustrated in the graph below), the share of the one-year increase in total unfunded national obligations per solvent and able to pay (above poverty-line) US household came to $54,600.
The source of that graph is my article, "Per Household Annual Deficit Exceeds US Income Per Household" (linked below), and as also covered in that article, according to the US Census Bureau, the median household income is only about $50,200 per year. So the situation is far worse than "merely" having a national debt burden that is greater than the size of the national economy. We are in the incredible place where the annual growth in total unfunded government obligations per above-poverty-line household exceeds the current annual income of the median household.
This sounds fantastical and difficult to believe, but the math is basic: take the results of a study of US government obligations by a major mainstream newspaper, divide the annual increase in obligations by the number of above-poverty line US households, compare to the median annual US household income, and you have the preceding graph.
Obviously, the Financial Repression techniques of the past aren't by themselves going to be enough to deal with the problem this time around. The future deficits are increasing at too great of a rate. So if Financial Repression is to be successful again - it's going to need to be modified in such a way that the size of those future payments is as much a target as earnings by savers. As we will cover below, that is the second edge of Modern Financial Repression: it is devastating for retirees, it will be getting worse year by year for current and future retirees, and it has been underway for some time now.
The Solution For Governments: Inflation Index Manipulation & Theft By Statistics
Simply put, the solution for governments is to not pay what has been promised to entitlement beneficiaries (especially retirees) and public sector workers who rely on inflation-indexed payments. Instead, governments use their direct control of how inflation rates are calculated and reported to deliberately understate the rate of inflation, which then steadily reduces retiree and inflation-indexed workers standards of living on an annual basis over the coming years and decades. From the perspective of governments - which is a very different perspective from fairness and justice for individual citizens - this leads to a highly desirable outcome.
What is causing the "sovereign debt crisis" which is threatening the economic viability of the US and the EU simultaneously is that impossible promises have been made from the perspective of overall society. There has been a fundamental demographic shift, with a post-war boom in population followed by smaller families. For decades, politicians have made generous promises to a rapidly aging population without considering the cost of meeting those promises in the future, or how a relatively smaller group of adult children in their prime working years could support a very large group of elderly parents in the style which the politicians promised. It's not even so much a matter of money and tax rates as that the promises made exceed the likely economic resources available to pay for them under any reasonable growth scenario. So it can't be done, and as I have been writing about in books and articles for some years now, these impossible promises will be broken in one form or another.
We know there will be higher and higher Social Security costs in the US (and its equivalent in other nations), higher and higher public and private pension costs, and most dangerous of all, higher and higher health care costs for an aging population - even as relatively fewer workers are available per retiree to pay for the burden. So we know there will be a steady mathematical decline in the ability to pay that will get a little bit worse every year. When $62 trillion or $200 trillion in future total deficits in the US are discussed - it is the demographics of an aging population that is the source.
One way of dealing with this is to explicitly and openly change the rules and reduce the entitlements, and the first stages of this approach are already in process. However, for politicians, this is a very dangerous path indeed when taken too far. People have been falsely told for decades when they paid payroll taxes that these taxes were a public savings plan for retirement. Of course, this has been a lie the entire time, the money was never saved but was always spent the same year it was taken in, and the Social Security "trust fund" has always only been IOUs which the government has written to itself.
But many people don't understand that, and naturally they get inflamed when what was promised to them, and what they thought they had paid for, is taken away from them. They feel cheated and they look for people – namely politicians – to blame. When this problem is compounded by particularly unscrupulous politicians seeking short-term advantage by denying that the problem exists at all - then open entitlement cuts are difficult, and no one is proposing a plan powerful enough to actually solve the problem.
The other path available is to use steady annual math to fight steady annual math. As covered in my article "Inflation Index Manipulation & Theft By Statistics", which was originally published in 2007, the mathematics involved are to publicly claim an inflation rate that is lower than the actual inflation rate. Then each consecutive year continue to deliberately understate the rate of inflation.
This methodology is employed because most benefits are promised in inflation-adjusted terms, which is both the problem and the loophole. The problem is that as long as the government honestly makes fully inflation-adjusted payments to beneficiaries, then the burden of future government promises is impossible. The loophole is that the government controls what the inflation rate is defined as being.
So when we look all around us: the costs of maintaining our standards of living are rising at a rate that is substantially higher than the earnings we receive on our savings; and there is also a higher rate of true inflation than the annual increases we get in Social Security payments or in cost-of-living adjustments to salaries. What we are seeing is a steady mathematical process of growing theft.
The illustration in the chart and graph above, from the article "Inflation Index Manipulation & Theft By Statistics", uses assumptions of 10% for the real inflation rate, and 3% for the official rate of inflation. This means that the government cheats retirees out of 7% of their incomes each year. There is a 7% reduction in year one, and another 7% in year two, and another 7% in year three, until by the 20th year, the government is able to wipe out 73% of its future debt burden without ever explicitly taking a benefit away or breaking a promise. Crucially, this mean the otherwise impossible promises are now well within the capacity of future tax rates and the future economy to pay. Albeit at a terrible cost in falling standards of living for retirees and those whose salaries are tied to inflation indexes.
For the economically impossible to become possible without explicitly reneging on retirement promises on a massive scale, the inflation rate must be deliberately understated. More specifically, the steady mathematical progression of breaking promises via reducing inflation-indexed payments is used to cancel out the steady mathematical progression of increasingly impossible promises, as the ratio of current workers to retirees falls with each year, even as the makeup of the population of retirees is transformed by age, with an ever increasing percentage of Boomer retirees reaching 80 and beyond, along with the associated explosive surge in average annual medical expenses. This is the necessary mathematics, it is why I've been educating people about inflation index manipulation since 2007, and it is the reason why it's likely to get only worse - indeed much worse - in the years to come. More on the math and the thoroughly interrelated political considerations can be found in the article itself, which is linked below.
The Double-Edged Risk For Retirees; The Triple Risk For The Military, Teachers & Other Public Sector Employees; and The Choice Between Impoverishment & Finding New Solutions
The second half of this article is continued on my website, linked below. Subjects include: 1) a detailed illustration of the effects of both edges of Financial Repression on a hypothetical couple who are saving for a planned retirement in ten years; 2) an examination of the third level of risk faced by public sector workers and others with inflation-indexed salaries; 3) a discussion that distinguishes between the investment challenges of Financial Repression versus currency meltdown; and 4) a discussion of the devastating effects of the second edge upon long-term stock investments.
About Daniel Amerman CFA
Daniel Amerman CFA Archive
|12/07/2016||The Imminent Multi-Trillion Dollar Surge In Social Security & Medicare Costs||story|
|09/23/2016||Pension Shortfalls Could Be 4X to 7X Greater Than Reported||story|
|07/01/2016||Italian Banks & Moving the Risk During Crisis||story|
|03/20/2015||Yellen’s Tiger Riding Dilemma Keeps Interest Rates Near Zero||story|
|03/25/2014||Why Is the Federal Deficit Really Falling?||story|
|03/11/2014||How Social Security Trust Funds Will Change Private Retirement Income||story|
|02/20/2014||Deadly Deflation Myths||story|
|01/31/2014||Who Most Benefits From MyRAs: Savers or the US Treasury?||story|
|01/23/2014||The Hidden Agenda Behind Quantitative Easing||story|
|01/07/2014||Six Reasons Why the Government Is Destroying the Dollar||story|