Financial Repression: A Sheep Shearing Instruction Manual
"Financial Repression" is currently a hot buzzword in the global economic community, and its effects are even worse than it sounds. Like other recent economic buzzwords such as "monetary sterilization" and "quantitative easing", the average person will never understand the meaning, if they hear the phrase at all. That is too bad, because governments around the world deliberately and methodically stripping wealth (and therefore security and retirement lifestyle) from hundreds of millions of people is the quite explicit objective of Financial Repression.
As published in a recent working paper on the IMF website, Financial Repression is what the US and the rest of the advanced economies used to pay down enormous government debts the last time around, with a reduction in the government debt to GDP ratio of roughly 70% between 1945 and 1980. Financial Repression offers a third way out - as it allows governments to pay down huge debt burdens without either 1) default or 2) hyperinflation. If you are a senior government official of a nation that has a huge "sovereign debt" problem – like the United States and almost all of Europe, and you want to stay in power - this proven method is a topic of keen interest.
To understand this miraculous debt cure for governments, you need to understand the source of the funding. As we will explore in this article, the essence of Financial Repression is using a combination of inflation and government control of interest rates in an environment of capital controls to confiscate the value of the savings of the world's savers. Rephrased in less academic terms - the government deliberately destroys the value of money over time, and uses regulations to force a negative rate of return onto investors in inflation-adjusted terms, so that the real wealth of savers shrinks by an average of 3-4% per year (in the postwar historical example), and it uses an assortment of carrots and sticks to make sure investors have no choice but to accept having the purchasing power of their investments shrink each year.
What the IMF-distributed paper really constitutes is a Sheep Shearing Instruction Manual. The "way out" for governments is effectively to put the world's savers and investors in pens, hold them down, and shear them over and over again, year after year. Uninformed and helpless victims is what makes Financial Repression work, and it worked very well indeed for 35 years. On the other hand, if you understand what is truly going on, then you do have the ability to turn this to your substantial personal financial advantage. With a genuinely out of the box approach to long-term investment, the more heavy handed the repression - the more reliable the wealth compounding for those who reject flock thinking.
Understanding Financial Repression
Pimco (Pacific Investment Management Co.), one of the largest investment managers in the world, released their three to five year outlook last month, and their CEO predicted that increasing debt problems would lead to higher inflation and a return to "financial repression" in the United States.
Earlier in May, the Economist magazine had published an article on Financial Repression that included the following summary:
"... political leaders may have a strong incentive to pursue it (Financial Repression). Rapid growth seems out of the question for many struggling advanced economies, austerity and high inflation are extremely unpopular, and leaders are clearly reluctant to talk about major defaults. It would be very interesting if debt (rather than financial crisis or growing inequality) was the force that led to the return of the more managed economic world of the postwar period."
The phrase "Financial Repression" was first coined by Shaw and McKinnon in works published in 1973, and it described the dominant financial model used by the world's advanced economies between 1945 and around 1980. While academic works have continued to be published over the years, the phrase fell into obscurity as financial systems liberalized on a global basis, and former comprehensive sets of national financial controls receded into history.
However, since the financial crisis hit hard in 2008, there has been a resurgence of interest in how governments have paid down massive debt burdens in the past, and a fascinating study of Financial Repression, "The Liquidation of Government Debt", authored by Carmen Reinhart and M. Belen Sbrancia, was published by the National Bureau of Economic Research in March, 2011 (link below).
The paper is being circulated through the International Monetary Fund, and to understand why it is catching the full attention of global investment firms and governmental policymakers, take a look at the graph below:
The advanced Western economies of the world emerged from the desperate struggle for survival that was World War II, with a total stated debt burden relative to their economies that was roughly equal to that seen today. The governments didn't default on those staggering debts, nor did they resort to hyperinflation, but they did nonetheless drop their debt burdens relative to GDP by about 70% over the next three decades - and the very deliberate, calculated use of Financial Repression was how it was done.
The Mechanics Of Financial Repression
The specifics of financial repression took somewhat different forms in each of the advanced economies, 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.
1) Inflation. First and foremost, a government that owes too much money destroys the value of those debts through destroying the value of the national currency itself. It doesn't get any more traditional than that from a long-term, historical perspective. Without inflation, Financial Repression just doesn't work. Historically, 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 financial repression is at quickly reducing a nation's debt problem.
For example, per the Reinhart and Sbrancia paper, the US and UK used the combination of inflation and Financial Repression to reduce their debts by an average of 3-4% of GDP per year, while Australia and Italy used higher inflation rates in combination with Financial Repression to more swiftly drop their outstanding debt by about 5% per year in GDP terms. As the crisis is much worse this time around, a substantially higher rate of inflation than that experienced in the 1945 to 1980 period is going to be necessary.
2) Negative Real Interest Rates. In a theoretical world, some would say that governments can't inflate away debts because the free market would demand interest rates that compensate them for the higher rate of inflation. Sadly, this theoretical world has little to do with the past or present real world.
In the past (and all too likely in the future), there were formal government regulations that determined the maximum interest rates that could be paid. As an example, Regulation Q was used in the United States to prevent the payment of interest on checking accounts, and to put a cap on the payment of interest on savings accounts.
Regulation Q is long gone, but government control of short term interest rates has been near absolute over the last decade in the United States. As described in detail in my article linked below, "Cheating Investors As Official Government Policy", the Federal Reserve has been openly using its powers to massively manipulate interest rates in the US, keeping costs low for the government while cheating tens of millions of investors.
So long as the Federal Reserve keeps control, there is no need for explicit interest rate controls. However, should the Fed begin to lose control, there is a strong possibility that interest rate controls will return to the US financial landscape, with similar regulatory controls being re-imposed in other nations.
3) Involuntary Funding. With this popular component of Financial Repression, the government establishes reserve or "quality" requirements for financial institutions that make holding substantial amounts of government debt mandatory - or at least establish overwhelming incentives for financial institutions such as banks, savings and loans, credit unions and insurance companies to do so. Of course, this is publicly phrased 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.
This involuntary funding is sometimes described as a hidden tax on financial institutions, but let me suggest that this perspective misses the important part for you and me. Because all financial institutions operating within a country are required to effectively subsidize this liquidation of government debt by accepting less than the rate of inflation on interest rates, the gross revenues of all financial institutions are depressed, and therefore less money can be offered to depositors and policyholders. Because financial institutions make their money not on gross revenues, but on the spread between what they pay out and take in, then arguably, financial institution profits are not necessarily reduced, rather the guaranteed annual loss in purchasing power is passed straight through to depositors and policyholders, i.e. you and me.
As an example, if a fair inflation-adjusted return were 8%, and the spread kept by the financial institution was 2%, then we as investors would get 6%. If financial institutions, through involuntary funding, are uniformly forced to accept a 3% return on the government debt that must constitute a big portion of their portfolios, then they still keep 2%, but only pass through 1%. So the financial institution keeps 2% either way, and we as savers are the ones who ultimately pay this "hidden tax" in full, by getting a repressed 1% instead of a fair market 6% return.
4) Capital Controls. In addition to ongoing inflation that destroys the value of everyone's savings and thereby the value of the government's debts, while simultaneously making sure that interest rate levels lock in inflation-adjusted investor losses on a reliable basis, there is another necessary ingredient to Financial Repression: participation must be mandatory. Or as Reinhart and Sbrancia phrase it in their description / recipe for Financial Repression, it requires the "creation and maintenance of a captive domestic audience" (underline mine).
The government has to make sure that it has controls in place that will keep the savers in place while the purchasing power of their savings is systematically and deliberately destroyed. This can take the form of explicit capital and exchange controls, but there are numerous other, more subtle methods that can be used to essentially achieve the same results, particularly when used in combination. This can be achieved through a combined structure of tax and regulatory incentives for institutions and individuals to keep their investments "domestic" and in the proper categories for manipulation, as well as punitive tax and regulatory treatment of those attempting to escape the repression. A carrot and stick approach in other words, to make sure behavior is controlled.
A Sheep Shearing Instruction Manual
Only a tiny fraction of 1% of the world's population will ever read the original paper on the IMF website, or detailed analyses thereof. This is dry and boring stuff when compared to dancing or singing with the stars! Of course, there are many millions of investors who do read daily or weekly about what is going on in the financial world - but they and the journalists and bloggers who inform them usually just follow the ever changing surface of the markets. Again, the academic papers involved are so dry, boring and fundamental as to seem to have little relevance for the practical matter of what actions to take today or this month.
That said, let me suggest that few things are more important for your financial future than understanding and taking to heart Financial Repression. Because understanding Financial Repression means pulling the curtain aside and looking into the inner core of financial reality. It means understanding that much of what you have read and been taught about investment markets and long term investments over the last several decades has effectively been a sham.
Investor returns are not - and arguably never have been - fully about people compounding wealth in free markets, with the collective wisdom of the markets guaranteeing returns that are based upon rational assessments of the risk. Rather, investments, investment markets, investor returns and investor behavior have always been matters of governmental policy; what has varied over the years has been the form of government policy and how overt the control is.
To fully understand Financial Repression, you need to understand that the Reinhart and Sbrancia paper is effectively a sheep shearing manual. You and I, along with the rest of the savers and investors of the world are the sheep, and the goal of Financial Repression is to shear as much savings from us as the governments can, year after year, without triggering excessive unrest, and while keeping us producing the resources that can be politically redistributed.
The governments of the world are in trouble, and they would prefer to avoid overt global defaults, hyperinflation, or comprehensive austerity coupled with massive tax hikes. Each of those routes is highly unpopular, and could lead to political turmoil that would remove the decision makers and the special interests who support them from power. A more overt "managed economy" sounds much more attractive if you are in power, particularly since it has worked before over a period of decades, with an almost boring lack of political turmoil.
To get out of trouble, the governments have to wipe out most of the value of their debts, without raising taxes to the degree needed to pay the debts off at fair value. In other words, they need to cheat the investors. There is nothing accidental going on here, all that is in question are the particulars of the strategies for cheating the investors, meaning the collective savers of the world. Again, the time-honored and traditional form that governments who incur too much debt use in cheating the investors is to devalue the currency. Create enough inflation, and tax collections will rise with inflation but the debts won't, and the savers of the world will be paid back in full with currency that is worth much less than what was lent to the governments in the first place.
Except that there is the technicality that in theory, interest rates will rise above the rate of inflation, so that the value of savings is not eroded. From the governmental perspective, this is demonstrably a rather absurd theory. The core point of the Reinhart and Sbrancia paper is that the advanced economies of the world quite effectively squeezed an average of 3-4% annually of the value of government debt out of investor real net worth for a period of 35 years, using a wide assortment of overt and less overt controls over interest rates and investor behavior. Today the mechanism is different in that the central banks are using massive monetary creation in combination with their regulatory powers over major banks to control interest rates. However, the bottom line is that interest rates are absurdly low compared to the inflation and default risks, and this is because of near complete government control.
One potential sheep shearing problem is that only a minority of us "sheep" directly own government debt. For maximum sheep shearing efficiency, all of us who lead productive lives and produce more than we consume (meaning we generate savings) need to be sheared - and sheared often - whether we buy government bonds or not. This next step is one of the hardest parts for non-financial professionals to understand, but through manipulations of capital requirements and the creation of regulatory incentives and disincentives (that never make the nonfinancial media) governments can effectively control the investment behavior of financial institutions, and force the institutions to take on investments that pay less than the rate of inflation. From which the institutions still take their cut, and then pass through a still lower real return to their depositors and policyholders. So wherever we put our money, in whatever financial institution - we get absurdly low rates of return that help the governments reduce the real value of their debts.
So we're getting sheared, we've got no choice about it, the government explicitly plans to keep on shearing us for every remaining year of our lives, and wherever we go in the meadow, we still get sheared. This leads to the more savvy of us sheep trying to escape the meadow, and again, this is anticipated in the Financial Repression structure right from the beginning, with the construction of capital control fences. Many of the controls on savings leaving the country have been loosened since 1980. However, these controls have been returning since 2008, and are just likely to grow stronger as the return to full-on Financial Repression likely grows more overt.
Leaving The Flock
There is a way to beat Financial Repression. How? Succinctly phrased: the first step is to stop thinking like a sheep and start thinking like a shepherd. Stop acting like a sheep, and change your financial profile so that it aligns with the objectives of the "shepherds", the governments of the world.
Instead of fighting the governments of the world - position yourself so that the higher the rate of inflation and the greater the destruction of the value of money - the greater your real wealth grows, in inflation-adjusted terms.
The fundamentals of Financial Repression are for governments to pin down their citizens, force them to take interest rates that are below the government-induced rate of inflation, and make it almost impossible for an older investor with a conventional financial profile to escape. This is a time to fight the good fight politically - but not with your savings or your future standard of living.
Instead, align your financial interests with your government and the governments of the world. So that the more outrageous the government actions become in squeezing the value of investor savings from their populations - the more reliable the compounding of your wealth becomes for you, and the greater the growth in your financial security.
So how does one stop thinking and acting like a sheep? This can be amazingly simple, or it can be impossibly difficult. It is you and the way your mind works that will determine whether thinking like a shepherd will become simple or be impossible. How open are you - truly - to changing the way you view investments and financial security? Can you change the personal paradigm that may have shaped your worldview for decades?
View the investment world in the way in which we have all been programmed, and maintaining wealth over the coming years of inflation and Financial Repression is going to be extraordinarily difficult, particularly in after-tax and after-inflation terms. Because everything around you really is set up for sheep shearing. That's not a conspiracy theory - that is how the world really worked between 1945 and 1980, and policymakers around the world likely see variants of this proven debt reduction methodology as their only way out.
The Great Sheep Shearing of the early 21st century is already in process (we're just using some different names and methods this time around), and it will likely succeed with the overwhelming majority of investors - much like it did before, only on a more thorough basis, because the problems are far larger this time around. Whether Financial Repression will successfully prevent a meltdown is a different question, but regardless, the attempt is still likely to dominate markets as well as government regulations and policy.
Your alternative is to accept the world as it is, take personal responsibility for your own outcome, and educate yourself. You can seek to fundamentally change your paradigm, turn it upside down - and personally turn that same world of high inflation and Financial Repression into a target-rich environment of wealth building opportunities.
It is all up to you.
About Daniel Amerman CFA
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