What do you do when you’re caught between a rock and a bigger rock? Most likely, you choose to chip away at the smaller rock until there is a way out, however long it may take.
And that seems to be the case with the global economy today, at least within many developed markets – policymakers are chipping away at the small rock in order to avoid being hit by the bigger rock. So what are the rocks and why are policymakers (arguably) choosing this option?
The smaller rock is better known as ‘Financial Repression’ – a term which is receiving more and more airplay by well-respected financial commentators. Paul Mason, economics editor of the BBC’s Newsnight, refers to it as ‘Repressionomics.’ Carmen Reinhart prefers to call a spade a spade, co-writing an article entitled ‘Financial Repression Redux’ which features on the IMF website. Last week, the term was mentioned several times at Credit Suisse’s excellent European Pensions Conference.
Between a rock…
The following definition of financial repression comes from Carmen Reinhart:
"Financial repression occurs when governments implement policies to channel to themselves funds that in a deregulated market environment would go elsewhere. Policies include directed lending to the government by captive domestic audiences (such as pension funds or domestic banks), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks, either explicitly through public ownership of some of the banks or through heavy “moral suasion.” Financial repression is also sometimes associated with relatively high reserve requirements (or liquidity requirements), securities transaction taxes, prohibition of gold purchases, or the placement of significant amounts of government debt that is nonmarketable. In the current policy discussion, financial repression issues come under the broad umbrella of “macroprudential regulation,” which refers to government efforts to ensure the health of an entire financial system.”
What are the effects? Interest rates would be lower than under ‘normal’ market conditions with inflation allowed to run higher than previously tolerated. This combination of low rates/high inflation helps to support financial asset prices by encouraging cash to flow into riskier investments, like equities. Financial institutions, such as banks/pension funds/insurers, would conversely be encouraged to hold government debt by new regulations, thus withholding investment in riskier assets which may benefit the economy. Capital controls may even fall within the realm of possibility.
What is the ‘Endgame’? As opposed to high inflation eroding away the ‘real’ value of debt until it becomes affordable, an extended period of moderate-to-high inflation combined with low interest rates (producing negative real yields) can do the same job – in this instance, creditors and savers bear the losses while debtors and borrowers reap the gains.
And a bigger rock
What would have happened if policymakers had decided (arguably) not to pursue financial repression? In order to answer this, we simply have to ask ourselves – “What would the world be like if central banks had not printed all that extra cash?”
The bigger rock refers to ‘Economic Depression’ which is the most likely scenario in a QE-less world. Individuals, companies and governments who had borrowed heavily to finance their spending would find themselves cut off from external financing as banks and governments are forced to cut back on lending and spending (assuming they are still solvent). Imagine the protests against austerity measures taking place not only in Athens, but also in a bankrupt London, Paris and Washington – that’s the harsh reality of why financial repression may be the less ugly option…
Beijing, on the other hand, would be laughing all the way to its central bank as it sits on $3 trillion of foreign currency reserves – foreign currency which the Bank Of England, Federal Reserve and European Central Bank would be unable to supply to their own domestic market to fuel spending.
In an economic depression, as almost occurred in 2008/9, the value of most assets would move in the same direction – Down!
Financial repression at least means that SOME assets are going up in price, it’s just that these assets may not be the ones you expect to appreciate given the bigger macro picture (eg. ‘safe’ sovereign debt). Let’s not forget that one of the aims of QE is to reduce ‘safe’ bond yields such that other assets look more attractive – we just need to look at discussions concerning the attractiveness of current Equity Risk Premia to see the effect.
This smaller rock makes the current investment opportunity in infrastructure and other ‘real’ assets far more attractive than would otherwise be the case. So long as policymakers can avoid being hit by the bigger rock!