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
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.
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 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
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
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
as a consequence of the financial crisis and global recession, Europe was
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.
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. In Europe, 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.
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.
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.”
The Road to
2012, the International Monetary Fund (IMF) projects GDP 2.2% growth in Japan
and the U.S. and 3.5% globally. Based on the Baltic Dry Index (BDI), which
reflects the price of moving major raw materials by sea, the global economy
has slowed in 2012. Nonetheless, there has been some improvement in
comparison to the depths of the global recession in 2009.
BDI is a leading indicator of economic growth because it reflects the demand
of manufacturers for raw materials. A decline in the BDI signals falling
global demand for manufactured goods. In the U.S., rail carloads also
indicate falling demand.
contrast, removing potentially optimistic projections, the U.S. Energy
Information Administration’s (EIA) liquid fuels consumption data
suggests an anemic recovery in the U.S. on a par with 2011.
the recent uptick in U.S. manufacturing, manufacturing currently accounts for
only 11.7% of U.S. GDP. In the past few decades, U.S. corporations moved
production offshore, eliminating domestic jobs. Credit expansion masked the
lost income of U.S. consumers but the process inexorably reached its logical
conclusion in 2007. The shift of U.S. workers to often lower paying service
sector jobs was counterproductive because debt levels rose while income
flowed out of the U.S. following on the heels of jobs.
policymakers, including Federal Reserve Chairman Ben Bernanke, deny it, in
fact, U.S. unemployment is a long term, structural problem linked to the
still ongoing outflow of U.S. consumer incomes to net exporter countries such
as India and China.
current surplus of U.S. labor, abundant capital and somewhat less expensive
energy (partly due to advances in hydraulic fracturing that have increased
U.S. domestic oil production) are insufficient to stimulate a broad-based
economic recovery. In addition to the U.S. federal government’s growing
debt and need for increased tax revenues, U.S. consumers remain burdened with
high debt levels.
U.S. manufacturing renaissance, for example, is unlikely to take hold unless
the U.S. dollar weakens significantly and global demand also rises. In a
global slowdown it remains unclear where new customers might come from for
new U.S. products or services.
the financial system has continued to function due to massive infusions of
liquidity, economic activity, with some exceptions, has not generally
recovered or has continued to deteriorate, e.g., the shrinking number of U.S.
citizens participating in the official workforce. Ignoring improvements in
the unemployment rate related to the shrinking size of the workforce, much of
the U.S. economic recovery in the post crisis period can be attributed to
government deficit spending.
GDP has been boosted by government deficit spending in excess of $1 trillion
per year. Removing the temporary effects of extraordinary deficits, U.S. GDP
remains negative. Compounding the problem, loose monetary policies, rather
than spurring lending to consumers or small businesses, have created
inflationary pressures and have lead to
than putting Americans back to work, inflationary policies have helped to
push prices higher. Based on U.S. Consumer Price Index (CPI), the official
inflation rate in the U.S. is roughly 2%, but the CPI does not accurately
measure the cost of maintaining a constant standard of living. Using the same
methodology as in 1980, the CPI should be 9.3% currently.
central bank policies support government borrowing and the banking system but
increased liquidity resulting from low interest rates, central bank asset
purchases or debt monetization can have destabilizing effects. Excess
liquidity can result in price inflation, fuel financial speculation or asset
price bubbles, or provoke competitive devaluations (currency wars). Asset
purchases and debt monetization by central banks alter the distribution of
money, thus of purchasing power over the economy and therefore redistribute
wealth. Monetary inflation erodes the value of savings replacing genuine
capital distributed throughout the economy with credit concentrated in banks.
In the U.S., one of the Federal Reserve’s policy assumptions is that
asset purchases will help small businesses by making more credit available.
While it is true that small businesses rely on bank credit for operations and
expansion, it is savings, not credit that fuels small business creation and
therefore job growth. Since most U.S. jobs are in small businesses, QE3 and
similar policies destroy jobs by redistributing wealth from savers,
entrepreneurs and investors to banks and stifling new business creation. The
combination of reduced new business creation, continuing high unemployment
and inflationary price pressures set against a backdrop of high debt levels
precisely defines stagflation.
Reign of Repression
stagflationary environment in the U.S. is a mild
example of financial repression. Countries in the European periphery, e.g.,
Greece, Italy, Spain, Portugal and Ireland, where high taxes and austerity
measures are already in place, are more pointed examples. In the case of
Greece, which has descended into an economic depression, the natural market
outcome would have been a Greek default and an exit from the European
Monetary Union (EMU) accompanied by losses for European banks and quite
probably a number of European bank failures, along with the systemic impact
of associated OTC derivatives, such as Credit Default Swaps (CDS). To prevent
bank losses and failures, however, policy decisions replaced market outcomes.
The normalization of market interventions, direct government control over the
economy and ongoing monetization by central banks represented a transition
from a market based status quo to a policy based status quo which maintained
or increased otherwise unworkable government debt levels. Maintaining the status quo, however,
requires financial repression.
the emergency measures that preceded it, financial repression has become a
fixture in a new economic paradigm, but it is no more likely to provide a
permanent solution. Financial repression will remain in place as long as bank
failures and sovereign defaults continue to be prevented, e.g., through
bailouts, asset purchases or debt monetization by central banks. Overall
economic conditions in Western countries can therefore be expected to remain
stagnant or to deteriorate. The continued debasement of major currencies,
such as the U.S. dollar and the euro, will reduce the real value of debts but
monetary inflation cannot create a genuine economic recovery as long as bank
balance sheets and government finances remain impaired. Without robust
economic growth, however, both the banking system and the finances of Western
governments certainly will remain impaired. In other words, financial
repression in the U.S. and in Europe is set to remain in place indefinitely.
an ongoing regime of financial repression, savings, jobs, economic
opportunity and living standards will all suffer. The middle class will be
reduced as generations of socioeconomic progress are gradually reversed.
Younger people, mired in stagflation, will be left behind in terms of income
and economic opportunity, which will have a long term negative impact. Since
U.S. banks stand to profit from financial repression, it will increase income
disparity and the concentration of wealth. The destructive forces set in
motion by financial repression will greatly increase the burden on government
social welfare programs. Thus, financial repression will fail to alleviate
government debt unless tax increases and austerity measures follow, which
could turn the United States into another Greece. In theory, financial
repression, together with other measures, can liquidate government debt but,
in practice, it is a destructive and highly destabilizing approach that will
result in a net loss of wealth to society.