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To tackle this macroeconomic question, the authors outline the methods that governments have historically used to monetize debt (we are focusing on domestically-held debt here):
1. Grow out of the problem–Economic growth
2. Tough love–fiscal adjustment/austerity
3. Give up–default or restructuring
4. Inflate away–sudden surprise burst of inflation
5. Stealth liquidation–steady financial repression (impose regulations and incentives that make debt artificially attractive) and steady inflation
It has long been assumed that the United States and Western European nations simply grew their way out of the massive debt problems they faced in the aftermath of WWII. What Reinhart and Sbrancia show is that, between the 1940s and the start of the 1980s, these governments made a concerted use of option 5: stealth liquidation. And, in fact, debt levels dropped dramatically over the course of three decades. Debt levels began to rise again during the period of liberalization marked by the 1980s and 1990s, as governments abandoned “financial repression.”
Here’s how the fantastic financial education resource Investopedia defines financial repression:
A term that describes measures by which governments channel funds to themselves as a form of debt reduction. This concept was introduced in 1973 by Stanford economists Edward S. Shaw and Ronald I. McKinnon. Financial repression can include such measures as directed lending to the government, caps on interest rates, regulation of capital movement between countries and a tighter association between government and banks.
The way that has historically worked in the United States, from the 1940s through the 1970s, was for the U.S. Federal Reserve to artificially lower short term interest rates, whereby U.S. banks and other financial institutions supported the mammoth growth in the debt the U.S. government took on during the Second World War, by facilitating the federal government’s solvency. Six years after the war ended, the Federal Reserve reached an accord with the U.S. Treasury to continue providing that support in return for being allowed to increase interest rates above the rock-bottom levels they had previously agreed to support back in 1942. In doing so, the Fed implicitly agreed to tolerate higher levels of inflation, the forces of which slowly built up over the next two decades until it ultimately resulted in the hyperinflation of the 1970s, which is really what led to the end of that period of financial repression.
Gray outlines the methods that governments have used in the past to execute their policies of financial repression:
- Explicit or indirect caps or ceilings on interest rates
- Regulated rates (e.g., government-mandated caps on savings deposits), interest rate targets (e.g., through central bank open market operations — buying/selling government bonds), etc.
- Creation and maintenance of a captive domestic audience
- Force domestic investment through regulation (e.g., through exchange controls, high reserve requirements for banks, gov’t bond holding requirements for banks, taxes on alternative investments (equity, corp bonds, etc)
- Control banking sector
- Eliminate entry, direct ownership of and/or management of banks, direct credit to certain industries.
Since 2008, we’ve seen each of these methods come back into play in the United States, primarily through two different vehicles: the Federal Reserve’s various Quantitative Easing programs, by which the Federal Reserve has filled the role of the “captive domestic audience,” and the Dodd-Frank Wall Street Reform and Consumer Protection Act, which is the means by which the U.S. government has both imposed controls over the banking industry and which a major study has revealed to have significantly impaired the ability of smaller community banks to compete with politically favored institutions.
Combined, the effects of the Fed’s interest rate lowering policies and the Dodd-Frank Act’s regulatory schemes are such that they are succeeding in eliminating the entry of new banks into the market, where the rate of new entrants has fallen from an average rate of 100 per year in the period before the passage of Dodd-Frank to fewer than 2 per year. The following chart, from Motley Fool, shows the FDIC’s recorded number of newly chartered banking institutions in each year from 1990 through 2014:
It could be worse, which is to say that it could still get worse. There are proposals that would force investors who have 401(k) and IRA retirement savings plans to “invest” in government-issued bonds, which could become the next major “captive” domestic audience for financial repression.
At present, President Obama’s “myRA” retirement account program represents an early step in that direction, which is currently being targeted at exploiting the most financially illiterate Americans, who likely don’t appreciate that when more money floods into Treasury auctions to buy government bonds, the yield (or interest rate) that the government will pay to borrow the money falls, which in turn means a worse rate of return for them in their myRA retirement account, which in turn would make it harder to accumulate a decent amount of money to even be able to afford to retire.
That President Obama’s myRA program is a bad deal for regular Americans can be confirmed by what some of the same people backing the President’s initiative are doing to advance the financial interests of the federal government’s employees in their default investment options for their Thrift Savings Plan retirement accounts, where currently, the default option for federal employees is to invest in the exact same government bond funds as for the myRA accounts. Because federal employees want better returns and bigger retirement savings, they’re pushing for legislation to have the default investment option changed to one that has a much higher rate of return.
Which perhaps indicates that they don’t believe they should have to face the same consequences as those upon whom they impose such policies of financial repression.