naked capitalism

Matt Stoller is a fellow at the Roosevelt Institute.  You can follow him on twitter at http://www.twitter.com/matthewstoller.

Over the past few months, the concept of “Financial Repression” has come into the lexicon and is increasingly used to describe a possible set of government strategies that constrains the financial sector.  Economists Carmen M. Reinhart and M. Belen Sbrancia reintroduced it with this paper, explaining that the public debts accrued during the financial crisis might be reduced through such strategies.

Historically, periods of high indebtedness have been associated with a rising incidence of default or restructuring of public and private debts. A subtle type of debt restructuring takes the form of “financial repression.” Financial repression includes directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks. In the heavily regulated financial markets of the Bretton Woods system, several restrictions facilitated a sharp and rapid reduction in public debt/GDP ratios from the late 1940s to the 1970s. Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt. Thus, financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation. Inflation need not take market participants entirely by surprise and, in effect, it need not be very high (by historic standards).

In other words, financial repression means doing things rentiers hate, like preventing them from moving their capital anywhere in the world at a moment’s notice, stopping them from engaging in predatory lending and usury, directing investment to national priorities (like public investment, war, health care and education, a safety net, etc), and regulating banks so they don’t become casinos.  Keynes called the process of reducing the return on capital “the euthenasia of the rentier and consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital.”

As we’ll see, rentiers don’t like this one bit; they prefer to retain their income streams and their place in the social hierarchy without sacrifice or risk on their part.  It’s why they’ve dubbed reasonable restrictions on what they perceive as their right to a riskless profit as “repression”.

Here’s the FT’s Gillian Tett, taking the financial repression meme seriously.

But what Reinhart and Sbrancia argue is that if you want to understand how the west cut its debts during the last great bout of deleveraging, namely after the second world war, then do not just focus on austerity or growth; instead, the crucial issue is that during that period, the state engineered a situation where the yields on government bonds were kept slightly below the prevailing rate of inflation for many years. This gap was not vast. But since asset managers and banks continued to buy those bonds at unfavourable prices, this implicit, subtle subsidy from investors helped the government to cut its debt pile over several years. Indeed Reinhart and Sbrancia calculate that such “repression” accounted for half of the post-second world war fiscal adjustment in the US and UK, due to the magic of compounding.

Now, these days, it is hard to imagine any western government overtly calling for a second wave of such “repression”. After all, as Kevin Warsh, a former Fed governor, recently pointed out, the drawback of financial repression is that it curbs private sector investment and credit growth.

Let’s start by fact-checking Warsh’s statement.  Here’s a chart of US gross private domestic investment.

The so-called “financial repression” of the pre-1981 financial system did not seem to suppress private investment.  I did a quick calculation with St. Louis Fed data.  Growth in private domestic investment from 1947-1980 was 9% a year.  Growth in private domestic investment from 1981-2010 was 5% a year.  And here’s GDP growth over that time period.

Once again, no obvious suppression of GDP growth.  It was on average 3.7% before 1981, and 2.7% afterwards.

Caps on interest rates, restrictions on cross-border capital flows, tighter regulation of banks, and directed private lending into the public sector are all characteristics of the World War II and New Deal-era financing system (also, the Civil War and WWI were funded with directed bank holdings of government bonds).  While most of these characteristics are not ones that exist in today’s financial system, we do in fact still have directed private lending in the form of housing finance (try lending money to a business if you are a small bank and watch the regulators come down on you for not putting your capital into conforming mortgages) and speculation.  If former Fed Governor Kevin Warsh had had his facts straight, he might have pointed out that not only were growth and private investment higher during the age when banks were constrained, but there were no financial crises during that era.  Of course the titans of finance don’t like such a system, because this is what democracy looks like when applied to the banking sector.  This is what public control over the monetary order implies.  You don’t just get riskless profit from holding sovereign bonds, you have to actually invest and risk your capital to get a return, invest in real things, real production, real wealth.  It’s really just a continuation of the “bondholders take no losses” attitude that so constrained our choices during the bailouts and has inevitably led to massive foreclosure fraud to prevent creditor losses.

So we see that the financial repression meme is at heart an aristocratic concept.  Bankers would prefer that we think of finance as essentially a private activity, but it isn’t.  There really is no such thing as a private bank (though we use that term in everyday parlance, and it’s not likely going away).  Every financial institution is at heart a hybrid public-private partnership, which becomes obvious when a crisis hits and the banks come crying to the government to fulfill a lender of last resort role.  It’s even more obvious when you look at a dollar bill, and you realize it is a liability owed to the taxpayer.  What that means is that either the public controls banks or banks control the public.  Just as aristocrats rely on state-sponsored privileges to maintain their social hierarchy while pretending to a fixed and immutable social construct, so too do bankers imply that their absolute right to gamble with public money is part of some fixed and immutable formula leading to prosperity.

A set of institutions that enforce versions of capital controls, interest rate caps, strong regulation, and some directed lending are necessary to live in a democracy.  And that’s why the financiers want to brand it financial repression.  They want you to enlist in their world view, that constraining finance is bad for society as a whole, when it is really bad for rentiers who do not actually know how to manage real risk and use a taxpayer backstop to make their bonds whole.  The record of the last few years is that more, not fewer, restrictions on financial speculation are needed.  Of course, rather than the term “financial repression”, I prefer a more quaint expression – the rule of law.