reducing government debt: the Carmen Reinhart cookbook (I)

“The Liquidation of Government Debt”

Over the Memorial Day weekend, I was catching up on my reading–including some back issues of the Financial Times that I just hadn’t gotten to in recent weeks.  That’s how I found out that Gillian Tett had written an article on May 10th, titled”Policymakers learn a new and alarming catchphrase.” 

The article calls attention to recent research by Carmen Reinhart (of This Time is Different; Eight Centuries of Financial Folly fame) and M. Belen Sbrancia, called “The Liquidation of Government Debt.”  Ms. Tett says the work is getting a lot of attention in Washington.  The paper is simultaneously a history of government strategies for reducing excessive debt, accumulated in the developed world mostly as a result of world wars.  More importantly, it also serves as a recipe book of sorts for the US and the EU to do so again today to shrink the liabilities created in the financial crisis.

opening points

Ms. Reinhart makes two opening points:

1.  As a percentage of GDP, the current surge in government debt in advanced economies, which stems from what she calls the Second Great Contraction, is stunningly large.  It dwarfs what was accumulated during the Great Depression.  It also exceeds the amounts amassed in fighting World War II.  (Alone, checking out the chart she uses to illustrate this is worth downloading the article for.)

2.  Growing out of debt of this magnitude is highly unlikely.  This is at least partly because the large debt burden itself acts to slow economic growth.  Yes, the popular myth is that the US grew out from under its WWII debt, but it didn’t happen that way.

shrinking post WWII debt:  “financial repression”

How did the US free itself from WWII liabilities?  …through “financial repression.”   Basically, this means the government of a country engineers a situation of:

–negative real interest rates and

–forced investor purchase of government bonds,

–over a very long period of time.

In the post-WWII US, which implemented such a regime, the country reduced its outstanding debt at the rate of 3%-4% of GDP yearly–suggesting “financial repression” would have to remain in place of at the very least ten years to get government borrowings under control.

two elements to financial repression

Financial repression has two elements:

1.  ceilings on nominal interest rates.  This would mean caps on the interest that banks or other financial intermediaries could pay to savers, as well as ceilings on the rates at which they could lend, either to all borrowers or at least to the government.

2.  forced lending to the government, including:

–capital controls to prevent money from leaving the country for more lucrative investments elsewhere, making government securities more attractive by default,

–high bank reserve requirements, i.e., mandated low- or no-cost loans to the government,

–“prudential” regulatory requirements that institutional investors–insurance companies, pensions funds, bond mutual funds–hold significant amounts of government debt in their portfolios.

financial repression is politically attractive…

As Ms. Reinhart points out, what makes financial repression especially attractive to politicians is its “steath” nature.  Unlike increases in taxes or cuts in government programs, it leaves no fingerprints that can be traced back to individual officeholders and foil their reelection chances.  Imagine trying to explain what’s going on in an election speech without having your listeners’ eyes glaze over.

…but very bad for bond returns

The bottom line:  in its simplest terms, financial repression is a hidden tax on bonds that could be in place for ten or twenty years.  From an investor’s point of view, having the government do this–and it might be the easiest choice for Washington–would return bonds to being the unattractive holdings they were in the pre-Volcker years.  No wonder bond fund managers are beginning to squawk.

Tomorrow, the effect of  financial repression on stocks.