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Playing Against the House
...Financial Repression and Real Rates
Financial repression is the easiest, most politically expedient path toward dealing with our global debt problem. Many of the world’s developed economies are on a collision course with insolvency (if not already there!), and the escape routes are not attractive to policymakers. Consider the options: Austerity is a long, painful road that requires a hit to GDP and economic prosperity as debt burdens decrease. This solution has not worked in Greece, and we certainly don’t expect any governments with access to a printing press to go down that path with any sustained vigor. Explicit default may occur in countries, such as those tied to the euro, that cannot print money or influence their market interest rates.
Inflating away the debt is often talked about as an alternative, but in reality inflation on its own will not achieve that goal. Expected inflation is quickly ncorporated into long-term interest rates, so costs of borrowing tend to rise along with inflation. And inflation is only helpful in reducing the value of long term debt, not short-maturity debt. But government regulation to artificially hold interest rates low, along with a steady dose of not-too-high inflation, will work—and is a far stealthier alternative than raising taxes or chopping government spending programs.
We are not arguing for or against the relative merits of the financial repression route. But clearly we are already witnessing a move in that direction. A few examples: in 2009, the United Kingdom increased the required holdings of gilts for its banks and their subsidiaries; the recent Basel III regulations provide preferential treatment for (supposedly) risk-free sovereign debt on a bank’s balance sheet; in 2010, Spain imposed interest-rate ceilings on bank deposits; and Japan reversed its planned privatization of Japan Post, the largest holder of personal savings in the world and a huge captive buyer of Japanese government bonds.
These sorts of regulations, along with the massive purchases of government bonds by the world’s central banks, are starting to have their intended effect. As can be seen in Figure 1, expected real interest rates for several countries around the globe are predominantly negative....MUCH MORE