Professor Carmen Reinhart, co‐author of This Time is Different about the economic impact of financial crises throughout history, recently published a working paper in which she postulates that current monetary policy is focused on debt restructuring through a means of “financial repression”. The term originally referred to a description of actions by monetary policy authorities in emerging market economies in the 1970s. Similar to earlier periods of excessive public debt, monetary policy measures adopted in response to the Financial Crisis of 2008 resulted in an explosion in the amount of global public debt. From Professor Reinhart’s paper (2011):
“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). For the advanced economies in our sample, real interest rates were negative roughly ½ of the time during 1945‐1980. For the United States and the United Kingdom our estimates of the annual liquidation of debt via negative real interest rates amounted on average from 3 to 4 percent of GDP a year. For Australia and Italy, which recorded higher inflation rates, the liquidation effect was larger (around 5 percent per annum). We describe some of the regulatory measures and policy actions that characterized the heyday of the financial repression era.”
What are the implications of Financial Repression? I would submit that the current environment certainly feels like financial repression. It is nevertheless worthwhile to examine the concept more thoroughly. In my view, Professor Reinhart’s thesis would manifest in the following manner: a) explicit or implicit caps on interest rates; b) debt servicing costs that decline despite massive increases in the amount of public debt; c) sharp declines in real interest rates. This paper examines the veracity of the thesis using current market trends and developments. More important, this paper proffers a portfolio management strategy designed to provide investors a reasonable rate of return in an era of financial repression, characterized by negative real interest rates.
