Shearing The Sheep
(you are a sheep)

Dateline: 14 January 2015

(photo link)

Last month I posted a blog about the Myth of Compound Interest. I recently got a comment there from someone who asserted that I was “all wet” because, among other things, for me to say that compound interest isn’t real is like saying gravity doesn’t exist. I answered the comment, though probably not to the commenter’s satisfaction. 

Financial repression (the point of that post) is so simple, yet so difficult for many people to grasp, that I’m returning to discuss this again. 

In agrarian terms, financial repression is akin to the government shearing the sheep. The sheep are you and I. The “wool” being sheared is the life savings of the sheep.

Governments typically and obviously shear the sheep by means of direct taxes. When this happens, the sheep know full well that they are being shorn. But with financial repression, the government shears the sheep, a little at a time, with most of the sheep not realizing what is happening.

According to This 2012 Bloomberg Article, by Carmen M. Reinhart, financial repression was intentionally and successfully used in America from 1945 to around 1980. A policy of financial repression was re-instituted after 2008.

The key component of government-directed financial repression is low interest rates, coupled with inflation, but not a rate of inflation that is “excessive.”

The net effect of this financial repression is a negative real interest rate, which results in a net loss of wealth. This is the whole point I was trying to make with my Myth Of Compound Interest essay. 

If I understand Ms. Reinhardt’s article correctly, real interest rates (inflation adjusted) have been negative for about half the time since 1945, and below 1% for 82% of that time period.

The easiest-to-understand article I’ve found on the subject of financial repression is THIS ONE by Daniel Amerman. Here are some informative quotes from Mr. Amerman’s article... 

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In practice, there are four primary methods which nations use to pay down huge government debts when they have borrowed in their own currency:

1) Decades of austerity with higher taxes and lower government spending.  This painful choice can lower economic growth rates for decades, and fundamentally change investment returns.  It is also overt and clearly understood by voters, and can thus have devastating political implications.

2) Defaulting on government debts. This radical option can devastate bond and stock portfolios, bank deposits and retirement accounts.  It is also clearly understood by voters, and thus can have devastating political repercussions.

3) Inflating away the value of the debt through rapidly slashing the value of the currency.  Very high rates of inflation rapidly reduce the value of savings, bonds, deposits and retirement accounts.  Because collapsing the purchasing power of savings and salaries powerfully impacts the day-to-day lives of voters, this can have devastating political implications.

4) Using "Financial Repression", a process that is complex enough that the average voter never understands how it works, thus allowing governments to use this potent but subtle method of taking vast sums of private wealth, year after year, decade after decade, with almost no political consequences.

This fourth method that nations use to control or reduce the real value of debt is by far the least known or understood. Which is why if you are a senior government official in a nation that has a huge "sovereign debt" problem – like the United States and almost all of Europe – and you want to stay in power, this method is of keen interest and appeal.

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This avoidance of any political cost is also proven by current events since 2010, for even while the major components of classic Financial Repression have been reappearing for the first time in decades in the United States and other nations – there has been relatively little media coverage or general discussion.

To understand this "miracle" debt cure for governments requires understanding the source of the funding. That is, the essence of Financial Repression is using a combination of inflation and government control of interest rates in an environment of capital controls to confiscate much of the purchasing power of a nation's private savings.

Rephrased in less academic terms – the government methodically destroys the value of money over a period of many years, and uses regulations to force a negative rate of return onto investors (in inflation-adjusted terms), so that the real wealth of savers shrinks by an average of 3-4% per year (in the postwar historical example). 

Indeed, over time Financial Repression can be every bit as destructive to wealth building through savings and retirement accounts as is austerity, default or high rates of inflation. 

When many people think of inflationary dangers, they think of high rates of inflation, perhaps 10% per year or more. They take a "High Drama" approach, and think that if rates of inflation are more moderate, then there isn't that much to worry about.

Ironically, however, this belief could not be more mistaken, for what history shows is something else altogether. "Moderate" rates of inflation have historically been quite effectively used over a period of decades to redistribute wealth from individual savers to national governments on a massive scale with virtually no political costs – because the general public has no idea what is being done to them so long as it is done relatively slowly and subtly, and they aren't reading about it in the paper.

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The fundamentals of Financial Repression are for governments to pin down their citizens, force them to take interest rates that are below the government-induced rate of inflation, and make it almost impossible for an older investor with a conventional financial profile to escape. 

Whether Financial Repression will successfully prevent another and perhaps even larger round of financial crisis is a different question. But regardless, the attempt is still likely to dominate markets as well as government regulations and policy for years and possibly decades to come. 

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I searched at YouTube for a simple video that explains financial repression in a nutshell. I didn't find any that I thought were particularly good. But THIS ONE (by a German bank)) does a pretty decent job of it. 

In my next essay I will share a simple example of how financial repression is not a part of the thinking of the average sheep. I'll do this by telling you a story about my mother-in-law’s house. 







15 comments:

Kathleen Stoltzfus said...

So I don't understand how this helps the government's debt load?

Phil Pogson said...

so.....if we create our own family economies then we lessen the ability for this type of financial monstrosity to affect us - because our wealth is tied up in a different type of currency...am I on the right track?

Herrick Kimball said...

Phil,

Yes, I think so.

If your money is wrapped up in a personal business, and actually generating income that way, it is less subject to financial repression, which targets "safe" conventional savings plans, like CDs and pensions.

But everyone loses to some degree in this kind of financial environment. The sad part is that it is primarily those who have worked hard and put money away in savings, which is what we've all been taught is the right thing to do.

I should make it clear that I'm one of the dumb sheep getting sheared along with everyone else, but I'm getting smarter all the time..... maybe.

Herrick Kimball said...

Kathleen—

I applaud you for putting some mental effort into trying to understand financial repression. Your question is a difficult one for me to answer, especially when I don't fully understand the dynamics myself. :-)

So I did a Google search of "How does financial repression benefit the government," and I read (skimmed) over every link in the first two search pages, looking for a clear answer to your question (which I have wondered too).

Here is what an article in Forbes Magazine said:

"The ideal climate for government to get out of debt is one with low interest rates and inflation. The combination of the two creates a negative real return and helps eliminate debt. This is what’s know as financial repression."

Hmmm. Not exactly clear is it? Well, here's a quote from another financial site:

"Financial repression describes measures by governments to channel funds their way to reduce national debts. Unlike headline tax hikes, financial repression measures are often less obvious and can include steps such as changing lending and investing rules so that governments benefit.

Part of the attraction of financial repression is that it typically relies on small changes affecting many people over long periods. As a result, it can have large effects, slowly shifting funds to the government. Financial repression plays upon the behavioural trait of individuals failing to consider long-term implications of small changes."

All the articles say the same thing, but don't fully explain exactly how government benefits. The simple answer is, I suppose, that the cost of borrowing is less. But there is a more subtle transfer of wealth that takes place.

The point is, regardless of our ability to fully grasp the mechanics of this financial repression thing, it works. It's real. It's happening. And I haven't yet found an economic analyst that says it isn't happening.

Anonymous said...

I am in agreement with your blog and comments above so if my comments below sound argumentative then I will have to work on my writing.

If this year I earn $40,000 per year and by a $100,000 dollar house because the payment all I can afford. 10 years from now with no job change and just cost of living increases I may earn $45,000 per year thus making my $100,000 loan easier to pay. I believe inflation does the same thing for the government and it's debt load.

Your repression theory works when comparing bank savings accounts to government inflation. However, my money invested in conservative stocks has done MUCH better than a savings account. So there are ways to avoid/stay ahead of the financial repression that are reasonable. I think?

Herrick Kimball said...

Anonymous,

Traditionally speaking, stocks (equities) outpaced inflation and that apparently made all the difference for investors during the previous period of postwar financial repression.

That may continue to be the case. It certainly is the case at the moment.

But America's postwar stock market was more stable than today's stock market. And the standard sage advice for retirees has long been to get the the majority of their money out of stocks when retirement rolls around, because the stock market has never been considered a safe investment.

So investors (retired and otherwise) are now driven by low interest rates to higher risk investments out of necessity. As I understand it, this is one of the facets of financial repression... it herds the sheep into investments that put their savings at a higher risk of loss.

So-called safe stocks make more sense than the risky ones, of course. The concept is a good one.... invest in a company and get a return on your investment if the company does well. But past performance is no guarantee of future results.

The house analogy is a good one, as long as you still have a job in ten years, and your income has risen with inflation. It has worked that way for many people in the past.And, evidently, it worked for America in the postwar decades.

Thanks for the comment.




Survival Gardener/David The Good said...

@Anonymous

You've recognized something important.

Part of the reason the gov't has made bank savings rates so low is to force people to take higher risk by buying stocks, bolstering the pocketbooks of the big players. When stocks crash, many of those big players make money betting on the downside as well... whereas we get shorn.

Traditionally in a sound money system, you could survive decently without taking big risks. The financial repression in progress makes that impossible.

Survival Gardener/David The Good said...

It seems Herrick and I were answering at the same time.

"So investors (retired and otherwise) are now driven by low interest rates to higher risk investments out of necessity. As I understand it, this is one of the facets of financial repression... it herds the sheep into investments that put their savings at a higher risk of loss."

Yep.

Patrick Kyle said...

Inflation, even at a small incremental rate, benefits those in debt.Dollars are borrowed worth a certain amount but are paid back in dollars that are worth less than the original dollars. Inflation and negative interest rates, as pointed out above, force savers into riskier investments, stimulating the stock and bond markets, creating the appearance of growth in certain metrics (stock markets, GDP, etc.) This allows the scheme to continue. The government reaps the dual benefit of paying back with cheaper dollars and the perception of 'growth.' However this 'financing' is done on the backs of the middle class and anyone who saves.

Sheila Gilbert said...

One way the Government MAY benefit is, if you use something like a reverse mortgage, you get the money the house is worth, and the Government holds the house. Yes they say that you own it, however we live in a digital age, and the Government can claim the value of the home, at whatever they decide is correct. SO, their books show and increase that is actually not valid.
You may argue that the Government does not own the home, the people that get the loans still own it. That is actually "up for grabs" in a lot of cases. The Government still gets the value increase on the books, regardless of who owns it in the end.
Remember, it's not REAL MONEY anyway.
I may be very wrong, It's just the way I see how Americans are getting lost in the shuffle.
Oh, and if the home remains with the person who took out the loan, the value of the home is lowered to the "depression" rate all over again, so we lose again.
It's a no win story all the way around. You may have cash today, but who pays the bill, and who benefits in the end is like I said, it's "up for grabs" who do you think will win? You, or the Government? I know who I think will come out on top.

Anonymous said...

Interesting term "financial repression" it is just another name for spending your way out of debt. The concept is an old one that has been used successfully for thousands of years. The Romans used it for example. When the Romans plundered Egypt and brought all the Egyptian gold back to Rome it wiped out all prior debts of the Roman government because of this. After all, before plundering, a gold coin was maybe worth 6 months of labor, after plundering, maybe 6 minutes of labor. Simple law of supply and demand caused inflation of thousands of percent in a few years.

The US government uses this concept today simply because they don't want people saving money, they want everyone to spend all their money the minute they earn any. When the value of a dollar drops over time faster than the interest rate will prop up a savings account, it is a disincentive to saving. So someone will buy a refrigerator, for example, because 5 years later the frige will cost $100 more - and they won't have gotten $100 in compound interest if they put the money in the bank.

Anyway, at least in the US, you forgot to mention WHY the government has all that debt in the first place. We simply have a situation where people are used to getting more from the government than they put in. They wanna have a war but they don't wanna have to pay. They wanna have Ronald Reagan tax cuts, they don't wanna give up Social Security returns. It is US PEOPLE who voted in the people like GW Bush who borrowed a trillion dollars from us and went war adventuring during his term - and now we are whining because we got to pay that back.

Anonymous said...

Hmm, a quagmire indeed. I like bullet points when trying to digest a large problem, do these semi-accurately summarize the problem?
-The head-of-the-snake is: The United States has a huge debt problem with $18+ Trillion owed and counting. All presidents and congresses have increased this debt load during their term, each one outdoing the last.
-We the people of the United States have to pay it back via one of the 4 ways mentioned above. Defaulting is not an option and it won’t go away on its own. Whichever way each one of us would pick to pay it back would likely be the way we each had to pay the least amount. But the debt has to be paid.

-We the people of the United States voted for the elected official who spent the money in the first place. And yes, both parties spent the money.

-We now all feel put upon and cheated because the government has chosen the way that is best for them to pay back the debt.

I know the bullet points above are high level but it feels like that covers most of the issues.

What to do?
- Elect better officials.
- Get the candidates to discuss the real issues.
- Stop all unnecessary government spending (good luck)
- Protect what money we do have – I don’t know how to do this because all avenues are subject to rapid change.
- Develop a public plan to reduce the national debt.

I will stop here because the more I dig the more of the quagmire I uncover and it does not appear to have an end.

Herrick, you have said it for years: Focus on family, provide for yourself where you can, develop skills that will isolate you from future financial changes and OWN a small piece of land. Still sounds good today.

Survival Gardener/David The Good said...

- Elect better officials.
- Get the candidates to discuss the real issues.
- Stop all unnecessary government spending (good luck)
- Protect what money we do have – I don’t know how to do this because all avenues are subject to rapid change.
- Develop a public plan to reduce the national debt.

All excellent ideas but completely impossible. The corporations/banks/gov't are all a restricted cartel at this point. You only get to vote for approved puppets. They play-fight over little details and shuffle the seats around... but there's absolutely no hope anything will change until this system falls apart and some other gov't arrives. Hopefully, it will be small and regional, rather than the empire that currently exists.

Ron Paul discussed real issues and was roundly mocked and silenced. Conservatives were worse than liberals in their attacks. We're in the endless warfare/welfare state now. Both parties are one.

"- Protect what money we do have"

That's all we can do, except it can only take place on a personal rather than national level.

Anonymous said...

I believe it has already been said in various ways, but it bears repeating...

As much as possible reduce your debt load and live as independently from "the system" as you can without forgetting to "Love your neighbor as yourself."

Herrick Kimball said...

Thank you, everyone, for adding to this discussion.

I think Anonymous summed it up nicely with that last comment.