Dateline: 14 January 2015
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...
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.
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.
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.
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.