The Return of Financial Repression?
Financial repression was used extensively by governments in the post-war period and is still common today in emerging markets such as China. As Cato scholar James Dorn writes in a recently posted commentary, “Financial repression is a hallmark of China’s market socialism.” Given developments in the wake of the financial crisis, the big question is whether financial repression will make a comeback in the industrial countries.
In his discussion forum, Martin Wolf, chief economics commentator of the Financial Times, poses this timely question: How likely is financial repression? He cites Carmen Reinhart, the co-author of This Time Is Different, a study of several hundred years of financial crises:
First comes financial crisis; then comes sovereign debt crisis; then comes financial repression.
The story, common to financial crises, is as follows:
First, governments encourage credit expansion by the financial sector. As a result, a mountain of bad debt is piled up. Then, at some point, comes panic. At this stage, governments nationalise the liabilities of their financial sector and, more important, find their revenues collapsing, along with the economy. Huge fiscal deficits then emerge and public debt starts to soar.
So, what do governments do when debt piles up? A lack of credibility in bond markets makes it harder for the government to fund its borrowing requirements. Thus it turns to its central bank–as we have seen in the Eurozone and as Kansas City Fed president Thomas Hoening warns of in the U.S.
This is when financial repression comes back with full force.
At this point, desperate governments look for ways to force institutions to hold their bonds, willy nilly. This is the point at which financial repression begins: banks are forced to hold government bonds, for “liquidity”; pension funds are forced to hold government bonds, for “safety”; interest rate ceilings are imposed on private lending; to prevent “usury”; and, if all else fails, exchange controls are imposed, to ensure nobody can easily escape from such regulations.
The motives behind such a regime of financial regulation is a desire to influence the flow of capital and to secure cheap funds for the government by forcing banks to buy and hold government securities at low interest rates. The larger the public debt and the more reluctant bond investors are to keep funding the public purse, the more incentives public officials and political leaders have to impose these kinds of controls on banks.
