Financial Repression: Gleaning Insights from the 20th Century and Its Current-Day Pertinence

1. Introduction

Post-Napoleonic Wars, the UK grappled with massive public debt, peaking at 260% of GDP. Despite price stability and substantial capital mobility, facilitated by the Gold Standard, reducing this debt to around 100% of GDP took over six decades. Yet, post-World War II, the UK remarkably achieved a similar debt reduction within a short 20-year span. This fiscal triumph was not by chance but a result of astutely applied financial repression made viable by the establishment of the Bretton Woods system.

In addition to the transformation of public debt into joint-stock company shares during the South Sea Bubble in the 1700s, financial repression emerged as the most significant means of effectively reducing public debt. It is worth noting that the South Sea approach resulted in painful recessions and an increase in poverty levels, impacting even the nobles and parliamentarians.

During the era of the gold standard, governments lacked the tools to manipulate money flow through interest rate management and credit allocation. As a result, they were also unable to reduce national debt through financial engineering

1.1Definition

Financial repression encompasses a range of government policies and measures that manipulate the financial system to achieve specific objectives, typically aimed at addressing fiscal challenges, reducing public debt, or supporting economic priorities. While this practice is subject to controversy, it has been utilized by governments acros different periods in history.

This article delves into the concept of financial repression, exploring its causes, implications, and potential remedies. Additionally, we examine evidence indicating that certain tools of financial repression continue to be employed by some regimes. Given the rising political polarization, populism, and high national debt in many countries, there is a higher likelihood of implementing financial repression measures in various forms across a significant part of the globe.

Here are some examples of the policies and tools used in financial repression:

?Imposing high reserve requirements for banks.

• Mandating banks, pension funds, and other institutions to hold government debt.
• Implementing controls on the flow of funds.
• Applying equity transaction taxes.
• Direct government ownership of banks and other financial institutions.
• Restricting entry into the financial sector.
• Providing direct lending at preferential rates to certain industries.
• Managing interest rates.

Governments employ these policies and tools to influence the financial system and achieve their objectives.

2. A Historical Perspective

Throughout history, debt/GDP ratios have been reduced by (i) economic growth (ii) substantive fiscal adjustment/austerity plans; (iii) explicit default or restructuring of private and/or public debt; (iv) a sudden surprise burst in inflation; and (v) a steady dosage of financial repression that is accompanied by an equally steady dosage of inflation.

An examination of two series in Figure 1 identifies a total of five peaks in world indebtedness. All allied governments, with the exception of Finland, defaulted on their World War I debts to the United States. Thus, the high debts of the First World War and the subsequent debts associated with the Depression of the 1930s were resolved primarily through default and restructuring (Table 1).

It is important to stress that post the WWI period, the gold standard was still in place in many countries. This meant that currencies were linked to a fixed amount of gold, limiting the government's ability to manipulate interest rates and control capital flows. The gold standard's discipline and stability acted as a deterrent against excessive government intervention in the financial sector so absolute financial repression was not possible.

3. An Era of Financial Repression

From 1945 to 1995, different countries, whether advanced or emerging, used one form or another of financial repression to manage debt, promote growth in targeted sectors, and protect their national economies.

Table 2 makes it clear how financial regulations and capital account controls were used for a prolonged period after World War II to stabilize the economy. One common element across countries, which is not highlighted in Table 2, is that domestic government debt played a dominant role in the asset holdings of domestic institutions, particularly pension funds.

Table 2: Brief Historical Account of Financial Repression

3.1 Real Interest Rates

Governments often impose interest rate controls to suppress market interest rates, particularly on savings and fixed-income instruments. This approach aims to reduce borrowing costs for the government and incentivize financial institutions to lend to priority sectors or purchase government bonds. However, when financial repression produces negative real interest rates, this also reduces or liquidates existing debts. It is a transfer from creditors (savers) to borrowers (in the historical episode under study here--the government).

Negative real interest rates have some interesting political advantages. Unlike income, consumption, or sales taxes, the "repression" tax rates are determined by financial regulations and inflation performance, which are opaque to the general public. Normally, deficit reduction is achieved through expenditure reduction and tax increases, which can be politically damaging for the government. On the other hand, repressive measures are more politically favorable.

By imposing interest rate ceilings on deposits, domestic savers were compelled to invest in government securities, effectively subsidizing the national debt. Figure 2 reveals a clear trend: approximately 60 percent of the time (1945-2010), real interest rates on deposits were negative. Remarkably, deposit rates remained below one percent for approximately 83 percent of the observed period. These persistently low or negative real interest rates played a crucial role in the substantial reduction of public debts and the transfer of wealth from savers to fund government deficits during the latter half of the 20th century.

Compared to the post-liberalization period and the pre-World War II era, the period of financial repression was characterized by significantly low real interest rates. Figure 3 illustrates the frequency distribution of real interest rates of deposits in the United Kingdom across three subperiods: 1880-1939, 1945-1980, and 1981-2010. This visualization demonstrates the notable divergence in real interest rates over time and underscores the distinctiveness of the financial repression era characterized by persistently low interest rate levels. Furthermore, this highlights the fact that the real rate of return on government debt portfolios during financial repression periods is expected to be negative.

3.2 Capital Controls

Capital controls refer to measures imposed by governments to regulate the flow of capital across borders. These controls aim to restrict or manage the movement of funds, investments, or foreign currencies in and out of the country. Capital controls were commonly used as part of financial repression strategies in developing countries during the 20th century.

Table 2 presents a concise historical account of how both Advanced and Emerging countries implemented exchange controls during different time periods. These controls were used as tools to redirect capital flows and manage currency risk. Through the implementation of such measures, governments were able to direct liquidity towards specific industries while also imposing barriers to entry for international players, particularly in sectors such as banking.

3.3 Prudential Regulations and Supervision

Governments can exert control over the financial system through regulations and supervision. These measures may include restrictions on interest rates, reserve requirements, limits on bank activities, or strict oversight of financial institutions. Such regulations are designed to ensure stability in the financial sector, but they can also contribute to financial repression by limiting competition, stifling innovation, and consolidating power in the hands of a few dominant institutions.

Regulation Q, implemented as part of the Glass-Steagall Act, and the transaction tax on equities introduced through the Revenue Act of 1914 in the United States, exemplify prudential regulations aimed at capping interest rates on savings and discouraging stock market investment. Similarly, in the post-World War II period, the Bank of England exercised stringent control over credit allocation in the UK. By providing formal guidance to banks, the Bank of England directed credit towards government priorities, including housing, exports, and specific industries, aligning financial resources with national objectives.

4. The Liquidation of Government Debt

When the real interest rate is negative, it effectively reduces government debt without any payment. Any year in which this occurs is called a liquidation year. We can broaden the definition by including any year in which the real interest rate was below the market real rate.

4.1 Saving to the government during liquidation years

This concept explains how the government can reduce interest costs by having a negative real interest rate on its debt. This means that the interest rate is lower than the inflation rate. These savings can be compared to regular budget revenues and measured as a percentage of the country's total economic output (GDP) or the amount of taxes collected. The savings are calculated by multiplying the negative real interest rate by the amount of government debt held domestically. This concept is known as the "liquidation effect" or the "financial repression tax." It demonstrates how the government benefits from low interest rates on its debt. A year in which the liquidation effect is positive is referred to as a "liquidation year."

4.2 ?Incidence and magnitude of the “liquidation tax”

Table 3 presents country-specific data for the period 1945-1980, outlining the occurrence of debt liquidation years as defined earlier. It provides a list of these liquidation years, along with the average negative real interest rate observed during those years and the corresponding year when the lowest recorded real interest rate was reached.

Argentina serves as an exceptional case study. From 1944 to 1974, Argentina implemented stringent financial regulations and capital controls. During this period, nearly 97% of the years were acknowledged as liquidation years, with real ex-post interest rates being negative, except for 1953.

In the case of India, the share of liquidation years was 53% during the period from 1949 to 1980. Similarly, during the period from 1945 to 1980, the United Kingdom had a share of 48% of liquidation years, while the United States had a share of 25%.

This evidence demonstrates that debt liquidation was not solely confined to emerging markets, as advanced economies such as the United Kingdom and the United States also experienced substantial periods of liquidation during the years 1945 to 1980.

The long-term trend of negative real interest rates observed in many emerging countries, as shown in Table 3, has led to a shift in the government debt structure of these nations. During the 1970s and 1980s, countries like Argentina, as well as other economies experiencing chronic inflation, increasingly relied on external debt due to the drying up of domestic debt markets. This occurred despite the presence of capital controls, as capital flight continued to rise.

4.3 Estimates of the Liquidation Effect

On the basis of liquidation years, we can estimate the magnitude of savings to the government. We can get these savings by estimating the “Tax Rate” (the negative real interest rate) and multiplying it by the “tax base” or the stock of debt.

The magnitudes of the negative real rates observed in all cases are significant, regardless of whether we consider the benchmark measure based solely on interest rates (coupon yields) or the alternative measure that incorporates capital gains or losses when bond price data is available.

Surprisingly, but not entirely unexpected, the average annual impact of the liquidation effect in Argentina is similar to that of the United States, even though the average real interest rate was around -3.5 percent for the US and nearly -16 percent for Argentina during the liquidation years from 1945 to 1980. This indicates that just like the value of money decreases during periods of high and chronic inflation, the domestic debt market also diminishes. In Argentina, the "tax base" represented by domestic public debt steadily declined over this period. At the end of World War II, most of the public debt was domestic, but by the early 1980s, domestic debt accounted for less than half of the total public debt. Since Argentina lacked the means to repay its external debts, it defaulted on its international obligations in 1982.

Countries such as Ireland, India, Sweden, and South Africa, which did not undergo significant public debt accumulation during World War II, achieved more moderate but still significant annual savings during the period of financial repression.

Table 5 presents evidence of how advanced economies successfully reduced their debt between 1945 and 1955 through the implementation of capital and prudential controls, as well as interest rate management and higher inflation. The data in the table demonstrates that the savings or revenue generated from these policies accounted for up to 6.3% of GDP, resulting in a significant decrease in domestic public debt

4.4 Inflation and Debt Reduction

The idea of governments using inflation to liquidate debt is hardly a new one since the widespread adoption of fiat currency, It is obvious that for any given nominal interest rate a higher inflation rate reduces the real interest rate on the debt, thus increasing the odds that real interest rates become negative and the year is classified as a “Inflation liquidation year.”

Historically, governments have utilized temporary inflation shocks or consistent, chronic inflation to achieve a liquidation effect. Table 6 catalogues the most significant instances of debt reduction, ordered by country. It pinpoints the final year of a three-year debt reduction span, with the year in italics denoting the most substantial single episode of debt reduction. Furthermore, the table furnishes details on the average and median inflation rates throughout these debt reduction periods, comparing them with the inflation rates recorded over the entire sample period for the corresponding country.

In 22 out of 28 countries, inflation during the debt reduction episodes was significantly higher compared to the inflation rates for the full sample. In extreme cases, such as the German hyperinflation in the early 1920s and the prolonged hyperinflations in Brazil and Argentina in the early 1990s, the wholesale liquidation of domestic debt occurred. Even without these extreme cases, the inflation differences between the debt reduction episodes and the full sample suggest the use of inflation as a means to intentionally reduce or eliminate government debts, even outside periods of heavy financial repression.

5. Conclusion from history

The substantial tax on financial savings imposed by the financial repression that characterized 1945-1980 was a major factor explaining the relatively rapid reduction of public debt in a number of advanced economies.

One can argue that repressive measures provided financial stability and directed funds toward industries that needed them most in the early post-World War II era. Governments utilized capital controls and prudential policy tools to restrict the free flow of money, which, in many cases, was beneficial for society considering the challenging state of most countries involved in WWII. However, like any policy tool, repressive policies had side effects that affected different economies differently in the long run.

In general, advanced economies did not experience detrimental effects from repression. This can be attributed to the fact that during that era, these countries had already developed extensive manufacturing and service industry infrastructure. Additionally, they had undertaken significant changes in financial markets and institutions before liberalizing economic policies, which prepared them for the transition to a free market system. However, the same cannot be said for emerging and poorer countries, as they faced greater challenges and limitations in adapting to repressive policies and transitioning to a free market economy.

The cost of financial repression manifests in various distortions that have historically affected society as a whole. Below are a few key areas where these costs have been evident.

• Financial repression can compress savers' returns, leading to suboptimal savings and reduced funds for investment. It hinders financial intermediation, limits access to financing, and creates inefficiencies through credit rationing. Imposing additional costs on banks, such as minimum deposit rates, can harm bank profitability, hinder capital adequacy ratios, and increase financial stability risks.
• By weakening price signals, financial repression also distorts the allocation of investment, reducing its average quality and rate of return.
• By warding rents to a limited number of beneficiaries, it encourages wasteful rent seeking, which may take illegal forms (such as corruption).

6. The Persistence of Financial Repression in the 21st Century

Financial liberalization began in the 1970s and continued throughout the 1990s, with the majority of countries, particularly developed economies, undertaking significant liberalization measures in various sectors of their financial markets.?

Figure 4 illustrates the share of countries implementing interest rate controls (left side) and the Interest Rate Control Index (right side), which ranges from 0 (highest level of interest rate control) to 3 (market-driven rates). The graph clearly shows that the liberalization process peaked during the 1990s, but there has been a notable policy shift since the Great Financial Crisis of 2008.

In recent times, we have witnessed a wave of populism and a resurgence of protectionist rhetoric in many countries. As a result, governments are resorting to a few repressive tools, primarily aimed at safeguarding specific sectors from external competition. These measures are often justified under the banner of national food and technology security. In the upcoming discussion, we will delve into a few examples from recent history that highlight the implementation of these tools.

6.1 South Korea Capital Controls 2010-11

During the period of 2010-11, South Korea implemented temporary capital controls to address concerns related to excessive short-term capital inflows and volatile exchange rates. These measures were primarily aimed at stabilizing the country's financial markets during the global financial crisis.

One of the key steps taken by South Korea was to tighten regulations on currency derivatives trading. This involved imposing restrictions on speculative activities in the derivatives market, particularly targeting short-term speculative capital flows. By implementing these regulations, South Korea aimed to reduce the potential risks associated with currency speculation.

Additionally, South Korea introduced restrictions on foreign exchange transactions to discourage short-term speculative investments. This included limitations on non-resident investment in local bonds, as well as stricter requirements for foreign exchange conversions.

6.2 India's Directed Lending for Agriculture

India has utilized directed lending policies to prioritize the agriculture sector, recognizing its importance for food security and rural development. Here's an example with relevant data:

According to the Reserve Bank of India, in the financial year 2020-2021, agricultural credit disbursement in India amounted to approximately 16.4 trillion rupees (around $224 billion USD). This marked an increase of 9% compared to the previous year.

The Indian government has implemented credit quotas and lending targets for banks to ensure the availability of credit to the agriculture sector. Financial institutions are required to allocate a specified portion of their lending to farmers, rural households, and agri-related businesses. These measures aim to support agricultural activities, enhance productivity, and provide financial inclusion for rural communities.

6.3?Agricultural Credit Policy of the European Union (EU)

The European Union (EU) has implemented a direct lending policy for agriculture, through which it provides financial institutions with instructions to prioritize lending to farmers and rural businesses. This policy is designed to strengthen the agricultural sector and stimulate economic growth in rural areas across the EU.

The EU's direct lending policy is a key component of its Common Agricultural Policy (CAP). The CAP is a comprehensive set of policies that aim to ensure the long-term viability of the agricultural sector in the EU. The direct lending policy is one of the ways in which the CAP supports farmers and rural businesses by providing them with access to essential financial resources.

The EU's direct lending policy is a significant commitment to the agricultural sector. It is a clear signal that the EU is committed to supporting farmers and rural businesses and that it believes that agriculture plays a vital role in the overall economy. The policy is also a testament to the EU's determination to create a more sustainable and prosperous future for its member states.

6.4 What to expect

Public debt is on the rise in both advanced and emerging economies. The COVID-19 pandemic has further exposed supply chain vulnerabilities, intensifying tensions among countries. Today, nations prioritize the availability of essential products such as food and medicine over the cost advantages offered by offshore production hubs.

The current urgency to address the debt overhang surpasses that of half a century ago. While post-World War II mainly saw public debt as the primary concern, with the private sector having undergone a challenging deleveraging process during the 1930s and the war, today's debt overhang extends to various sectors within advanced economies. It affects households, firms, financial institutions, and governments to varying extents, raising concerns about financial health and overall stability. Resolving this extensive debt burden becomes crucial to mitigate potential risks and ensure long-term sustainability.

Looking ahead, we may witness the implementation of softer tools of financial repression, as evidenced by recent legislation in the US and EU. These measures involve supporting critical sectors and imposing local sourcing requirements on consumer goods. However, emerging economies may face limitations in utilizing interest rate controls due to their significant external currency debt, which renders such policies less effective. Nevertheless, both advanced and emerging countries can employ capital controls, as exemplified by recent restrictions imposed by the US and EU on investment in China, and vice versa. These developments signify the potential expansion of financial repression measures across regions, driven by governments' efforts to safeguard domestic industries and manage capital flows.

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