Increased risk of financial repression

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The author is T. Rowe Price's chief European economist.

Financial markets and fiscal rules are putting pressure on governments to reduce historically high public debt-to-GDP ratios. Fiscal restraint and inflation are politically unpopular ways to do that. And given the lower expected real GDP growth, getting out of debt is less likely today. What is known as financial repression appears to be the path of least resistance to reducing debt and keeping bond vigilantes at bay.

It is defined as a policy with the express purpose of reducing the cost of government debt, such as by forcing down real interest rates or inducing central banks and commercial banks to buy up government debt. There is historical precedent for financial repression being used as an effective solution to reducing public debt burdens. In response to the accumulation of debt from World War II, the U.S. Federal Reserve fixed interest rates on government debt at low levels until 1951. The Federal Reserve then kept interest rates below inflation levels for many years. As President of the United States, Richard Nixon pressured Federal Reserve Chairman Arthur Burns to ease monetary policy in 1971 ahead of the 1972 election. His recent IMF working paper estimates that financial repression during this period reduced the debt-to-GDP ratio by more than 50 percent.

Subtle restraint in bond markets can be achieved by governments relying on central banks. Despite quantitative tightening programs to reverse years of asset purchases, central banks will continue to be important participants in government bond markets. And they will need to intervene in times of market turmoil. The Bank of England was able to temporarily maintain support for the bond market after the 2022 gilt crisis. However, there is a risk that this type of central bank intervention will become more common and persistent.

Attempts to shift central bank losses onto commercial banks can also be a form of repression. Central banks are currently facing huge losses. This is because the yield on central banks' investments in government bonds is much lower than the interest rate on the reserves issued to fund the purchase of government bonds during quantitative easing. There is active debate about whether the majority of these reserves should be zeroed out. This would push costs onto commercial banks and, by extension, borrowers and savers, and hinder the capital allocation process.

A more direct form of repression of banks and bond markets can occur through the abuse of regulatory policies. After the financial crisis, bank liquidity requirements were designed to ensure that banks had enough liquid assets to sell in the event of a crash. This liquid asset is typically government debt. Financial repression requires banks to hold significantly more government debt than is necessary for prudential purposes. In fact, this has been Italy's strategy for the past decade. Recently, Italian banks have been divesting from government bonds. However, public debt as a percentage of total bank assets is still about 10 times that of Germany or France. More governments may adopt this approach in the future.

Issuing bonds directly to individual investors also amounts to financial repression when the scale is large and the specific objective is to reduce bond yields. Banks are unlikely to offer the same high yield on savings accounts due to brokerage fees. Therefore, selling bonds directly to retail investors siphons money from bank accounts. These funds finance government borrowing rather than being brokered to the private sector.

The economic consequences of financial repression are significant. These policies crowd out private sector investment. This will lead to lower growth and inflation in the short run, as funds that would have been invested in private sector capital stock will instead be spent on servicing and servicing public debt. However, in the medium term, the supply side of the economy will become more structurally rigid due to lower capital accumulation. As demand increases, inflation increases, which structurally increases interest rates.

Obviously, it is easier to suppress domestic investors than foreign investors. This increases risk for countries that rely on foreign funds to finance their bond issuances. If foreign investors stay away due to fear of repression, bond yields will need to rise to attract more domestic investors. It is up to politicians to decide whether financial repression is the way to solve the current fiscal problems of developed countries. However, it must be recognized that in the long run, such policies can backfire significantly by reducing growth and raising interest rates.