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Tuesday, 17 January 2012

How Sneaky Governments Steal Your Money

Debt Do-Do

Many nations in the developed world are in deep do-do with their debt levels. On one hand they need growth to earn their way out of their problems, while on the other they’re being forced into anti-growth austerity measures by markets, concerned about their spiralling interest obligations. It’s a grim position for those of us brought up to expect an unrelentingly rosy economic outlook.

This isn’t a new situation, though. We’ve been here many, many times before and governments have, by design and evolutionary accident, developed many, many ways of dealing with these problems. The cunning thing is that many of these involve stealthily thieving from their own citizens, but done so surreptitiously that, if we’re not careful, we won’t even notice it.

Face Chewing Mosquitos

One of the things that’s being lost in the welter of rhetoric around the debt crises of sovereign nations is that these are not normal debtors, and government debt is not the same as personal debt. If you or I are in debt we’re obliged to fulfil the terms of our repayment obligations or to go bankrupt or to pretend to die and go off and live on the life insurance. A country in the same situation has a range of other measures available to it; for us the law is an immovable object, for a government it’s simply another variable where its own citizens are concerned.

Bond holders in General Motors and Irish junior bank debt have already found this to their cost. In their analysis of the risks associated with these investments they took the existing framework of obligations – both legal and common practice –  as a given. Unfortunately for the bondholders, when the finances of GM and the Irish banks imploded and their respective governments were forced to step in, these “obligations” turned out to be rather less obligatory than the bondholders would have liked, as the politicians favoured their own preferred creditors, taking the view that without government funding the bondholders would have been wiped out anyway.

Bondholders were angered, possibly with just cause, but in part they only had themselves to blame because they’d failed to understand the rights of sovereign governments to interpret, or even change, the legal framework within which they were operating. Political risk is something less sophisticated investors need to try and avoid, if at all possible.  To take a broader example, consider our freedom to go about our everyday business unimpeded by restrictions on what we do and where we go.

So how would you feel if you were yanked off the street, handed a rifle and a tin hat and then sent half-way across the world to lie in a swamp getting your face chewed off by mosquitoes in order that unknown people could take pot-shots at you for reasons you don't understand? But, of course, this has happened in living memory – conscription or the draft in times of war was, for a long time, part of the pattern of everyday life and not one people had much choice over: governments have the ability to change their terms of engagement with their citizens, and their creditors if they so wish.

The Liquidation Effect

When it comes to managing the mountain of debt they’re currently sitting on this control offers governments a number of get out clauses not available to you or I. However, if chosen, they will leave us considerably poorer than we are today, as our cash gets drafted in the service of our nations.

A paper by Carmen Reinhart and Belen Sbrancia, The Liquidation of Government Debt, has looked at the issue of how governments have historically dealt with debt mountains. Reinhart, in collaboration with Kenneth Rogoff, has previously examined government debt defaults (see Triumph of the Pessimists), and how remarkably common they are, contrary to our general expectation, a sure sign of disaster myopia (aka It's Not Different This Time).  Here, though, she expands on this to look also at the other ways in which governments can use their privileged positions to manage down debt – methods that the authors refer to as “financial repression”:
“Financial repression includes directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks.”
Financial Repression

So, for instance, governments can regulate that pension funds must hold certain types of security – which, it might so happen, turn out to be government bonds, which might be quite useful if you have to sell bucket-loads of them in order to keep your finances in good order. However, normally associated with this is one common factor:
“Financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation. Inflation need not take market participants entirely by surprise and, in effect, it need not be very high (by historic standards).”
The pillars of financial repression that the authors list include ceilings on interest rates – which can be explicitly legislated for or can be implicit, through mandated central bank targets for instance – creation of a captive domestic audience, through blunt measures like exchange controls or more subtle ones like the pension liability issue mentioned above, and enforcing more or less direct control of bank lending policies. All of these can be used to draft domestic markets into lending to governments and, accompanied by a bracing dose of inflation, can reduce the real value of that debt – often quite quickly.

Negative Interest

The paper shows that there have been five debt crises over the past hundred years, including the latest one, and the last two, since World War II, have both been accompanied by financial repression. The key to these measures, which are many and varied in nature, are to keep nominal interest rates lower than would otherwise be the case, which reduces the interest payable by governments. If you add in inflation this can lead to effective negative interest rates, and the rapid erosion of the debt mountain.

A “negative interest rate” is simply where the interest we get on our cash is less than the prevailing rate of inflation. The beauty of these measures, from a politician’s perspective, is that they’re not obvious to the general public – as the authors state:
“The financial repression tax has some interesting political-economy properties. Unlike income, consumption, or sales taxes, the “repression” tax rate (or rates) are determined by financial regulations and inflation performance that are opaque to the highly politicized realm of fiscal measures. Given that deficit reduction usually involves highly unpopular expenditure reductions and (or) tax increases of one form or another, the relatively “stealthier” financial repression tax may be a more politically palatable alternative to authorities faced with the need to reduce outstanding debts.”
Money Illusion

Interestingly the paper indicates that real US interest rates have only rarely been as high as 3% since 1945 and were under 1% for over 60% of the time. The use of financial repression was highly effective at reducing debt levels – 2% to 3% a year rapidly makes a difference:
“The UK’s history offers a pertinent illustration. Following the Napoleonic Wars, the UK’s public debt was a staggering 260 percent of GDP; it took over 40 years to bring it down to about 100 percent (a massive reduction in an era of price stability and high capital mobility anchored by the gold standard). Following World War II, the UK’s public debt ratio was reduced by a comparable amount in 20 years.”
This relies on the sleight of hand that lies behind money illusion – the idea that people focus on nominal interest rates rather than real ones. Unfortunately, this seems to be hardwired into people.  Of course, if financial repression was on the cards then we might expect to see abnormally low interest rates, stubbornly high inflation rates and governments imposing all sorts of new capital holding requirements on banks and pension funds. We’d better keep an eye open for those, then …

Booming and Busting

A number of commentators have noted that there's an interesting corollary to the periods of financial repression in developed countries post war - the economies of those countries boomed.  That's fine if you're happy to reduce government debt by impoverishing savers at the expense of borrowers, and even more fine if the government is prepared to take up the slack by offering retirees inflation adjusted pensions. However, if governments are determined to cut back on such benefits as well, then a future booming economy isn't going to benefit everyone, and it's every investor for themselves as we all look for safe havens.

If financial repression was to occur then inflation linked bonds – which are generally expensive anyway – and higher yielding, “safe” equities (whatever those are) along with some gold would probably be about as safe as you could get. What you wouldn’t want to be doing is holding cash or those ultra-safe government bonds for anything other than the very, very short term.


  1. Any financial liability by definition requires a corresponding financial asset. "Dealing" with government debt implies not only to changes to liabilities but also equivalent changes to assets. These assets become non-performing and need to be written down. Government is an abstraction built on all layers of society.

  2. Yep.
    Inflation is the hidden tax.

    And since there is seldom political will to raise taxes or cut spending, it is so much easier to let inflation 'accidently' ramp up and then point the finger at the other guy.

    Of course, most people don't realize this, which is why owning pieces of successful businesses (stocks) is considered 'risky', but holding cash is considered 'safe'.

  3. For some reason I do not understand that,Government of Canada bonds can just drop the interest rate without notifying the bond holders. As of the end of December 2011 January 1st 2012. My bonds went from 2.65% to 1% Without any notice of any kind.Also they were supposedly the good bonds

  4. "are to keep nominal interest rates lower than would otherwise be the case"

    Ewwww. Blech. What a horrible meme. You have glossed over the entire subject of macroeconomics... manipulating interest rates is somehow "artificial".

    OK, wise guy. What should the Bank of England do to interest rates right now which will make us all better off? How will it affect the unemployment rate? You need a very strong counterfactual to make the case that interest rates are "artificially" low.

    The other thing you gloss over is that for most purposes the UK inflation numbers are just noise.

    The type of inflation which eases the real debt burden is fast growth of *nominal incomes*, not prices. For the government, nominal GDP is the benchmark. For households, it is wages.

    We do *not* have high inflation in nominal GDP or wages - the growth rate of those is both low and WAY off the trend growth line. In fact, the OBR recently *downgraded* the nominal GDP growth expectations for the next couple of years. That is not what "stubbornly high inflation" looks like.

  5. Hi impedant

    You seem to be interpreting the article as a description of the current state of the British economic policy. However, the article isn't saying that, merely that the research of Reinhart and Sbranica into the post-war history of financial repression suggests that it's a future possibility in some countries and that governments have a whole range of measures at their disposal to ensure this - including the creation of a group of captive bond investors who can be made to purchase bonds virtually regardless of yield. Of course, whether you regard the resultant interest rates as artificial or not is dependent on your view of the role of markets in price setting. There's also a wider question about whether such measures could be successful in today's globalised markets, but that's an argument for another day.

  6. My company has been voted as the fastest growing companies by Inc Magazine and being a best selling author, I think it is my responsibility to write something on this! I have contemplating for quite some time, but couldn't materialize it, Will be writing on government stealing your money pretty soon!