Policy makers are now systematically undermining trust in instruments and institutions, and are turning to financial repression in trying to deal with the current economic crisis.
Financial repression, a term coined in 1973 by Stanford economists Edward Shaw and Ronald McKinnon, entails a variety of measures to channel funds to governments to help liquidate otherwise unsustainable debts. It can take the form of higher taxation, manipulating interest rates, regulations to force purchase of government bonds, controls on the free movement of capital and nationalisation of businesses or seizure of savings. Ironically, financial repression is generally packaged as measures to ensure the stability and solvency of the economic and financial system.
Current government policies focus on low interest rates, with returns artificially set below the true inflation rate. Where interest rates are near zero, governments print money, manipulating the amount rather than the price of money.
These measures reduce borrowing costs, allowing borrowers to maintain high levels of debt. Rates below the rate of inflation help reduce the value of the debt, effectively decreasing the amount that must be paid back in economic terms. The policy subsidises borrowers at the expense of savers.
These policies debase currencies, undermining money’s function as a mechanism of exchange and a store of value. Investors in government bonds, once an unquestioned store of wealth, are now threatened by the risk of sovereign defaults or destruction of purchasing power. Some nations have used regulations and political pressure to force banks and investors to adopt patriotic balance sheets. This entails institutions purchasing government bonds and prioritising lending to domestic borrowers.
More aggressive financial repression is also evident. In the restructuring of Greek debt, retrospective legislation was used to deliberately prefer official creditors including European Central Bank (ECB), allowing them to avoid losses at the expense of other creditors. Unsurprisingly, investors are now reluctant to finance some governments, fearing adverse future changes to their legal status.
Governments have seized private savings or have directed it into approved investments. In Spain, the approximately €60 billion Fondo de Reserva was created to guarantee pension payments in times of hardship. The fund’s investments now constitute primarily (97.5 percent) of Spanish government bonds.
According to data from Bank of Spain, Spanish government entities hold around 14 percent of the total government debt of around €658 billion. Encouraged by the Spanish government, and financed by the national central bank and the ECB, domestic banks hold a further 31.5 percent. In contrast, foreign investor holdings of Spanish government debt have fallen to around 37 percent from around 50 percent in 2011.
Purchases by such captive investors have helped the Spanish government finance itself and also reduced its cost of borrowing. Exposure to the government increases the risk to these investors in case of a restructuring of Spanish government debt and its ability to meet its future liabilities to its beneficiaries.
Portugal used its own pension fund to meet its 2011 deficit targets, having already raided Portugal Telecom’s pension fund the previous year. Argentina has seized pension funds, central bank foreign exchange reserves and re-nationalised YPF, the national oil company, allowing the government access to $1.2 billion of annual profits. Bolivia has nationalised Transportadora de Electricidad, the national power-grid company.
In India, tax authorities retrospectively imposed a large tax liability on UK telecom firm Vodafone. Raghuram Rajan, head of RBI, commented: “A government that changes the law retrospectively at will to fit its interpretation introduces tremendous uncertainty into business decisions, and it sets itself outside the law. [It] has missed a golden opportunity to show its respect for the rule of law even if it believes the law is poorly written. That is far more damaging than any tax revenues it could obtain by being capricious.”
The ECB has implemented programmes that entail ‘monetary financing’, that is, central bank funding of governments prohibited under European Union treaties. As Jens Weidmann, president of the German central bank, the Bundesbank, warned in November 2011: “I cannot see how you can ensure the stability of a monetary union by violating its legal provisions.”