WASHINGTON'S PLAN TO AVOID AN OUT OF CONTROL US DEBT PROBLEM

FINANCIAL REPRESSION: THE COMING BLEND OF OLD & NEW MACRO-PRUDENTIAL MONETARY POLICY APPROACHES

-- SOURCE: Blended excerpts by MATASII from the Financial Repression Authority & Daniel Nevins, Equity.com

When you hold Treasuries, you’re aligning your interests with those of the entire political class, along with the interests of arguably the politicians’ most influential patrons—bankers. You’re gaining the backing of powerful forces, to say the least, and that’s about as powerful a controlling force as you can get!

Whereas many investors consider rising government debt to be a bearish indicator, owing to the risk of default or hyperinflation, I’m saying it should continue to be a bullish indicator, owing to the likely policy responses of Financial Repression. That’s exactly how the situation has played in Japan, whose debt is already well above 200% of GDP, and I don’t see the United States being much different. For now, at least. At some (tipping) point, the risk of default or hyperinflation is likely to overwhelm everything else.

Assuming the United States can avoid World War III, I would place the tipping point well beyond the average investment horizon.  You should expect financial repression to keep the decades-long bull market in Treasuries intact.

WHAT IS FINANCIAL REPRESSION?

Financial Repression is not a conspiracy theory, it is rather a collective set of macroprudential (good-intentioned) policies and regulations focused on controlling and reducing excessive government debt through 4 pillars – negative interest rates, forced inflation, ring-fencing regulations and data obfuscation – which effectively transfer purchasing power from private savings.

This concept was introduced in 1973 by Stanford economists Edward S. Shaw and Ronald I. McKinnon.

This chart shows how the good-intentioned objectives by government & central banks translate into policies, financial reform and regulations which collectively cause unintended consequences ultimately resulting into the adverse risks to investors and retirees:

ELEMENTS OF FINANCIAL REPRESSION

United States debt fundamentals are so weak and so short of politically viable solutions that policy makers will resort to a strategy as old as government borrowing. That is, they’ll exploit every possible method for suppressing US Treasury yields.

I see a potluck table full of yield-suppression methods—within a general category of financial repressionand my nickel’s worth of advice is this: Don’t fight financial repression.

Centuries and even millennia of recorded history show overindebted governments habitually using financial repression as an essential part of their debt management strategies. That’s not likely to change in a cold flash circa 2018.

But even before we look at history, we can see financial repression having significant effects on government bonds today. We only need to look at the bond holdings of commercial banks, as in a recent article by Victor Sperandeo:

As it happens, the biggest buyers of Treasury debt are commercial banks. Just when the Fed started tapering its purchases in December 2013 and left some issuance for private players to absorb, their Treasury and agency holdings started to skyrocket, from $1.8 trillion to $2.55 trillion, as of July 2018.

Sperandeo suggests a few reasons why commercial banks are content to hold so many government securities, despite an almost continuous bearish consensus on that market. His reasons include:

  • The ability to buy bonds with money that banks create from nothing,
  • Banks aren’t required to mark government securities to market for accounting purposes,
  • Zero risk-weighting for government securities in required capital calculations,
  • Banks can “infinitely buy government bonds and still not have to put up additional capital.”

In other words, heavily skewed regulations have gifted banks the proverbial money machine.

By cranking that machine, the banking sector has become a gigantic and somewhat price-insensitive government bond buyer, one on which the Treasury Department can depend even as debt spirals higher.

But accounting regulations and required capital calculations are just a few of the levers policy makers can operate to suppress yields. In the decades immediately following World War II, for example, the United States used tactics including:

  • Caps on deposit rates (Regulation Q),
  • A continuation of the Great Depression–era prohibition on gold holdings.

By making other low risk investments either uncompetitive (bank deposits) or illegal (gold), policy makers ensured plenty of demand for the vast debt America accrued during the war. Bond buyers had little choice but to settle for yields on government securities that were either below or close to inflation rates, and those unusually low real yields helped open a large gap between GDP growth and debt growth.

In over three decades from World War II to the 1970s—a period that scholars Carmen Reinhart and M. Belen Sbrancia have dubbed the “financial repression era”—America’s financial repression triggered an unprecedented drop in the debt-to-GDP ratio.

Of course, when it comes to financial repression, we have to look also at the behemoths in the room—central banks. Much of central banking history is, in fact, a history of governments seeking affordable financing and then tasking central banks with achieving that goal.

Sovereign nations have granted central banks a variety of rights and privileges, and in return, central banks have:

  • Pegged interest rates on government debt,
  • Bought large amounts of government debt, sometimes with a commitment to cover demand shortfalls at the pegged interest rates, and
  • Worked with and regulated privately held banks to further support government financing.

The Federal Reserve, for example, did all of the above during both World War II and the Korean War and throughout the five years in between. And to state the obvious, the Fed once again bullied the Treasury market during the last ten years.

Outside the United States, we’ve seen an even broader array of tactics, especially during Reinhart and Sbrancia’s financial repression era but also in the last decade. Additional forms of repression include

  • Capital controls,
  • More aggressive central bank purchases (the ECB has bought so many German bunds that private investors are left with less than 10% of the market by some estimates) and
  • Directed investments, whereby policy makers require government managed or regulated asset pools to invest in government securities.

In the future, desperate American politicians, who seem to have lost any interest in fiscal discipline as a method for slowing debt growth, could decide to add any of the globally popular financial repression tactics to their policy mix. And don’t scoff—just a few years ago you might have ridiculed anyone predicting a fierce tariff war.

(For anyone interested in the longer history of government financing and financial repression, I recommend Fragile by Designby Charles Calomiris and Stephen Haber, and Founding Financeby William Hogeland, both of which are packed with original insights and helped inform my perspective above.)