Are we in a new era of financial repression?
Government bonds sold off last week. An escalating conflict with Iran pushed oil prices above $105/barrel and inflation expectations higher, sparking a readjustment in sovereign debt markets.
The yield on 30-year US treasuries (which moves in opposite direction to prices) rose to its highest level in almost 20 years and 10-year treasuries also saw their yields rise sharply. Most developed-world sovereigns experienced similar sell offs, with UK, German and Japanese government borrowing costs also reaching their highest levels in decades.
Last week's developments extend a more than five-year-long bear market for government bonds.
Developed-world sovereigns have seen their borrowing costs rise over this period primarily due to two reasons. First, a post-pandemic bounce in activity, followed by energy shocks due to the wars in Ukraine and Iran, has raised inflationary pressures and, therefore, short-term interest rates. Second, growing investor concern that many developed economies will struggle to reduce their historically high levels of post-pandemic debt has also pushed up yields.
Increased borrowing costs have made debt reduction more pressing for western sovereigns. But most have struggled to make progress on that front.
Neither the Trump nor the Biden administration preceding it have made reducing the US fiscal deficit a priority. According to the Congressional Budget Office, the US government's deficit is set to average at around 6% of GDP over the next ten years, taking its debt to a record high by 2036. In Europe, a surge in populism has made it harder for centrist parties to effect structural reforms. France saw four prime ministers resign over a two-year period due to their inability to cobble together support for fiscal tightening. In the UK, despite significant tax rises announced by the Labour government, concurrent increases in spending are set to keep debt-to-GDP levels largely unchanged between now and 2031.
How have governments reduced such high levels of public debt in the past?
The last time the developed world tamed similar levels of debt was after the second world war. Western economies reduced their level of public debt from 100% of GDP in 1945 to around 20% by the 70s. This dramatic decline in indebtedness was largely achieved through what economists call 'financial repression'.
Broadly, financial repression works through two policy channels - government interventions that keep interest rates lower than rates of GDP growth and inflation, and policies that force domestic investors to hold more sovereign bonds.
Both these channels were at work in the post-war period. The UK government capped the Bank of England's benchmark interest rate at 2% from 1932 to 1951. Meanwhile, the US Treasury and Federal Reserve introduced direct yield curve control in 1942, ensuring interest rates were capped at several maturities, from 0.37% for short-dated T-bills to 2.5% for long-term Treasuries, until 1951. The US government also set and maintained interest rate ceilings for bank deposits well into the 80s.
This coincided with the introduction of capital and exchange controls and regulatory changes that created a captive investor base for domestic sovereign debt. In the UK, the Exchange Control Act of 1947 curtailed foreign currency exchanges and stopped British citizens from freely investing in foreign stocks, property or other assets. These restrictions remained in place until 1979, when they were abolished by the Thatcher government. Alongside this, high liquidity requirements were introduced forcing banks and informally pressuring institutional investors to hold more gilts. In the US, specific controls on private capital flows were introduced in the 60s, including a tax on the purchase of certain foreign securities.
These artificially low interest rates and capital controls were maintained over a prolonged period when inflation averaged above 4% in the UK and above 3% in the US. Ownership of gold, often bought as a hedge against inflation, was also severely restricted through this period. The result was a real-terms loss for savers and investors. But public debt, usually denominated in nominal terms, was inflated away.
Although financial repression did the heavy lifting it wasn't entirely responsible for the dramatic reduction in public debt levels. The US and UK governments also maintained primary budget surpluses through this period. Estimates by economic historian Nick Crafts suggest that 60% of the reduction in British debt-to-GDP was delivered through financial repression, with the remaining 40% through primary surpluses. There was a similar split estimated for the US.
Could this be done again?
Some have pointed to the recent interventions in currency and treasury markets by the US government and pressure from the Trump administration on the Federal Reserve to cut rates as early signs of a new era of financial repression. While recent purchases of the yen and long-dated treasuries could both be seen as attempts to bear down on treasury yields, US borrowing costs and benchmark interest rates remain above inflation.
Crucially, financial repression of the post-war scale is highly unlikely to be achievable today. Decades of economic liberalisation make implementing capital controls much harder and politically more contestable now. Caps on interest rates were partly made possible by the enactment of price controls, which did the job of managing inflation in the post-war period. In the open western economies of today, such distortions of the price mechanism would see greater challenge.
The issuance of long-dated bonds during and after the second world war also helped in the sharp reduction of debt-to-GDP by giving inflation years to erode their value. Nowadays, the average maturity of western government debt is far shorter. So, surprises in inflation will be quickly repriced as governments roll over new debt. The fact that despite the extraordinary financial policies of the post-war period, governments still needed to run primary surpluses to tame their debt piles also points to the limits of a similar approach now. Given the older and faster ageing populations across the developed world, welfare spending is much higher and funded by a proportionally smaller base. That will make running primary surpluses, and therefore, delivering a swift reduction in debt levels that much harder.
Most importantly, western central banks are now independent, committed to maintaining low inflation and prize their credibility. They are unlikely to allow artificially low interest rates of the post-war sort.
So, what could financial repression look like today?
To assess what might be possible today, it is instructive to look at the post-global-financial-crisis period, which economists Carmen Reinhart and Beren Sbranica see as having introduced a modern variant of financial repression. Here, quantitative easing programmes supressed borrowing costs while new macroprudential regulation forced financial institutions to increase their holdings of sovereign debt. But the last decade saw inflation in G7 nations average at 1.5%, below the 2% target of most western central banks. That, and the absence of consistent primary surpluses, meant their debt levels did not decrease over the period.
So, the modern variant has demonstrated limited efficacy so far. But rising geopolitical uncertainty, trade restrictions and the energy transition have meant a step change in price pressures since the pandemic. Given this backdrop, markets are increasingly wary of growing inflation risk and any policy interventions that could be seen as suppressing government borrowing costs.
Investors may not see this as a new era of financial repression. But, in this world of elevated policy risk, they will subject the actions of central banks and their relationships with domestic sovereigns to very close scrutiny.
Chart of the week
US households are increasingly reliant on equity markets as a store of wealth. The share of household assets held in equities has risen to a record high of 34%, exceeding the dotcom-era peak of 27% and the share of assets held in real estate (31%) at the peak of the housing bubble.
Low interest rates, quantitative easing and the outperformance of tech firms supported a prolonged rise in US equity prices over the last decade. More recently, a rapid appreciation in AI-related stocks has extended the bull run. The US S&P 500 index has risen nearly eight-fold since 2009, raising the share of household assets held in equities. House prices have only doubled over that period.
Household participation in stock markets has also increased over time. Changes from defined benefit to defined contribution pension schemes has resulted in greater household exposure, while the rapid growth of low-cost investment funds has reduced the barriers to investing. Almost 60% of US households now hold stocks, up from 32% in the late 1980s, according to the Securities and Exchange Commission.
Given their greater exposure to equities, rising valuations have supported US households' spending via a ‘wealth effect’. But it has also raised concerns over the risk of sharp squeeze in consumption should equity markets see a readjustment. Given financial market investments are largely made with cash, most economists think such a correction would likely induce a short-lived recession rather than a prolonged downturn, such as during the global financial crisis, which unwound highly leveraged holdings of real estate.
What we're looking out for this week?
This week will, we’re looking out for interest rate decisions in the UK, US and Japan.
In the UK, labour market and inflation data set to be released this week will inform the Bank of England’s interest rate decision on Thursday. Inflation is expected to have risen to 3.1% last month. But economists expect the Bank to maintain its benchmark rate at 3.75% as policymakers balance growing inflationary pressures due to the conflict in Iran against continuing signs of labour market softening.
By contrast, economists expect the US Federal Reserve to raise interest rates on Wednesday by 25 basis points to a policy range of 3.75%-4%. This follows recent data showing inflation continues to run well above the Fed’s 2% target while the labour market remains resilient. Economists also expect the Bank of Japan to raise interest rates on Friday by 25 basis points to 1.25%. This would be its second rate hike this year, taking its benchmark rate to the highest level since 1995.
And finally...
An amateur goalkeeper and captain for south London club SE Dons is set to leave the club to become king of the Tooro Kingdom in western Uganda. It is widely reported that the goalkeeper, whose team recently reached the second round of the FA cup, is next in line to the throne, which yields significant cultural influence over the region - keeper of the crown