Financial repression - myth, metaphor and reality

Financial repression:

“a pejorative term akin to political repression”, Ronald McKinnon

“a technical term”, Carmen Reinhart

A spectre is haunting economists and creditors across the world – the spectre of “financial repression”. The fear that governments may throw regulatory grit into the otherwise frictionless working of the financial services machine, and so limit the “freedom” of the machine’s owners to manufacture financial gains however they will, wherever they will, whenever they will.

The financial sector, let us recall, caused the 2008/9 crash through greed and speculation, was bailed out by governments and taxpayers in gigantic sums, which led to rises in public sector debt as measures were taken to rescue economies and look after victims of the crash.

But now the financial sector and its intellectual lobbyists are deeply concerned.  Concerned, that is, to protect their assets and interests.

On 8th January 2014 on the BBC Today Radio 4 programme, emerging market investor Jerome Booth told listeners:

We’re certainly going to have to have a decade or so of reducing the debt through maybe inflation eventually. At the moment it is through financial repression.

Asked what this meant, he defined financial repression as “any policy which captures domestic savings in order to fund the government and to do so at lower cost.”

He added that after the Second World War, “financial repression basically stole the money of savers over many, many years.”

“Captures”, “stole”, “repression” – this is emotive language.  In Metaphors We Live By (first published in 1980) George Lakoff and Mark Johnson argued that our use of language – indeed language itself - is pervaded by coherent systems of metaphors which we may no longer be conscious of.  They explain:

Political and economic ideologies are framed in metaphorical terms. Like all other metaphors, political and economic metaphors can hide aspects of reality. But in the area of politics and economics, metaphors matter more, because they constrain our lives. A metaphor in a political or economic system, by virtue of what it hides, can lead to human degradation.

“Financial repression” is self-evidently a metaphor.  Someone or something is being kept down by the repressor, evoking mental images such as tanks crushing peaceful demonstrations, or robber barons “capturing” or “stealing” your money.

The term was first coined in 1973 by two Stanford University economists, Ronald McKinnon and Edward Shaw, who worked in the field of LDCs (“less developed countries”). That year, McKinnon’s book Money and Capital in Economic Development was published, as was Shaw’s Financial Deepening in Economic Development.

McKinnon’s thesis begins as follows:

Most of the population, and most actual and potential entrepreneurs, in LDCs (especially in rural areas) are not served by the banking system.  They are forced into the hands of local moneylenders and pawnbrokers at very high rates of interest. They are thus financially repressed.

Here at the outset, it is poor people who are the victims of financial repression. In this context the metaphor seems to makes sense. McKinnon’s remedy is to remove maximum rates on interest rates (usury ceilings), and thus to encourage the banking system to increase and broaden lending, at very high real rates of interest – of around 15-25%.

However McKinnon is not consistent in his assessment of who is being repressed.  At another point he writes:

Unfortunately, the more usual method in LDCs is to maintain a small and repressed monetary system and then to rely on a battery of fiscal and other interventions in commodity and factor markets as a substitute for bank intermediation. [My emphasis]

A repressed monetary system? He has shifted the metaphor from the “repressed rural masses” to the “repressed monetary system”. And both he and Shaw go on to use it generally in this sense.

Recently, he has disclosed that he coined the term “financial repression” to make a political point.  In his paper “Hot Money Flows, Commodity Price Cycles, and Financial Repression in the US and the People’s Republic of China” (January 2013) co-authored with Zhao Liu, he explains its origin:

In the 1970s, the term financial repression originated with McKinnon and Shaw when inflation was a problem in a number of less developed countries (LDCs). In the 1960s and 1970s, governments in many LDCs intervened to put ceilings on nominal interest rates and impose high reserve requirements on their banks, along with other techniques to direct the flow of credit in the economy…Wanting to find a pejorative term—akin to political repression — to describe this syndrome, McKinnon and Shaw first used the term financial repression in 1973. (My emphasis).

Here we are in classic Lakoff and Johnson territory. This is a politically-driven metaphor the finance sector and economics profession have lived by for over 40 years!

Many orthodox economists followed McKinnon and Shaw in using “financial repression” as a concept. Only a few economists challenged it: for example Carlos Diaz-Alejandro, in a 1984 paper with the great title “Good-bye financial repression, hello financial crash”:

This paper seeks to understand why financial reforms carried out in several Latin American countries during the 1970s, aimed at ending “financial repression”, as defined by Ronald McKinnon … and generally seeking to free domestic capital markets from usury laws and other alleged government-induced distortions, yielded by 1983 domestic financial sectors characterized by widespread bankruptcies, massive government interventions or nationalizations of private institutions and low domestic savings.

In recent times, alas, many others – including those of a generally progressive bent, such as Duncan Weldon of the TUC, Larry Elliott of the Guardian, and Paul Mason (when Economics Editor of BBC’s Newsnight) have been drawn into using the term as if it were value-free.

It is relentlessly promoted by Carmen Reinhart, co-author with Kenneth Rogoff of the 2010 paper “Growth in a Time of Debt”. This publication was famously replete with spreadsheet errors and flawed conclusions, but was nonetheless frequently cited by leading conservative politicians in the US, UK and Eurozone as intellectual ballast for austerity policies.

In an interview with Der Spiegel in April 2013, Ms Reinhart described financial repression as a “technical term”:

SPIEGEL: When the inflation rate is higher than the interest rates paid on the markets, the debts shrink as if by magic. The downside, though, is that this applies to the savings of normal people.

Reinhart: The technical term for this is financial repression. After World War II, all countries that had a big debt overhang relied on financial repression to avoid an explicit default. After the war, governments imposed interest rate ceilings for government bonds. Nowadays they have more sophisticated means.

SPIEGEL: Which means?

Reinhart: Monetary policy is doing the job. And with high unemployment and low inflation that doesn't even look suspicious. Only when inflation picks up, which is ultimately going to happen, will it become obvious that central banks have become subservient to governments.

For Reinhart, anything that impedes the finance sector in any way is deemed to be financial repression.  In a 2011 paper co-authored with Maria Belen Sbrancia entitled “The Liquidation of Government Debt”, she asserted that “financial repression” can include any of the following:

- Explicit caps or ceilings on interest rates, including caps on rates charged by the finance sector to governments

- Indirect caps or ceilings on interest rates

- Capital account restrictions

- Exchange controls

- High reserve requirements,

- Requirements to hold government debt,

- “Prudential” regulatory measures requiring that institutions hold government debts in their portfolios

- Transaction taxes on equities,

- Prohibitions on gold transactions,

- Direct ownership of banks and other financial institutions

- Extensive management of banks and other financial institutions

- Restrictions of entry to the financial industry

- Directing credit to certain industries.

In their famous 2009 book “This Time is Different”, Kenneth Rogoff and Carmen Reinhart analyse banking and financial crises from 1900 to 2008. They include a chart (Figure 13.1, p.205) which plots the proportion of countries with banking crises, weighted by their share of world income.  The chart shows several crisis peaks from 1900 to 1928, then the giant peak of the Great Depression, falling back to almost zero in 1940. The chart is flat at zero from 1950 to 1972 – in other words there are no financial crises of any significance over this period - after which the chart rises and falls dramatically: most recently in 2008-9.

In other words, the post-1945 age of so-called “financial repression” was an age of stability, and in many parts of the world, of sustained economic progress.  The authors’ comment is revealing:

Figure 13.1 also reminds us of the relative calm from the late 1940s to the early 1970s.  This calm may be partly explained by booming world growth but perhaps more so by the repression of the domestic financial markets (in varying degrees) and the heavy-handed use of capital controls that followed for many years after World War II …

Since the early 1970s, financial and international capital account liberalization – reduction and removal of barriers to investment inside and outside a country – have taken root worldwide. So, too, have banking crises  (my emphasis).

In the early 1980s, a collapse in global commodity prices, combined with high and volatile interest rates in the United States, contributed to a spate of banking and sovereign debt crises in emerging economies, most famously in Latin America and Africa. High interest rates raised the cost of servicing large debts… Falling prices for commodities, the main export for most emerging markets, also made it more difficult for them to service debts. (my emphasis)

That is, emerging countries were hit by high interest rates (advocated, let us recall, by the creators of the demon of “financial repression”) set not locally, but in the USA.

Rogoff and Reinhart also find that

banking crises almost invariably lead to sharp declines in tax revenues… On average, during the modern era, real government debt rises by 86 percent during the three years following a banking crisis.

In brief, policies of financial liberalization are far more likely to lead to private sector banking crises, which then have a grave impact on public finances and thus on public services. Yet we are supposed to believe that “financial repression” is always a bad thing, something akin to political repression!

In a response to her 2011 paper co-authored with Ms Sbrancia, Professor Alan Taylor, University of California at Davis and adviser to Morgan Stanley, neatly but politely dissects (from p.49) the flawed logic and approach of Ms Reinhart, and indeed of the “financial repression” concept.  He concludes, under the sub-heading “Financial regulation sounds better than financial repression” (at  p.53):

We must be wary of confusing financial repression (which sounds like a terrible thing) with financial regulation (which sounds a good deal more wholesome).  In the context of current debate on how better to regulate the financial sector after the recent debacle, it is entirely understandable that the authorities have decided that banks and other entities were given far too much leeway to pursue activities that were not only self-destructive, but also destructive of the wider economy…

Whether we call it financial repression, lack of competition, tough regulation, the fact remains that the 1945 to 1975 era was a glorious period of economic growth in the advanced countries, as well as in many emerging economies.  It was a time of rapid economic growth with the allocation and mobilization of large amounts of capital, generalized macroeconomic and financial stability, sustained real wage growth and low unemployment.

For good reason, it is a time remembered glowingly through terms such as The Golden Age, Les Trente Glorieuses, and so forth. In marked contrast, the subsequent thirty-some year period from 1975 to the present has been one of financial liberalization, but at the same time has seen a pronounced slowdown in growth and capital accumulation, more financial crises, real wage stagnation, and elevated unemployment.

Despite this, the “financial repression” meme rolls on. From its origins as a call for action to help small rural farmers access credit, it is now a general term of abuse of governments whenever, and for whatever motive, they regulate the activities of the finance sector.

Yet curiously, while creditors and their economist allies cry “foul, financial repression” whenever real rates are negative, they do not see other falls in real returns in the same light. Take the “theft” of savings by the financial services industry, through financial failures, absurd administration charges or extremely low annuity payments. But above all, take the long-standing and continuing fall in real rates of pay to employees – both in the UK and US. So far no economist, to my knowledge, has described this fall in incomes as “financial repression”.

So let’s invent our own pejorative term for this. Not a “metaphor to live by” perhaps, but one to just about scrape a living by.

How about “financial oppression”?