Friday, January 5, 2018

Paper: "The Liquidation of Government Debt" by Carmen M. Reinhart and M. Belen Sbrancia

From an IMF paper called The Liquidation of Government Debt by Carmen M. Reinhart and M. Belen Sbrancia:

The term financial repression was introduced by Edward Shaw (1973) and Ronald McKinnon (1973). Subsequently, the term became a way of describing emerging market financial systems prior to the widespread financial liberalization that began in the 1980s (see Agenor and Montiel, 2008, Giovannini and de Melo, 1993, and Easterly, 1989). As we document, financial repression was also the norm for advanced economies during the post-World War II period and in varying degrees up through the 1980s. We describe here some of its main features.

(i) Explicit or indirect caps or ceilings on interest rates, particularly (but not exclusively) those on government debt. These interest rate ceilings could be effected through various means including: (a) explicit government regulation (for instance, Regulation Q in the United States prohibited banks from paying interest on demand deposits and capped interest rates on saving deposits); (b) ceilings on banks’ lending rates, which were a direct subsidy to the government in cases where it borrowed directly from the banks (via loans rather than securitized debt); and (c) interest rate cap in the context of fixed coupon rate nonmarketable debt or (d) maintained through central bank interest rate targets (often at the directive of the Treasury or Ministry of Finance when central bank independence was limited or nonexistent). Allan Meltzer’s (2003) monumental history of the Federal Reserve (Volume I) documents the US experience in this regard; Alex Cukierman’s (1992) classic on central bank independence provides a broader international context.

(ii) Creation and maintenance of a captive domestic audience that facilitated directed credit to the government. This was achieved through multiple layers of regulations from very blunt to more subtle measures. (a) Capital account restrictions and exchange controls orchestrated a “forced home bias” in the portfolio of financial institutions and individuals under the Bretton Woods arrangements. (b) High reserve requirements (usually non-remunerated) as a tax levy on banks (see Brock, 1989, for an international comparison). Among more subtle measures, (c) “prudential” regulatory measures requiring that institutions (almost exclusively domestic ones) hold government debt in their portfolios (pension funds have historically been a primary target). (d) Transaction taxes on equities (see Campbell and Froot, 1994) also act to direct investors toward government (and other) types of debt instruments. And (e) prohibitions on gold transactions.

(iii) Other common measures associated with financial repression aside from the ones discussed above are, (a) direct ownership (e.g., in China or India) of banks or extensive management of banks and other financial institutions (e.g., in Japan) and (b) restricting entry into the financial industry and directing credit to certain industries (see Beim and Calomiris, 2000).
They go on to say:
One of the main goals of financial repression is to keep nominal interest rates lower than would otherwise prevail. This effect, other things equal, reduces the governments’ interest expenses for a given stock of debt and contributes to deficit reduction. However, when financial repression combined with inflation produces negative real interest rates, this also reduces or liquidates existing debts. It is a transfer from creditors to borrowers. The financial repression tax has some interesting political-economy properties. Unlike income, consumption, or sales taxes, the repression tax rate is determined by financial regulations and inflation performance that is opaque to most voters. 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.
Very good thinking. I can certainly see these types of moves being used against the US's (and states' and municipalities') debts. Just the federal debt is now $20.5 trillion [Dec 2017 PDF], which is getting closer to the value of all the S&P 500 companies' equity.

However, as I have pointed out many times, these financial repression moves do not help with the governments' obligations to pay retirement benefits: particularly Social Security and Medicare. (These are only counted within the $20.5 trillion federal debt number to the extent that the federal government has put aside IOUs from itself to pay for them.)

Where everyone else now sees a "permanently high plateau" for asset prices, I see upcoming political battles. At the state and local level, they will be between public employee retirees (many of whom robbed their employers blind), taxpayers, and bondholders. Note that the bondholders are the most unsympathetic characters and politically impotent. Not a good combination. I would expect a bull market in long-form journalism about the retirement benefit abuses committed by public sector workers; the better for taxpayers to mobilize and rescind the excessive promises.

At the federal level, the battles will be between taxpayers, Social Security/Medicare bagholders, and the military industrial complex. I expect higher corporate and individual taxes in the future. (Notice we raised the idea of eliminating the SALT deduction in 2011.) Social Security stands a decent chance of prevailing mostly intact because it is a big group with free time that has cohesive interests and will be hard to divide and conquer. Medicare is much less defensible. And despite the fact that non-nuclear forces are obsolete and of no benefit to ordinary Americans, the only MI-complex expenses that I can see being cut would be the massive procurement boondoggles. The vast majority of Americans think that the military somehow "protects their freedoms".

Here are some of my thoughts on how to handle this:
  • Keep Treasury maturities short. I have written about this extensively [see 1 and 2 recently]. Short term paper seems to be safe - watch T bill yields rising and rising! Being in the six month zone seems to be a sweet spot right now. Note that the yield curve is currently so flat that this isn't exactly a hard decision. The 30 year Treasury currently yields only one percent more than the 1 year Treasury.
  • Don't be too dependent on Medicare. It will be a lot easier to ration medical care than to repudiate the Social Security obligations. There may be means testing for SS, or maybe raising taxes on the payments (currently only 50-85% is taxable), but Medicare can be re-engineered in ways that are more difficult to notice. So, think Mangan.
  • Don't be long stocks at a 33x CAPE or corporate bonds at ultra low credit spreads. The "indexing" strategy is going to have a comeuppance. Also, sharply rising rates (i.e. a sovereign debt crisis) would cause earnings multiples and corporate profits to crash.
  • Watch for situations where politics will trump capital structure and contracts. Remember Indiana State Police Pension Trust v. Chrysler LLC?
This too shall pass: Bitcoin, Etherium, Ripple, girls wearing shirts that say Après Moi Le Déluge, unprofitable startups by the thousands, Tesla, crappy banks trading at 1.5x book value, bugmen on the west coast making mid six figures, tearing down perfectly good houses to build gigantic ones.

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