[This blog post is an excerpt from a recent commentary published at TSI]
It is claimed that government indebtedness can be reduced via something called “financial repression”, which is the combination of “price inflation” and interest rate suppression. The idea is that the government debt burden can be made smaller in real terms in a relatively painless way by depreciating the currency in which the debt is denominated while the central bank prevents a large rise in the cost of servicing the debt. At a superficial level it seems plausible and may well be attempted over the years ahead by some governments, including the US government. However, aside from it having never worked as advertised in the past, the problem with financial repression is that when viewed through the lens of good economic theory it is not plausible. On the contrary, good economic theory indicates that the financial repression path leads to the destruction of the currency and economic collapse.
To support their argument, advocates of the idea that financial repression can achieve its intended goal (a reduction in the real government debt burden without dramatically adverse economic consequences) point to the US experience during the decade following the end of the Second World War. During this period there was significant “inflation”, a large reduction in federal government indebtedness and a successful effort by the Fed to prevent the yield on US government bonds from rising to reflect the inflation. However, this is an example of the logical error of observing that ‘B’ followed ‘A’ and concluding that ‘A’ must therefore have caused ‘B’.
In economics there are always many potential influences on an outcome. As a result, to avoid coming up with nonsensical cause-effect relationships you must be armed with prior knowledge in the form of good theory. For example, an observation that over the past twenty years the US unemployment rate has tended to move inversely, with a lag, to the price of beer in Iceland, should not lead to the conclusion that the rate of US unemployment could be reduced by increasing the price of beer in Iceland.
With regard to the US post-War experience, the key to success was not “financial repression”. The keys were the dismantling of New Deal programs, the general freeing-up of the economy, a reduction in government spending (government spending collapsed in the two years immediately after the War and then essentially flat-lined for a few years), and a currency linked to the world’s largest gold reserve. It was the combination of economic strength and restrained government spending, not the combination of inflation and interest-rate suppression, that enabled the US government to greatly reduce its debt burden.
In today’s world, we can safely assume that a general freeing-up of the economy leading to strong real growth is not on the cards.
To envisage what would happen in response to financial repression over the years ahead, bear in mind that if the central bank stops one pressure valve from working then the pressure will blow out somewhere else. For example, by monetising enough government debt the Fed could create a situation involving high price inflation and a low interest expense for the US government, but even in the unlikely event that the US government tried to its rein-in its spending the non-interest-related cost of running the government would surge due to price inflation. As a result, the total amount of government debt would rise rapidly and the Fed would be forced to ramp-up its bond monetisation to keep a lid on government bond yields, causing more “inflation” and giving another substantial boost to the cost of running the government, and so on.
Summing up, in a high-inflation low-growth environment, financial repression would lead to a downward spiral in currency purchasing power and an upward spiral in government indebtedness.
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