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The author is chief economist for Europe at T. Rowe Price
Financial markets and fiscal rules are putting pressure on governments to reduce historically high levels of national debt to GDP. Fiscal restrictions and inflation are politically unpopular ways to achieve this. And given low expected real GDP growth rates, exiting debt is less likely today. So-called financial repression appears to be the path of least resistance to reduce debt and keep bond watchdogs at bay.
This refers to any policy with the express aim of reducing the cost of national debt – such as lowering real interest rates or directing central banks and commercial banks to buy government bonds. Financial repression has always been an effective solution to reduce the burden of national debt. After the accumulation of debt during World War II, the Federal Reserve kept interest rates on government debt at low levels until 1951. The Fed then kept interest rates below inflation for many years. As US President in 1971, Richard Nixon put pressure on Fed Chairman Arthur Burns to loosen monetary policy in the run-up to the 1972 elections. A recent IMF working paper estimates that financial repression during this period has led to a reduction in the debt ratio by over 50 percentage points.
A subtle suppression of bond markets can be achieved by governments relying on their central banks. Central banks will remain important participants in government bond markets, despite quantitative tightening programs to reverse years of asset purchases. And they have to intervene in times of market turmoil. The Bank of England successfully maintained its support in the bond market following the Gilt crisis in 2022. However, there is a risk that this type of central bank intervention will become more frequent and permanent.
Attempts to pass on central bank losses to commercial banks can also be a form of repression. Central banks are currently suffering major losses. This is because the return on central bank investments in government bonds is much lower than the interest rate on the bank reserves issued to finance the purchase of these bonds during quantitative easing. There is a lively debate about whether a larger portion of these reserves should be revalued at zero. This would shift the costs to commercial banks and ultimately to borrowers and savers and affect the capital allocation process.
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A more direct form of oppression of banks and bond markets can occur through abuse of regulatory policy. After the financial crisis, banks' liquidity requirements were designed so that banks had enough liquid assets to sell in times of a run. This liquid asset is usually government debt. Financial repression forces banks to hold significantly more government debt than is required for regulatory purposes. In fact, this has been Italy's strategy for the last decade. More recently, Italian banks have divested themselves of government bonds. However, their share of national debt in total bank assets is still around ten times higher than in Germany or France. More governments could adopt this approach in the future.
Issuing debt directly to private investors, when done on a large scale and with the specific purpose of reducing bond yields, also amounts to financial repression. Due to intermediation costs, banks are unlikely to offer the same high returns on their savings accounts. Direct debt sales to retail investors will therefore drain funds from bank accounts. These funds are not passed on to the private sector, but are used to finance the national debt.
The economic consequences of financial repression are significant. These measures crowd out private sector investment. In the short term, this will lead to lower growth and inflation as money that would have been invested in the private sector capital stock will instead be spent on debt servicing and repaying government debt. However, in the medium term, lower capital accumulation leads to a structurally more rigid supply side of the economy. As demand increases, this leads to higher inflation and therefore structurally higher interest rates.
Apparently it is easier to suppress domestic investors than foreign ones. This poses risks for countries that rely on foreign money to finance debt issuance. If foreign investors stay away for fear of repression, government bond yields must rise to attract more domestic investors. It is up to politicians to decide whether financial repression is a way out of developed markets' current fiscal problems. However, you must be aware that such policies could backfire significantly in the long run, leading to lower growth and higher interest rates.
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