The Capital Note: Inflation and Financial Repression

William Arsn

Welcome to the Capital Note, a newsletter (coming soon) about finance and economics. On the (abbreviated — Daniel Tenreiro is away) menu today: Inflation and financial repression, inflation as a revolutionary weapon, Joe Biden’s tax plans, Chinese banks, and vomit fraud.

If there’s one thing that seems clear (if anything is clear these days) after Fed Chairman Jerome Powell’s comments this morning, it is that rates are going to continue (even) lower for longer.

Inflation Ahead? Financial Repression Ahead?

The Federal Reserve announced a major policy shift Thursday, saying that it is willing to allow inflation to run hotter than normal in order to support the labor market and broader economy.

In a move that Chairman Jerome Powell called a “robust updating” of Fed policy, the central bank formally agreed to a policy of “average inflation targeting.” That means it will allow inflation to run “moderately” above the Fed’s 2{5667a53774e7bc9e4190cccc01624aae270829869c681dac1da167613dca7d05} goal “for some time” following periods when it has run below that objective.

Not the best news for savers then, and I cannot help wondering if de facto financial repression is lurking somewhere in the game plan.

Scroll though (no, read it all: It’s very good) this piece by George Magnus in The Article on what looks like very tough times ahead for the U.K. until you come to Magnus’s discussion of inflation:

While there will be a multitude of short-term variations in measures of inflation, the underlying tendency into 2021 is likely to be up, and a year from now, it would not be surprising to see inflation over 2 per cent . . .

This makes it even more important for the economy and for debt management to keep interest rates from rising. Few people working today will recalls the so-called “financial repression” that lasted in many countries, including the UK, from 1945 until about 1979-80. In that period, interest rates and bond yields were pegged, borrowing costs were controlled, institutions were forced to buy government debt at yields below inflation, and controls were used extensively including over capital movements abroad.

Indeed, financial repression is, in effect, a subtle type of debt restructuring, one of the four options referred earlier. Keeping nominal interest rates at zero or very low keeps debt servicing costs down, while high negative real interest rates — i.e. interest rates below inflation — liquidate or erode the real value of government debt. If you combine financial repression with a dose of inflation, the liquidation of debt can prove to be both successful and fairly rapid, even obviating the need for politically and socially damaging increases in taxation.

The “Spectre of inflation”, as Brian Griffiths’s article was entitled, does indeed loom, and, I would argue, so does the possibility of financial repression. These may not be freely-made political choices, but debt has been used as the catch-all to end successive crises since the 1980s. We have now reached the end of that road.

The dollar’s status as a reserve currency perhaps removes some of the urgency from the debate over here, but the fact remains that the debt is piling up, and somehow, sometime it has to be paid.

Writing last week for Project Syndicate, Anne O. Krueger:

In any advanced economy, the prospect that the government might not be able to roll over its debt to finance its expenditures is simply unacceptable. But while reducing current and prospective fiscal deficits (and even running a surplus) is the obvious solution to the problem, it also tends to be the most difficult to pull off politically.

This implies that there will be a strong temptation to reduce the debt through measures known as “financial repression.” Policymakers could try to cut the costs of debt service by capping the interest rates that financial institutions – including banks and pension and insurance funds – are allowed to pay.

An interest-rate ceiling enables governments to sell and roll over government bonds at lower interest rates than they otherwise could, because savers cannot obtain better returns elsewhere. Governments have even put such caps on the interest that lenders can charge, resulting in credit rationing across potential borrowers.

When used in the past, financial repression has worked, reducing the US debt-to-GDP ratio after World War II from 116{5667a53774e7bc9e4190cccc01624aae270829869c681dac1da167613dca7d05} in 1945 to 66.2{5667a53774e7bc9e4190cccc01624aae270829869c681dac1da167613dca7d05} in 1955 (and further thereafter). Moreover, Carmen M. Reinhart, now the World Bank’s Chief Economist, and Maria Belen Sbrancia of the International Monetary Fund have estimated that between 1946 and 1955, the US liquidated debt amounting to 5.7{5667a53774e7bc9e4190cccc01624aae270829869c681dac1da167613dca7d05} of GDP per year through financial repression.

This gradual reduction came about because interest-rate ceilings were lower than the rate of inflation, resulting in a negative real return to creditors during this period. Reinhart and Sbrancia estimate that if real interest rates had been positive, US federal debt in 1955 would have stood at 141.4{5667a53774e7bc9e4190cccc01624aae270829869c681dac1da167613dca7d05} of GDP. That 75-point difference reflects the amount by which government debt would have increased had the government not resorted to financial repression, all else being equal.

Still, analysts since then have concluded, more or less unanimously, that financial repression reduced GDP growth and was harmful to the economy. Financial repression diverts private savings from private investment toward government securities – usually accompanied by rising inflation because of excess demand at the controlled interest rate. For these reasons, it is almost always accompanied by relatively slower growth. Only in the 1980s were interest rates permitted to be determined by markets.

But just because something is a bad idea doesn’t mean it won’t be tried again. In fact, it almost ensures that it will be, but is the option even there?

Also in Project Syndicate, Todd G. Buchholz:

What about the post-war experience with inflation? Should we try to launch prices into the stratosphere in order to shrink the debt? I advise against that. Investors are no longer the captive audience that they were in the 1940s. “Bond vigilantes” would sniff out a devaluation scheme in advance, driving interest rates higher and undercutting the value of the dollar (and Americans’ buying power with it). Any effort to inflate away the debt would result in a boom for holders and hoarders of gold and cryptocurrencies.

His cheery conclusion?

Unlike military campaigns, the war against COVID-19 will not end with a bombing raid, a treaty, or celebrations in Times Square. Rather, the image we should bear in mind is of a ticking time bomb of debt. We can defuse it, but only if we can win the battle against policy inertia and stupidity. This war won’t end with a bang, but it very well could end in a bankruptcy.

Perhaps not that, but it is hard to see how this is going to end well.

Around the Web
Financial repression may or may not be in our future, but if Joe Biden gets his way, taxes certainly will be.

Over at the Manhattan Institute’s City Journal, Noah Williams has some of the grisly details:

For high-income earners, the Biden plan would substantially raise effective tax rates. Biden would increase the top marginal tax rate to 39.4 percent, limit deductions to 28 percent of income, roughly double the capital gains tax to 39.4 percent, phase out business income deductions, and subject earnings above $400,000 to the 12.4 percent payroll tax. Statutorily, the payroll tax is divided between workers and employers, but the incidence falls on workers. The Tax Policy Center and Tax Foundation have found that, in total, these changes would lead to a 13 percent reduction in after-tax income for the top 1 percent of the income distribution.

The effects of this tax hike on top incomes would go far beyond making the rich “pay their fair share.” One reason: the income makeup of top earners differs from most taxpayers, whose prime source of income comes from their labor. Recent studies find that most of today’s top income earning derives from private business income, which passes through to owners and gets taxed according to federal individual income-tax schedules. As much as 95 percent of all businesses in the U.S. are such pass-through businesses, and they account for more than 55 percent of all business income (since most pass-throughs are small). In 2017, for taxpayers earning less than $500,000, wages and salaries accounted for 75 percent of total income, and business income for only 4 percent. But for taxpayers making more than $500,000, salaries accounted for 37 percent of income and business income 26 percent. At the very highest end of the income distribution, business income is even more concentrated. In 2014, over 69 percent of the top 1 percent and over 84 percent of the top 0.1 percent earned pass-through business income.

Increasing taxes on “the rich” thus means increasing effective taxes on pass-through businesses, which would lower their demand for both labor and capital. Just as part of the corporate tax gets shifted onto workers, an increase in taxes on top incomes would lead to a reduction in wages paid by pass-throughs. In a recent empirical study of a boost in top marginal tax rates, economist Max Risch found that approximately 15 cents to 18 cents per dollar of new tax liability affected pass-through employees through lower earnings. In addition, the higher levy on pass-through business capital would lead to lower investment, capital accumulation, and growth. END

As Todd Buchholz explained in his article for Project Syndicate, part of the way that the US was able to emerge out from under its Second World War debt load was super-charged growth:

BLOK [T]he US economy grew fast. From the late 1940s to the late 1950s, annual US growth averaged around 3.75{5667a53774e7bc9e4190cccc01624aae270829869c681dac1da167613dca7d05}, funneling massive revenues to the Treasury.

That’s not likely to be where Biden’s tax plan takes us, and that’s before a Green New Deal slows things down further.

China’s Biggest Banks Are Possibly Not in the Best Shape

China’s four largest lenders are facing a funding gap in the trillions of yuan to meet global capital requirements designed to protect the public and the financial system against massive bank failures, according to S&P Global Ratings.

Industrial and Commercial Bank of China Ltd., Bank of China Ltd., China Construction Bank Corp. and Agricultural Bank of China Ltd., all considered globally-systematically important banks, last year had a total shortage of 2.25 trillion yuan ($323 billion) to comply with the total-loss absorbing capacity, S&P said in a report on Wednesday. The [shortage] may grow to as much as 6.51 trillion yuan by 2024 as the pandemic erodes their earnings capacity, the ratings firm said.

Perhaps the best we can hope for in the current environment is that human ingenuity will find a way out.

And if fraudstersv — generally a pretty ingenious crowd — are any indication, there may be some grounds for optimism.

The Chicago Tribune:

The next time you use Uber, check your bill. The trip could turn out to be expensive — not just for the distance but for a type of fraud that is on the rise.

It’s called “vomit fraud,” a scam repeatedly denounced in social networks yet still taking place around the world.

Random Walk
More From Bankers and Bolsheviks: International Finance & The Russian Revolution, by Hassan Malik:

In the context of the chaos of the Civil War, the Bolshevik regime’s fiscal machinery was even in worse shape than that of the Provisional Government, leading it to monetize the deficit to an even greater degree.

That couldn’t happen here, of course.

[In 1921], the theoretical gold value of a ruble stood at less than half a percent of its early 1919 value. Bolshevik Russia had entered the monetary twilight zone whereby the value of the currency was dropping faster than the central bank could print it.

At the same time, the Bolsheviks were seeking to forge a new economic order. Preobrazhensky notoriously referred to the printing presses as the “machine-gun of the People’s Commissariat of Finance” with which it destroyed the value of paper assets held by the bourgeoisie as the Bolsheviks continued fighting the revolution along the financial front.

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