Feeling repressed? Take two aspirin and call your central banker in the morning.
Those of us who like to save and invest money, or who start businesses – I’m guilty on both counts – tend to be glass-half-full optimists. We do not overlook today’s challenges, but we assume that hard work and thoughtful planning can make for a better future.
Lately, however, a lot of us are seeing the glass half empty. Our carefully nurtured Wall Street “animal spirits” have departed for greener pastures.
Trying to borrow money from a bank for personal or business reasons will put you through underwriting hell. You may not get the loan anyway. It can seem as though the bank has only a few carefully guarded dollar bills hidden in a vault somewhere, whose release requires the approval of a cabinet-level official.
Yet if you bring your personal savings or your business cash reserves to that same bank for deposit, the institution will almost certainly offer you a near-zero interest rate for your capital, as though it could not possibly find a more productive use for your money than to stash it in that vault. When you consider the plethora of additional fees most banks charge and take taxes and inflation into account, putting money in a bank today is a foolproof way to reduce its purchasing power.
The main purpose of banking is to put idle capital to use. If the banks can’t do that, you have to wonder what their function is.
Yet the banks are not the root of the problem, so don’t bother calling your branch manager. The problem is not your mood, either. That you are unable to get out of bed financially does not mean you are suffering from depression. Don’t call your therapist either, unless of course you really are so anxious or depressed that you truly feel overwhelmed by daily life.
You and I, and the economy in general, are suffering from a condition known as financial repression.
I did not invent this term. Nearly 40 years ago, Stanford University economists Edward Shaw and Ronald McKinnon first used financial repression to describe situations in which governments seize control of credit and capital markets, primarily to ensure that the governments’ own funding needs are met.
But back in 1973 Shaw and McKinnon were mainly talking about smaller, less-developed countries that could not attract foreign investment or generate sufficient internal funds to support government services and economic expansion. These countries tended to rely on measures such as setting artificial limits on interest rates, limiting the movement of capital across national borders, maintaining tight government control of banks and having the central bank lend money directly to the national treasury.
If this sounds familiar, it is because these techniques have spread rapidly to the largest and most important economies around the world within the past few years. The repression is likely to get worse, possibly much worse, before it gets better.
In the United States, the world’s largest national economy, the Federal Reserve has now held short-term interest rates near zero for nearly four years. The Fed promises that this will continue for another two years with still further extension possible. When cutting short-term rates failed to spark the economy, the Fed began aggressively trying to push down long-term rates. More action may come as early as next month.
The result has been record-low rates across the board. The Treasury can borrow money today for two years at less than 1 percent, and for 10 years at around 1.5 percent. Inflation is targeted to run at 2 percent per year with a good chance that it will be even higher. These rates are a losing bet even for debt holders that are not subject to taxes on the interest they earn.
The Treasury has been the main beneficiary of ultra-low rates. Quoted extremely low rates, private borrowers expect to pay around 3.6 percent for a 30-year fixed-rate mortgage. Actually getting a loan is another matter. Last week, as trustee of a client’s property, I canceled a sale after the buyer could not get a bank to decide on his loan application after more than two months even though the buyer’s credit had been pre-approved.
The Fed insists that it will raise interest rates as needed if the economy recovers or if inflation spikes. This is highly unlikely. By the end of this year, the accumulated national debt will be $16 trillion. Every 1 percent increase in the Treasury’s average interest cost will increase the federal budget gap by $160 billion per year. My colleagues and I estimate that in a historically normal interest rate environment, with the current level of inflation, Treasury interest rates would be at least 3 or 4 percentage points higher than now. To restore normal rates, the Fed would have to inflate the budget deficit, or force federal spending cuts of around $500 billion to $700 billion per year.
It won’t happen-not before there is a major overhaul of federal budget and tax policy. Federal Reserve Chairman Ben Bernanke and his colleagues have become hostages to the national debt and the artificially low rate environment they created.
China, the world’s second-largest economy, has strict controls over capital flows and aggressively manages the value of its currency. It also has massive state involvement in heavy industry and banking. While this is already starving its consumer and small business sectors for credit, this has not stopped the state-directed banks from amassing huge volumes of loans that are likely never to be paid.
Japan, as the third largest economy, has the world’s largest debt relative to national output and a population among the oldest on Earth. The only plausible source of funds will be the country’s central bank when the national debt needs to be rolled over.
The Euro zone economy is collectively larger than the United States. Germany, its anchor, is the fourth largest national economy. It, too, is embarking on a course of expanded central bank funding of national debt. This is most urgently fueled by the need to preserve Spain’s access to global capital markets.
While the details vary, the story is much the same: industrialized nations have amassed financial obligations that they are in no position to satisfy. Some of the consequences will come in the form of staff and pension cuts, reduced military and social spending, and divestment of state-owned businesses. As shown by the crisis in Greece, there will also be some outright defaults, especially on bonds issued by regional and local governments.
Many other consequences will be hidden and distributed around the globe. Higher inflation is one inevitable outcome if enough time passes and central banks keep printing money to paper over their governments’ debts. Reduced returns on capital mean less income for retirees and financially strong businesses. Lower returns also foreshadow less available credit in the banking system. An unavoidable consequence of artificial controls and manipulation of interest rates, this credit scarcity is already hurting people who are applying for loans.
Scarce credit directed toward government spending eventually results in lower economic growth over a long period of time. This is exactly what we have seen since financial repression became a long-term economic stimulus plan rather than a short-term response to a financial emergency.
So like a lot of people, I’m feeling repressed. I wish I had something better to offer, but all I can tell you is to take two aspirin and call your central banker in the morning.
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