UK: Investment Q&A - Financial Repression

Last Updated: 12 February 2013
Article by Jonathan Davis

Jonathan Davis has been a senior adviser and investment director at Smith & Williamson Investment Management since March 2012. A former journalist on The Times and Economist, he is a regular columnist for the Financial Times and author of several investment books.

Financial repression does not sound very pleasant. What does it mean?

It is an ugly phrase to describe a disagreeable state of affairs, one which unfortunately many investors are experiencing at the moment. It refers to a deliberate attempt by financial policymakers to hold down interest rates below the rate of inflation in an attempt to force people to change their savings and spending habits. The phrase was popularised by the American academic Carmen Reinhart, the author (with Kenneth Rogoff) of a bestselling recent book on the history of financial crises and their aftermath.

But aren't lower interest rates a good thing?

They are for some people. In general lower interest rates help borrowers and penalise savers. What financial repression specifically refers to are periods when interest rates are being set at or below the current and expected rate of inflation - in other words, when interest rates in real terms are zero or negative, as they are today. The consequences are much more serious when that is the case.

Why does that make such a difference?

Essentially because when real interest rates are negative it starts to distort the way in which money is priced and capital is allocated across the economy. For example, there no incentive for anyone to save or keep money in the bank, if they know that by doing so they are sure to become poorer. The purchasing power of money left in the bank inevitably declines if the interest it pays fails to keep up with the cost of living.

On the other side of the coin, it also removes the pressure on those who have borrowed too much - whether they are individuals, companies or governments - to take action to sort out their finances. When real interest rates are kept artificially low, borrowers no longer have to pay a proper market price for their debt. In fact every year that passes reduces the amount they have to repay, as inflation slowly erodes the value of their debt.

Although that can be helpful in the short term, avoiding bankruptcies, repossessions and banking losses, among other things, in the longer term it is not a force for good. Over time it will produce lower productivity, a decline in competitiveness and a host of other economic problems. In effect negative real interest rates gum up the workings of a free market capitalist system. It is no accident that financial repression is usually the result of some serious financial crisis, such as a credit bubble, banking collapse or the aftermath of war.

So there have been examples of this happening before?

Yes, a lot. The UK, for example, lived with financial repression for the best part of a quarter of a century after the Second World War. It started with the Government holding down interest rates as the country tried to rebuild after the war. But it also extended to a host of other measures, such as rent controls, price controls, limits on how much money you could take out of the country and credit controls. There were a lot of ways in which individuals and institutions were constrained from spending money the way they wanted to.

Why then are we having to live with it now?

This time round the decline in real interest rates is the direct consequence of the global financial crisis of 2008. As we can all see now, the great credit expansion that took place in the years after 2000 inflated a huge and dramatic expansion of the use of debt, by consumers, banks and governments alike. Ever since the bubble burst governments and central banks have been struggling to control the fallout. Slashing interest rates has been one of the few readily available tools to prevent their economies melting down under the burden of their accumulated debts.

Is quantitative easing part of this policy response?

Yes, very much so. In the UK the Bank of England, like the Federal Reserve in the United States, has been using QE to pump money into the financial system in an attempt to rekindle economic growth. By buying billions of pounds of government bonds from banks, pension funds and others it has been forcing down the yields on gilts, in the hope that doing so will stimulate bank lending and keep the price of shares and other assets higher than they might otherwise be - blatant market manipulation, really, but by another name.

And is it working or not working?

It depends what effect you are measuring. The Bank believes that its efforts have been successful, up to a point at least, in preventing the country slipping into a 1930s style slump. It is not easy to prove one way or another. True to form, economists are still debating how effective the policy is. But so far QE has yet to produce either a surge in bank lending or a sustained period of renewed economic growth.

The one certain effect it has produced is that interest rates have fallen sharply towards and then below the rate of inflation. While consumer price inflation remains around 2.0% - 2.5% per annum, base rate has remained at 0.5% (its lowest level in recorded history) for more than three years. The yields on most conventional and index-linked gilts are now below the rate of inflation - a classic case of financial repression.

How are investors reacting to this state of affairs?

The most dramatic impact has been on the yields offered by almost every type of investment. Cash in the bank offers a negative real yield. Combine that with falling income from gilts and corporate bonds, and the yield on a conventional investment portfolio (made up of shares, gilts, corporate bonds and debt) has also been falling steadily. It has rarely been as low as this in the past.

Annuity rates are meanwhile at record low levels, hurting pensioners. Anyone who relies on their investments for income is struggling to cope, just as the history of financial repression makes clear is bound to happen. The search for yield has been forcing many investors to shift their money into other assets, even if it means taking on more risk than they would normally prefer to do.

Who are the major beneficiaries of this policy?

Governments and the over-indebted - banks, companies and individuals - are the main beneficiaries. Governments in particular have accumulated record levels of debt. Because it is invariably easier to promise benefits than to cut public spending, inflation has historically been one of the few politically acceptable ways to reduce excessive levels of public debt. Financial repression, or a sustained period of negative real interest rates, may unfairly penalise one group in society at the expense of another. But it is, for better or worse, one of the few policy tools that the authorities know how to use, and which voters appear willing to support at the ballot box.

How long will the current phase of negative real interest rates continue?

Nobody knows, but it will probably be for quite a long time. Historical precedents suggest several years. The Bank of England has pledged to keep base rates where they are for the foreseeable future, and although bond yields have risen somewhat in the last six months, there is no sign as yet that they will move sharply higher any time soon. The worry is that higher inflation will be the inevitable consequence of keeping rates too low, but that too does not yet look imminent. Savers and investors may however have to learn to live with this new world for some time.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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