Default, Deflation and Financial Repression

Back in March 2011, author Carmen Reinhart wrote a comment in Bloomberg describing the term “financial repression.”  She wrote:

“As they have before in the aftermath of financial crises or wars, governments and central banks are increasingly resorting to a form of “taxation” that helps liquidate the huge overhang of public and private debt and eases the burden of servicing that debt."

Such policies, known as financial repression, usually involve a strong connection between the government, the central bank and the financial sector. In the U.S., as in Europe, at present, this means consistent negative real interest rates (yielding less than the rate of inflation) that are equivalent to a tax on bondholders and, more generally, savers.”

In the FDIC data released this week, the financial repression imposed by Ben Bernanke, Janet Yellen and the rest of the Federal Open Market Committee over the past five years is very apparent.  Chief among the data points to be noted is that net interest expense, which is the money paid to depositors at banks, continues to fall.  While all banks earned about $118 billion in interest income last quarter, they paid just $13 billion to depositors, a graphic example of the “financial repression” used by the Fed to subsidize the US banking industry.

Notice that while the Fed has maintained the net interest income to banks, the earnings of depositors have fallen more than 90% since 2008.  Via QE, the Fed is subsidizing all banks to the tune of over $100 billion per quarter in artificially depressed interest cost and income to depositors of all stripes. By robbing consumers and all savers of income, the FOMC is in fact feeding deflation and hurting growth and employment.  The chart below using data from the FDIC shows the interest earnings, expenses and net interest income through the end of September 2013 for all US banks.

Prior to the 2007 financial crisis, total interest expense for all US banks was over $100 billion every three months and interest income was almost $200 billion.  In order to maintain the net interest margin for banks at +/- $100 billion per quarter, the Fed is confiscating income of US savers, including companies, investors and the elderly, of almost the same amount each quarter.  This badly needed income is transfered from savers to the banks and is not available to support consumption.  This data graphically illustrates the deflationary nature of current Fed interest rate policies and why Janet Yellen and the Federal Open Market Committee need to raise interest rates soon.  But when rates rise, the next phase of the economic crisis will begin.

In a paper published this month by Carmen Reinhart and Ken Rogoff, the authors argue that financial repression is a necessary part of the adjustment process for heavily indebted nations, even the advanced nations.  The Guardian reports: “They say that if history is any guide countries will not be able to return to more sustainable levels of public debt through a combination of austerity and growth. They cite Europe, where the assumption is that normality can be restored by a combination of belt-tightening, forbearance and rising output, as an example of Panglossian thinking.”

Say Reinhart and Rogoff:   "The claim is that advanced countries do not need to apply the standard toolkit used by emerging markets, including debt restructurings, higher inflation, capital controls and significant financial repression. Advanced countries do not resort to such gimmicks, policy makers say."

The Guardian:  “Historically, this is poppycock according to Reinhart and Rogoff. Rich countries, when faced with high levels of debt in the past have been more than happy to default, inflate away their debts or indulge in financial repression (capping interest rates or putting pressure on savers to lend to the government).”

The current policy mix in the US certainly shows this tendency to resort to financial repression, but the real question is whether current Fed policy has not resulted in a deflationary trap, with falling income driving consumption, jobs and economic activity lower. Taking $100 billion in income away from savers each quarter does not seem to be a recipe for economic growth. 

But as Reinhart and Rogoff document well, there is no easy solution available for the US, EU, Japan and other heavily indebted developed nations.  Once interest rates start to rise, the necessity of debt restructuring in Europe, Japan and even the US will become more apparent.  There is no free lunch.  Either we kill growth via financial repression of savers or we embrace the painful process of debt restructuring for the major industrial nations.