IMF Paper: Debt-Ridden Western Nations May Resort to ‘Financial Repression’

Barbara Hollingsworth | January 3, 2014 | 3:15pm EST
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Cyprians protesting bank bailout outside their parliament in March, 2013. (AP photo)

( –  The highest debt-to-GDP levels in 200 years could force advanced Western nations to adopt “financial repression” measures typically reserved for economically unstable debtor nations, including mass write-offs and a tax on savings, warns a working paper published last week by the International Monetary Fund (IMF).

According to “Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten,” a working paper written by two Harvard economists who used to work at the IMF, “there are essentially five ways to reduce large debt-to-GDP ratios:

1. Economic growth;

2. Fiscal adjustment- austerity;

3 .Explicit default or restructuring;

4. Inflation surprise; and

5. A steady dose of financial repression accompanied by a steady dose of inflation."

“The first on the list is relatively rare and the rest are difficult and unpopular,” writes co-authors Carmen Reinhart and Kenneth Rogoff, IMF’s former chief economist.

Total public debt in the U.S. reached 98.9 percent of GDP in the third quarter of 2013, according to the Federal Reserve Bank of St. Louis. The Congressional Budget Office’s alternative scenario projects the debt to reach 190 percent of GDP by 2038.

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Although financial repression “is a form of taxation that, like any form of taxation, leads to distortions,” Reinhart and Rogoff note that  “a mix of financial repression and inflation can be a particularly potent way of reducing domestic-currency debt.”

They define “financial repression” as “directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and generally a tighter connection between government and banks.”

Other forms of “financial repression” that can be used to reduce domestic debt include higher inflation, a tax on savings, and “stuff[ing] debt into local pension funds and insurance companies, forcing them through regulation to accept far lower rates of return than they might otherwise demand.”

Last April, the Cyprian parliament approved a deal that forced depositors to bear the brunt of a $23 billion bailout by the Euopean Union and the IMF. Large depositors in the Bank of Cyprus lost access to 90 percent of their funds, and a final deal negotiated in July forcibly converted 47.5 percent of  savings over 100,000 euros into bank shares.

Americans who think such a thing could never happen here should think again.

A “collective amnesia” prevails in Western nations, the authors warn, and “lessons from the historical track record….seem to have [been] collectively forgotten.” There is little historical evidence that economically advanced countries that have racked up unsustainable levels of debt can escape the fate suffered by their less developed counterparts, the authors point out.

“The claim is that advanced countries do not need to resort to the standard toolkit of emerging markets, including debt restructuring, and conversions, higher inflation, capital controls and other forms of financial repression,” Reinhart and Rogoff state.

“As we document, this claim is at odds with the historical track record of most advanced economies, where debt restructuring, financial repression, and a tolerance for higher inflation, or a combination of these were an integral part of the resolution of significant past debt overhangs.”

They add that there is also scant evidence that the U.S. and its European allies can rely solely on economic growth and austerity measures to pull themselves out of their current debt crises.

“Of course, if policymakers are fortunate, economic growth will provide a soft exit, reducing or eliminating the need for painful restructuring, repression, or inflation,” Reinhart and Rogoff conclude. “But the evidence on debt overhangs is not heartening.”

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