Ken Rogoff and Carmen Reinhart are still paying attention to sovereign debt. In fact, there are so many links in this paper to recent work of theirs that surely another book is in the offing. Here, they write,

the current stage often ends with some combination of capital controls, financial repression, inflation, and default. This turn of the pendulum from liberalization back to more heavy-handed regulation stems from both the greater aversion to risk that usually accompanies severe financial crises, including the desire to prevent new ones from emerging, as well as from the desire to maintain interest rates as low as possible to facilitate debt financing. Reinhart and Sbrancia (2011) document how, following World War II (when explicit defaults were limited to the losing side), financial repression via negative real interest rates reduced debt to the tune of 2 to 4 percent a year for the United States, and for the United Kingdom for the years with negative real interest rates. For Italy and Australia, with their higher inflation rates, debt reduction from the financial repression “tax” was on a larger scale and closer to 5 percent per year. As documented in Reinhart (2012), financial repression is well under way in the current post-crisis experience.

(Can anyone find the 2012 paper? It’s not listed in the references.)

Reinhart’s story is that once upon a time, countries emerged from WWII with a lot of sovereign debt. They used financial repression to keep interest rates low, and they got out from under that debt. Then they liberalized, and the financial sectors went crazy, growing rapidly and fueling bubbles. Then the crash came, governments took on a lot of debt again, and now we are back in the cycle of financial repression.

As a story, this is cute. But I cannot buy into it, at least for the United States. Re-read my history of U.S. government debt. Most of the reduction in the ratio of debt to GDP from 1946-1979 was due to the government running primary surpluses in the 40’s, 50’s, and 60’s. That is, if you took out interest payments, outlays were below revenues. The negative real interest rates were during the Great Stagflation, and they only reduced the debt/GDP ratio by a small amount.

Also, I am not sure where the financial repression is coming from today. Reinhart cites risk-based capital requirements that favor sovereign debt, but we have had those since before the financial crisis.

I think my larger issue is that I am unclear about the concept of financial repression. Some possibilities.

1. Financial repression consists of regulations that subsidize purchases of government debt and/or penalize risky private investment. In this case, the interest-rate differential between private securities and government securities is wider than normal. How does one distinguish this from a shift in the risk premium due to market psychology?

2. Financial repression reduces the amount of financial intermediation. But what does that mean?

To me, financial intermediation consists of the financial sector holding long-term, risky assets and issuing short-term, risk-free liabilities. The nonfinancial corporate sector and the household sector get to issue long-term, risky liabilities and to hold short-term, risk-free assets. The household sector ultimately owns the equity in the nonfinancial corporate sector and in the financial sector. The government, through deposits insurance and ad hoc bailouts, has in some sense written put options on firms in the financial sector, and as taxpayers we are on the hook for those put options.

If the government comes up with regulations that make it more difficult for the financial sector to expand and exploit its put options, then you might call that financial repression. But in that case, it is not clear that financial repression is a bad thing.