Excessive leverage and risk in the financial system, e.g., using
customer funds to speculate, never ends well. Stock market crashes,
bank and investment firm failures or economic recessions are all
potential consequences. Following the failure of the United States
to regulate over the counter ((OTC)) derivatives and the repeal of
the Glass-Steagall Act, U.S. banks became the largest financial
business entities in history. The U.S. real estate bubble,
sub-prime lending and mortgage backed securities ((MBS)), along
with unregulated OTC derivatives, then led to bank insolvencies, a
historic stock market crash and a near collapse of the global
financial system.
Central banks and governments intervened to prevent systemic
collapse, but governments were saddled with enormous debts due to
bank bailouts, lost tax revenues and massive social welfare costs.
Rather than systemic collapse, and perhaps another Great
Depression, the post crisis period came to be characterized by (1)
market interventions, (2) direct government control over the
economy, and (3) ongoing monetization by central banks. Longer-term
solutions that would have allowed a return to putatively free
markets failed to emerge, and government debt, particularly in
Europe, became a crisis in its own right.
Measures that began as emergency interventions became routine,
suggesting a new economic paradigm. In the new paradigm, big banks,
politicians and academics would decide what market outcomes, e.g.,
bankruptcies, interest rates or bond yields, would be permitted, as
well as when to apply accounting rules, regulations and laws.
Despite increased centralization of decision making and greatly
expanded powers, however, policymakers were unable to repair the
financial system. Instead, mounting government debt led to
de facto
financial repression.
Financial repression occurs when governments channel funds into
their own sovereign bonds in order to reduce debt levels through
mechanisms such as directed lending, caps on interest rates,
capital controls, debt monetization, or by other means. Economist
Carmen M. Reinhart, et al., brought the term back into popular
usage in 2011 after a long hiatus. Past examples of financial
repression include several South American countries, such as
Argentina. The promise of financial repression is that it will hold
down government borrowing costs and reduce government debt levels,
but critics argue that financial repression merely targets the
producers of society, i.e., the middle class, and therefore harms
the economy.
(Click to enlarge)
The Liquidation of Government Debt, Carmen M. Reinhart and M.
Belen Sbrancia (NBER 16893, 2011)
Debt monetization, which can be a tool of financial repression,
destroys savings while a zero percent interest rate policy (ZIRP),
which reduces government borrowing costs, deprives savers and
pensioners of interest income and can lead to inflation. What is
more important, however, is that financial repression prevents
capital formation. Of particular concern in the U.S. is the link
between capital formation and new business creation, which is
primarily a middle class phenomenon. The vast majority of
corporations in the U.S. are small businesses and they account for
the majority of jobs. By preventing capital formation, financial
repression short circuits the engine of new business creation,
increases unemployment and threatens to bring down the middle
class.
Governments cannot supply entrepreneurship or innovation in the
marketplace, nor can they effectively replace savings (genuine
capital derived from surplus production) or private investment with
bank credit or with public funds, which represent debt and a
transfer of wealth, respectively. The deployed capital, inventions,
products and services of new businesses drive innovation, fuel
competition, provide jobs and increase the wealth of society. In
contrast, financial repression can only produce economic stagnation
and result in a net loss of wealth to society.
Crisis and Consequence
Substantially as a consequence of the financial crisis and
global recession, Europe was engulfed in a sovereign debt crisis
characterized in the European periphery by austerity measures and
Great Depression levels of unemployment. In the U.S., the real
estate collapse and stock market crash represented a direct loss of
household wealth, while bank bailouts represented a transfer of
wealth from proverbial Main Street to literal Wall Street. Deficit
spending, debt monetization and the Federal Reserve's purchases of
MBS and U.S. Treasury bonds expressed a radically inflationary
monetary policy and, although much of the money is idle in the
banking system, the overall increase in the supply of U.S. dollars
is concerning. The True Money Supply ((
TMS
)), formulated by economist Murray Rothbard, represents the amount
of money in the economy that is available for immediate use in
exchange.
(Click to enlarge)
The True Money Supply ((
TMS
)), Ludwig von Mises Institute, 518 West Magnolia Avenue, Auburn,
Alabama 36832-4501 U.S.A.
Despite the 2008 financial crisis, global recession and
inflationary policies, confidence in the U.S. dollar, the U.S.
stock market, the U.S. federal government and the U.S. economy
remained largely intact. Inflationary policies reduced certain
risks, such as the risk of a deflationary collapse, and increased
liquidity from central bank monetization lifted financial markets,
but the effects were only temporary. Confidence was also boosted in
Europe by the European Central Bank's ((ECB)) outright monetary
transactions ((OMT)) program and in the U.S. by the Federal
Reserve's quantitative easing III (QE3) program. In Europe, the
risks of sharply rising sovereign bond yields, sovereign defaults
and the potential breakup of the euro were muted by OMT while
European leaders putatively moved toward a permanent solution, such
as a fiscal union. Thanks in part to the Federal Reserve's ZIRP and
ongoing "operation twist," U.S. Treasury yields remained near
historic lows.
(Click to enlarge)
10-Year Treasury Constant Maturity Rate (WGS10YR), Weekly,
Ending Friday, Not Seasonally Adjusted, Updated: 2012-11-05 3:32
PM CST, Federal Reserve Bank of St. Louis, One Federal Reserve
Bank Plaza, St. Louis, MO 63102 U.S.A.
On the surface, the fallout of the 2008 financial crisis was
effectively managed, but the basic causes of the crisis were never
addressed. The lines between depository institutions and securities
firms, erased in the U.S. by the final repeal of the Glass-Steagall
Act in 1999, were not restored and the U.S. Financial Accounting
Standards Board's (FASB) mark-to-market rule was never
reinstated.
Although bank capital ratios have improved, leverage remains
excessive, bank balance sheet assets remain troubled and economic
conditions have deteriorated compared to the pre-crisis period.
Banks deemed "too big to fail" in 2008 have become bigger and the
gross credit exposure associated with high risk OTC derivatives is
roughly as large as it was before the financial crisis. By the end
of 2013, the Federal Reserve's balance sheet will have exceeded
$3.4 trillion. At the same time, the U.S. federal government faces
a so-called "fiscal cliff."
The Road to Stagflation
For 2012, the International Monetary Fund ((
IMF
)) projects GDP 2.2% growth in Japan and the U.S. and 3.5%
globally. Based on the Baltic Dry Index ((BDI)), which reflects the
price of moving major raw materials by sea, the global economy has
slowed in 2012. Nonetheless, there has been some improvement in
comparison to the depths of the global recession in 2009.
(Click to enlarge)
Baltic Exchange Dry Index ((BDI)) Average Value of the Four
Main Shipping Routes applicable for each of the 3 types of ships
(Cape/BCI, Panamax/BPI and Supramax/BSI/BHMI), DryShips Inc.
The BDI is a leading indicator of economic growth because it
reflects the demand of manufacturers for raw materials. A decline
in the BDI signals falling global demand for manufactured goods. In
the U.S., rail carloads also indicate falling demand.
(Click to enlarge)
Association of American Railroads ((AAR)), Bill McBride,
Calculated Risk, Finance and Economics,
http://www.calculatedriskblog.com/
In contrast, removing potentially optimistic projections, the
U.S. Energy Information Administration's ((
EIA
)) liquid fuels consumption data suggests an anemic recovery in the
U.S. on a par with 2011.
(Click to enlarge)
U.S. Energy Information Administration, Short-Term Energy
Outlook November 2012, U.S. Energy Information Administration,
1000 Independence Ave., SW, Washington, DC 20585 U.S.A.
Despite the recent uptick in U.S. manufacturing, manufacturing
currently accounts for only 11.7% of U.S. GDP. In the past few
decades, U.S. corporations moved production offshore, eliminating
domestic jobs. Credit expansion masked the lost income of U.S.
consumers, but the process inexorably reached its logical
conclusion in 2007. The shift of U.S. workers to often lower paying
service sector jobs was counterproductive because debt levels rose
while income flowed out of the U.S. following on the heels of
jobs.
(Click to enlarge)
Civilian Employment-Population Ratio (EMRATIO), Federal
Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St.
Louis, MO 63102 U.S.A.
Although policymakers, including Federal Reserve Chairman Ben
Bernanke, deny it, in fact, U.S. unemployment is a long term,
structural problem linked to the still ongoing outflow of U.S.
consumer incomes to net exporter countries such as India and
China.
(Click to enlarge)
Balance on Current Account (BOPBCA), Federal Reserve Bank of
St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102
U.S.A.
The current surplus of U.S. labor, abundant capital and somewhat
less expensive energy (partly due to advances in hydraulic
fracturing that have increased U.S. domestic oil production) are
insufficient to stimulate a broad-based economic recovery. In
addition to the U.S. federal government's growing debt and need for
increased tax revenues, U.S. consumers remain burdened with high
debt levels.
(Click to enlarge)
Debt Outstanding Domestic Nonfinancial Sectors - Household,
Consumer Credit Sector (HCCSDODNS), Federal Reserve Bank of St.
Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102
U.S.A.
A U.S. manufacturing renaissance, for example, is unlikely to
take hold unless the U.S. dollar weakens significantly and global
demand also rises. In a global slowdown, it remains unclear where
new customers might come from for new U.S. products or
services.
Although the financial system has continued to function due to
massive infusions of liquidity, economic activity, with some
exceptions, has not generally recovered or has continued to
deteriorate, e.g., the shrinking number of U.S. citizens
participating in the official workforce. Ignoring improvements in
the unemployment rate related to the shrinking size of the
workforce, much of the U.S. economic recovery in the post crisis
period can be attributed to government deficit spending.
(Click to enlarge)
Karl Denninger, The Market Ticker Commentary on The Capital
Markets, http://market-ticker.org/
U.S. GDP has been boosted by government deficit spending in
excess of $1 trillion per year. Removing the temporary effects of
extraordinary deficits, U.S. GDP remains negative. Compounding the
problem, loose monetary policies, rather than spurring lending to
consumers or small businesses, have created inflationary pressures
and have led to stagflation.
Rather than putting Americans back to work, inflationary
policies have helped to push prices higher. Based on U.S. Consumer
Price Index ((
CPI
)), the official inflation rate in the U.S. is roughly 2%, but the
CPI does not accurately measure the cost of maintaining a constant
standard of living. Using the same methodology as in 1980, the CPI
should be 9.3% currently.
(Click to enlarge)
Shadow Government Statistics, American Business Analytics
& Research LLC, http://www.shadowstats.com/
Inflationary central bank policies support government borrowing
and the banking system, but increased liquidity resulting from low
interest rates, central bank asset purchases or debt monetization
can have destabilizing effects. Excess liquidity can result in
price inflation, fuel financial speculation or asset price bubbles,
or provoke competitive devaluations (currency wars). Asset
purchases and debt monetization by central banks alter the
distribution of money, thus of purchasing power over the economy
and therefore redistribute wealth. Monetary inflation erodes the
value of savings replacing genuine capital distributed throughout
the economy with credit concentrated in banks. In the U.S., one of
the Federal Reserve's policy assumptions is that asset purchases
will help small businesses by making more credit available. While
it is true that small businesses rely on bank credit for operations
and expansion, it is savings, not credit that fuels small business
creation and therefore job growth. Since most U.S. jobs are in
small businesses, QE3 and similar policies destroy jobs by
redistributing wealth from savers, entrepreneurs and investors to
banks and stifling new business creation. The combination of
reduced new business creation, continuing high unemployment and
inflationary price pressures set against a backdrop of high debt
levels precisely defines stagflation.
Reign of Repression
The stagflationary environment in the U.S. is a mild example of
financial repression. Countries in the European periphery, e.g.,
Greece, Italy, Spain, Portugal and Ireland, where high taxes and
austerity measures are already in place, are more pointed examples.
In the case of Greece, which has descended into an economic
depression, the natural market outcome would have been a Greek
default and an exit from the European Monetary Union ((EMU))
accompanied by losses for European banks and quite probably a
number of European bank failures, along with the systemic impact of
associated OTC derivatives, such as Credit Default Swaps ((CDS)).
To prevent bank losses and failures, however, policy decisions
replaced market outcomes. The normalization of market
interventions, direct government control over the economy and
ongoing monetization by central banks represented a transition from
a market based status quo to a policy based status quo which
maintained or increased otherwise unworkable government debt
levels. Maintaining the status quo, however, requires financial
repression.
Like the emergency measures that preceded it, financial
repression has become a fixture in a new economic paradigm, but it
is no more likely to provide a permanent solution. Financial
repression will remain in place as long as bank failures and
sovereign defaults continue to be prevented, e.g., through
bailouts, asset purchases or debt monetization by central banks.
Overall economic conditions in Western countries can therefore be
expected to remain stagnant or to deteriorate. The continued
debasement of major currencies, such as the U.S. dollar and the
euro, will reduce the real value of debts, but monetary inflation
cannot create a genuine economic recovery as long as bank balance
sheets and government finances remain impaired. Without robust
economic growth, however, both the banking system and the finances
of Western governments certainly will remain impaired. In other
words, financial repression in the U.S. and in Europe is set to
remain in place indefinitely.
Under an ongoing regime of financial repression, savings, jobs,
economic opportunity and living standards will all suffer. The
middle class will be reduced as generations of socioeconomic
progress are gradually reversed. Younger people, mired in
stagflation, will be left behind in terms of income and economic
opportunity, which will have a long-term negative impact. Since
U.S. banks stand to profit from financial repression, it will
increase income disparity and the concentration of wealth. The
destructive forces set in motion by financial repression will
greatly increase the burden on government social welfare programs.
Thus, financial repression will fail to alleviate government debt
unless tax increases and austerity measures follow, which could
turn the United States into another Greece. In theory, financial
repression, together with other measures, can liquidate government
debt but, in practice, it is a destructive and highly destabilizing
approach that will result in a net loss of wealth to society.
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
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