An Economist's Prediction of Widespread \"Financial Repression\"
In case you haven't noticed, interest rates are at rock bottom. For example, three-month Treasury bills pay just 0.05%. Even ten-year Treasury bonds yield less than 2%. Inflation will almost certainly be higher than the yield of T-bills and will probably be greater than the yield on ten-year bonds, so expect negative real, or after-inflation, returns from Treasuries. The same goes for bank deposits and certificates of deposit.
Get used to it. That's the word from Carmen Reinhart, the economist who co-authored This Time is Different, with Kenneth Rogoff. Their groundbreaking book illuminates financial crises throughout history, including what they believe is an ongoing calamity that began with the 2007-09 recession. They found that recessions sparked by financial crises were almost always much worse and longer-lasting than other economic downturns. Reinhart continues to expect subpar growth and high unemployment in the U.S. and most of the developed world over the next five years or so.
For a variety of reasons, countries around the world are bent on keeping interest rates artificially low, she says. Advanced economies are doing it because they're heavily indebted. "Financial repression" -- a term used to describe measures by which governments channel funds to other places than where they would end up in a deregulated economy -- "transfers money from savers to borrowers," Reinhart says. "It's essentially a tax on investors."
The U.S. and other advanced economies are holding down rates by investing heavily in their own government bonds. The Federal Reserve and foreign governments own more than half of the outstanding U.S. Treasury debt. The Fed wants to keep rates low largely to juice the fragile U.S. economy but also to depress government borrowing costs.
Emerging economies are seeking to keep hot, yield-seeking money away for fear that it will destabilize their economies. These governments accomplish their goal through direct taxes on investments or restrictions on how much foreign money they allow to be invested.
Financial repression has costs and benefits, Reinhart argues. One big cost is that it distorts the normal functioning of debt markets. We have no way to tell what interest rates would be without all the government meddling.
Financial repression is nothing new. The U.S. held down short-term interest rates for several decades after World War II. During that period, interest rates on longer-term bonds were kept artificially low, Reinhart maintains, through fixed currency-exchange rates and tightly controlled capital markets. Longer-term interest rates rose gradually over those years, meaning bonds lost money. By the 1970s, investors bitterly dubbed bonds "certificates of confiscation." Yet the post-war period was a wonderful one for stocks.
Reinhart doesn't think low interest rates will be accompanied by surging stock markets this time around. After all, the U.S. economy was booming in the post-war period, and that's hardly the case today. Nevertheless, Reinhart predicts that stock prices will be higher in five years than they are today and that you'll do better in stocks than in bonds over that period.
Not that the financial crisis is behind us. This Time is Different studies 15 financial crises. In seven, there was a new recession before the crisis ended. "When you're highly indebted, it's as though your immune system is weak," Reinhart says. Recession or not, stocks will remain volatile.
Reinhart views the Wall Street bailout and Obama's 2009 stimulus package as crucial in avoiding a depression. But since then, the U.S. and other governments have dithered while the crisis has continued to fester.
Reinhart is frustrated that the Obama administration hasn't put more pressure on Fannie Mae and Freddie Mac, the giant, government-owned mortgage firms, to write down the principal of home loans on which borrowers owe more than their property is worth. When a business buys a building and the building plunges in value, the business renegotiates the loan with the lender. Why shouldn't homeowners get the same break? Reinhart asks.
She also wants more action to force banks to realize losses on mortgage securities they hold on their books. Banks are still carrying "zombie" loans on their balance sheets at inflated values. "That's exactly what the Japanese did," Reinhart says.
Finally, and most importantly, she wants the U.S. to tackle its long-term debt problem. Three bipartisan commissions have agreed that there should be cuts in health-care spending and tax hikes to defuse the debt crisis. But so far, the political will to make these changes is lacking.
Meanwhile, Europe poses the biggest danger to the global economy. Reinhart says that the restructuring of Greek loans is just the start. Next will be Portugal and Ireland. But Reinhart doesn't think the euro will fall apart anytime soon. "The Europeans will go to great lengths to preserve the euro," she says.
Reinhart's analysis is, in my view, as incisive as her book, and her prescriptions are right on the money. All that stops us from taking her sound advice, alas, is politics.
Steve Goldberg is an investment adviser in the Washington, D.C., area.