Financial Repression

With crisis comes new vocabulary. Out of the Great Depression came the use of the word "recession" to denote the end of a business cycle rather than crises, panics, and depressions, which had previously been used.

The recent crisis has given rise to many new words, including "haircut", "re-profiling" and the "Vienna Agreement". To the lexicon, we must add "financial repression". Like the other words, the concept of "financial repression" existed long before this crisis, but its use has risen and is becoming more central to the debate.

The term was first coined by Stanford economists in the early 1970s. It was meant to denote government action that designed to thwart or mitigate economic considerations in investment choices. Specifically, financial repression refers to official actions that run counter the market based incentive structure. In one expression, government could force some domestic participants to buy or hold bonds that they would otherwise avoid due to credit risk or inflation risk.

Financial repression could include a wide array of policies, including interest rate caps, capital controls, government ownership or control of domestic banks, the creation or maintenance of a captive domestic market for government bonds.

While financial repression was applicable to the emerging markets, the more recent discussion, led by a NBER Working Paper by Reinhart and Sbrancia, tends to highlight the importance in advanced developed countries, and as a important way in which the debt incurred during WWII was reduced. Reinhart and Sbrancia suggest a clear line between financial crisis to sovereign crisis to financial repression.

The risk is that nearly any type of financial regulation could be broadly called financial repression. And financial repression could exist even before financial liberty. For example, Bretton Woods was predicated on limited capital mobility and the US had a cap on domestic interest rates. Reinhart and others consider this as an example of financial repression.

The recent re-discovery of "financial repression" may be understood as 1) a push back against new financial regulation, real or imagined, and 2) the move away from the capital liberalization high water mark and the flirtation with macroprudential policies.

The IMF has, for example, has endorsed the use of capital controls in certain circumstances and has in other ways put some distance between it and the Washington Consensus. It is not clear how much this had to do with IMF leadership and how much is a reflect of broader representation in the IMF itself.

A number of developing countries experimented with heterodox policies that fell shy of the customary raising interest rates and/or controlling money supply to address price pressures, such as emphasizing required reserves, taxes on certain kinds of investments, banning some investments (such as in money market instruments) altogether.

One important difference is that the financial repression that is being discussed is not in developing countries but in the advanced industrialized countries. The ostensible goal is to support the government bond markets. Moral suasion, the cajoling of investors are soft forms of financial repression, where the government can impose such cooperation by fiat.

The issue is likely to get more play in the US as QEII is completed and some worry about who is going to buy US Treasuries when the Fed is done. There is talk in the blogosphere about potential actions the US can take. The demand for Treasuries may increase as regulators try to strengthen the global financial system by forcing large institutions to reduce risks and hold more of the "safest" assets.