Many central banks have begun lowering policy interest rates. The aim is to counteract economic slowdowns or even a potential recession. When both short- and long-term interest rates are consistently below the nominal growth rate of the economy, the situation is referred to as reflation.
Reflation results in savers and bond investors receiving lower returns than they otherwise would. It is therefore often described as financial repression. Thanks to Einstein’s so-called eighth wonder of the world—the power of compound interest—financial repression becomes a mechanism to make debt more manageable.
However, it requires time. Debt is expressed as a percentage of income, which in economic terms is GDP. Due to the Great Financial Crisis and the Covid-19 pandemic, debt as a percentage of GDP has further increased. This issue needs addressing.
There are several ways to solve a debt problem. One approach is the financial markets› tendency to address the pain in one go. However, this solution often leads to significant disruptions, such as bankruptcies.
The “Minsky moment”
In finance, there’s always a tipping point when, seemingly overnight, lenders realise the money lent is unlikely to be repaid. Whatever was financed no longer has the capacity to meet its obligations. This phenomenon, named the “Minsky moment” after economist Hyman Minsky, describes how long periods of stability encourage ever-greater risk-taking until a sudden recognition of these risks causes instability.
Thus, stability ultimately breeds instability, drawing a parallel between finance and physics, such as the fractals of Benoit Mandelbrot.
Another way to tackle debt is through economic growth. After the Second World War, war-related debts were high, but so was economic growth potential. Strong growth helped reduce debt as a percentage of GDP. However, even the Wirtschaftswunder was insufficient to significantly reduce debt levels. Additionally, there was no potential to cut costs through austerity, an approach attempted by Germany in Europe after the Great Financial Crisis, with far-reaching consequences.
Finally, financial repression is considered the ideal method for addressing debt problems. It requires no parliamentary approval and, due to the compounding effect, feels relatively painless in the short term, though it has significant long-term implications.
Erosion of purchasing power
In the early 20th century, financial repression caused American bondholders to lose half their purchasing power over approximately 20 years, even accounting for reinvested coupons. Similarly, after the Second World War, financial repression was used to address debt problems. For Dutch government bondholders, this meant a staggering two-thirds loss in purchasing power between 1945 and the early 1980s.
After the Great Financial Crisis, financial repression re-emerged, although achieving structurally low short- and long-term interest rates below the economy’s nominal growth rate proved challenging. Interest rates had to be brought down to zero or even negative, as both economic growth and inflation approached the zero mark. This situation has since improved. Thanks to essential investments and productivity gains from artificial intelligence, growth potential is now higher, and inflation is much greater than before the pandemic. For most central banks, the 2 percent inflation target now seems more like a floor than a ceiling.
During periods of financial repression, equity markets tend to overshoot. This is unsurprising since keeping interest rates below the nominal growth rate may not stimulate the economy directly but does inflate the prices of existing assets.
A flawed assumption
Many central bankers make the flawed assumption that lowering interest rates theoretically encourages investment while discouraging saving. In practice, however, low interest rates prompt investors to prefer purchasing existing assets, which is always safer than investing in the future. This behaviour inflates bubbles in the housing market, stock markets (via share buybacks), and even alternative investments such as classic cars, wine, and whisky, extending into the broader economy. It also exacerbates economic inequality, as savers either join the ranks of investors or save even more to compensate for the longer time required to achieve their goals with low interest rates.
Financial repression is detrimental to bondholders. In the European Union, it has also proven to be a mechanism for transferring wealth from the pension funds of the wealthy North to the debt-ridden, poorer South. Given the high levels of debt, particularly in countries that have experienced monetary excesses in recent decades, bondholders risk losing a substantial portion of their purchasing power in the coming decades.
Escape is possible, but not easy. Numerous rules and institutions continue to promote government bonds from these countries as the ultimate safe haven for investors—albeit with a guaranteed loss.
Han Dieperink is the Chief Investment Officer at Auréus Vermogensbeheer. Previously, he served as Chief Investment Officer at Rabobank and Schretlen & Co.