There has been a lot of discussion on financial repression emerging in advanced economies as way for governments to handle the looming debt crisis. According to some, financial repression is already in play in the United States as the Federal Reserve is keeping long-term interest rates artificially low to minimize financing costs to the Treasury. Advocates of this view go on to note that the lowering of long-term interest rates is narrowing the net interest margins for banks and reducing the incentive for savers to fund the shadow banking system. Financial repression, therefore, is causing financial intermediation to fall and is preventing a robust recovery.
There is a big problem with this view: it wrongly assumes that the drop in long-term interest rates over the past few years is solely the result of the Fed’s large scale asset purchases (LSAPs). While it is true that there has been a spate of empirical studies showing the LSAPs have lowered the term premium portion of long-term interest rates, most of these studies only show modest effects. It is unlikely, for example, that the LSAPs can account for much of the 300 basis points plus drop in the 10-year treasury interest rate since 2007. The financial repression advocates, however, want to attribute all of this decline to the Fed’s actions.
A far better explanation for the large drop in long-term interest rates is one, the growing global demand for safe assets and two, the ongoing slump in the economy. The first of these factors is about the increasing scarcity of safe assets in the world economy even as the global demand for them grows. U.S. treasuries remain the go-to safe asset for the world. As I discussed previously, there are both structural and cyclical factors behind this shortage of safe assets with both implying a reduction in the term premium for U.S. public debt. The second factor is that since the current and expected economic outlook continues to look bleak, the current and expected path of the short-term natural interest rate is low. With the short-term natural interest rate expected to remain low, actual short-term interest rates will be expected to remain low too and thus pull down the long-term interest rate. Some observers seem to forget that the natural interest rate itself is determined by the state of the economy.
Another problem with the financial repression view is that the Fed’s LSAPs, while very imperfect, were never explicitly intended to keep down government financing costs. They were always about either saving the financial system (e.g QEI) or more recently the broader economy (eg. QEII and Operation Twist). These programs had serious flaws–they should have explicitly targeted the level of nominal spending without committing dollar sums upfront–but to attribute to them a motive of repressing the financial system to help save public finances seems unfair.
For these reasons the financial repression view seems untenable to me. It is much ado about nothing.
This post originally appeared at Macro and Other Market Musings and is posted with permission.