Keeping a big debt down

By R.A. | WASHINGTON

THE years immediately prior to the crisis and up to now were characterised by an enormous run-up in sovereign debt across the rich world. This spike in borrowing has had few recent historical precedents; among advanced economies only the growth in debts associated with the Great Depression and the World Wars were comparable. And historically, it has been extremely difficult to address debts of these magnitudes.

There are only a few ways to bring down sovereign debt burdens. Growth is one, but growth may be impaired by high debt burdens. Austerity is another, but to cut debts this way requires a long period of painful policy, of the sort that's rarely tolerable to electorates. Default is another way. And rapid inflation is another way still. In the years after the Depression and the First World War, debts were often resolved—painfully and occasionally chaotically—through austerity, default, or inflation.

The experience after the Second World War was quite different despite the fact that debt levels were often much higher than they had been in the 1920s and 1930s. Faster growth explains some of the difference in debt outcomes, but not all of it. Rather, say Carmen Reinhart and Belen Sbrancia in a new IMF paper, a fifth option—financial repression—was key to quickly and relativley painlessly addressing large sovereign debts. What's financial repression? The authors identify three pillars:

(i) Explicit or indirect caps or ceilings on interest rates, particularly (but not exclusively) those on government debts. These interest rate ceilings could be effected through various means including: (a) explicit government regulation (for instance, Regulation Q in the United States prohibited banks from paying interest on demand deposits and capped interest rates on saving deposits). (b) In many cases ceilings on banks' lending rates were a direct subsidy to the government in cases where the government borrowed directly from the banks (via loans rather than securitized debt); (c) the interest rate cap could be in the context of fixed coupon rate nonmarketable debt; (d) or it could be maintained through central bank interest rate targets...

(ii) Creation and maintenance of a captive domestic audience that facilitated directed credit to the government. This was achieved through multiple layers of regulations from very blunt to more subtle measures. (a) Capital account restrictions and exchange controls orchestrated a “forced home bias” in the portfolio of financial institutions and individuals under the Bretton Woods arrangements. (b) High reserve requirements (usually non-remunerated) as a tax levy on banks... (c) Among more subtle measures, “prudential” regulatory measures requiring that institutions (almost exclusively domestic ones) hold government debts in their portfolios (pension funds have historically been a primary target); and (d) transaction taxes on equities... also act to direct investors toward government (and other) types of debt instruments. (e) prohibitions on gold transactions.

(iii) Other common measures associated with financial repression aside from the ones discussed above are, direct ownership (China or India) of banks or extensive management of banks and other financial institutions (i.e. Japan). Restrictions of entry to the financial industry and directing credit to certain industries are also features of repressed financial markets...

The tight financial controls associated with post-Depression financial regulation and the introduction of the Bretton Woods system enabled a period of financial repression that persisted from the end of the war to around 1980. This period was characterised by low real interest rates (during this time they were quite often negative) persistently, modestly high inflation rates, and rapid reduction in debt levels thanks largely to this "financial repression tax". It was an incredibly effective mix of policies:

For the United States and the United Kingdom, the annual liquidation of debt via negative real interest rates amounted to 3 to 4 percent of GDP on average per year. Such annual deficit reduction quickly accumulates (even without any compounding) to a 30-40 percent of GDP debt reduction in the course of a decade. For other countries, which recorded higher inflation rates the liquidation effect was even larger.

There are obviously some downsides to this model. Certainly it's not sustainable over a long period of time, but then it only "needs" to be sustainable while debt levels are high. And it may well be more sustainable, politically speaking, than alternatives. But can the postwar debt-reduction strategy work for indebted nations now? The paper concludes by arguing that some of the financial policies put in place, ostensibly as a response to the financial crisis, are moving advanced economies toward a more repressed financial system which might allow a return of this debt-reduction strategy. But it's not clear that Bretton Woods can be duplicated. Thirty years of financial liberalisation has made markets broader, deeper, and more complex. It has also created strong constituencies in favour of liberalised finance, most of which were not dislodged by the crisis. Putting the genie back in the bottle will prove very difficult.

But political leaders may have a strong incentive to pursue it. Rapid growth seems out of the question for many struggling advanced economies, austerity and high inflation are extremely unpopular, and leaders are clearly reluctant to talk about major defaults. It would be very interesting if debt (rather than financial crisis or growing inequality) was the force that led to the return of the more managed economic world of the postwar period.