Investors seem optimistic about the prospect of negative real rates in the indefinite future: they shouldn’t
High levels of debt require permanently low interest rates. It is the political and economic logic behind the policy of keeping rates well below the growth rate. After 1945, this state of affairs, which economists call financial repression, effectively wiped out a large part of the war debts of the United States and Europe. But when this policy was tried again after the financial crisis, debt levels continued to rise. In the aftermath of the pandemic, markets anticipate more decades of repression. But they have not taken into account neither its costs nor the measures necessary to make it work.
At the end of World War II, US short rates were below 1% and the return on 10-year bonds was barely above 2%. The Fed bought bonds directly from the Treasury. Public debt reached 120% of GDP. Deposit rates in Western economies have been negative in real terms for decades. Between 1945 and 1980, this form of repression reduced the size of the public debts of the United States and the United Kingdom by almost 3% of GDP a year, according to María Belén Sbrancia, an IMF economist.
After the bankruptcy of Lehman Brothers, the world once again resorted to repression. In both the US and Europe, short rates remained below nominal GDP growth and remained negative in real terms. But while ultra-low rates helped US households reduce their excessive indebtedness, businesses and the government took advantage of easy money to borrow even more. The pandemic dramatically accelerated this process. As a result, US non-financial debt reached a record nearly three times GDP at the end of 2020, according to the Bank for International Settlements. Public debt has returned to its post-war high.
Massive purchases of securities by central banks have facilitated the recent profligacy of governments. But they also make a rate hike much more expensive. This is because quantitative easing, in practice, involves replacing long-term sovereign bonds with short-term debt issued by the central bank. In the United Kingdom, the average maturity of the national debt has been reduced to just over four years. So a one point increase in the rate would cost the government 0.8% of GDP in additional interest costs. So the political imperative to keep rates low has never been stronger.
Investment strategist Russell Napier expects rates to remain below growth for years to come. This new round of financial repression will be accompanied by significantly higher inflation, predicts Napier. After 2008, banks did not use the money newly printed by the Fed to make new loans. Instead, bank reserves soared and the money multiplier plummeted. Today, banks are better capitalized and have fewer bad debts. In 2020, when the Fed doubled the size of its balance sheet, much of its new money went directly into the pockets of the public. America’s banks are brimming with deposits and eager to lend.
Napier predicts that the money supply will grow 10% this year in the US and Europe, leading to inflation of 4%. If it remains at this level and the governments control their desire to spend, the repression will liquidate the public debt more or less at the same rate as in the postwar period.
But it is not free. Repression acts like a wealth tax in the closet. Government creditors are the biggest losers. In 1946, a bear market began in US bonds that lasted 35 years. In the postwar decade, British Gilts lost 40% of their purchasing power. Furthermore, as Napier points out, when credit is no longer allocated on the basis of its market price, governments must take a bigger role. In postwar France, most bank loans became the province of the state. In Britain, companies wanting to raise money in the City needed the approval of a Capital Issues Committee.
To paraphrase Keynes, when the development of a country’s capital becomes a by-product of the political process, the job is likely to be poorly done. By fueling inflation and retarding growth, financial repression leads to stagflation, a term coined by Tory politician Iain Macleod in the 1960s.
Investors appear optimistic about the prospect of negative real rates in the indefinite future. You should not. Since Treasuries are priced even higher today than they were in 1945, holders face potentially greater losses. Napier advises investors to substitute fixed income for their portfolios for gold, which tends to perform well when rates are below inflation.
Equities are not directly hurt by the crackdown and did relatively well after 1945. But then US stocks were extremely cheap, whereas today they are extremely expensive. When bond returns start to rise, stocks will likely go down.
Investors in regulated financial institutions, such as insurers and pension plans, will also suffer when the state directs their savings towards preferred ends, such as green energy. New regulations may also be needed to prevent companies from using cheap credit for financial engineering. A simple and long-awaited reform would be to end the tax deductibility of interest payments. That would put an end to share buybacks and leveraged purchases.
Financial repression is associated with capital flight. The Bretton Woods system authorized capital controls. His return would mean a new headache for investors. But perhaps the biggest risk is that the current repression experiment will overflow. Under repression, investors resemble the frog that slowly boils to death. High inflation, on the other hand, is the fire whose scorching heat is immediately felt and from which you cannot escape.