History of Financial Repression: Will it make a comeback?

John Mullin in this Richmond Fed article traces history of financial repression and whether it will comeback:

In the early 1960s, South Korea’s economy was far from the dynamic performer that would later become known as an “Asian Tiger.” On the contrary, its disappointing growth drew unfavorable comparisons to North Korea at the time.

In their seminal 1973 treatises on financial markets and economic development, Stanford University economists Ronald McKinnon and Edward Shaw labeled South Korea’s ailment “financial repression.” According to their diagnoses, the country’s economic development had been impaired by well-intentioned but counterproductive policies — chiefly interest rate ceilings and administratively directed investment programs — that combined to tax savings and misallocate investment. The country’s prospects improved greatly after it introduced fiscal and banking reforms in 1964-1965 that substantially removed these polices and allowed interest rates to increase toward market-clearing levels.

Many policies have been associated with financial repression over the years, and they have had many rationales. For example, governments have often barred domestic residents from buying foreign currency to invest abroad. These restrictions, known as “capital controls,” are regularly used in tandem with domestic interest rate ceilings in order to channel inexpensive funds toward a government or its preferred beneficiaries. But capital controls are also motivated in many cases by the more benign goal of insulating domestic financial markets from volatile international capital flows.

Bank reserve requirements are also often implemented with mixed goals. While there is no doubt that they can facilitate deficit financing by creating a captive market for government debt, in most cases they are at least partially motivated by the goal of reining in excessive risk-taking by private banks, particularly when governments provide bank deposit insurance.

He goes on to discuss Financial repression in Europe, US and Emerging markets. Experiences differ widely.

Concerns about a reemergence of financial repression have been raised by the cumulative effects of the 2007-2008 global financial crisis, the European debt crisis, and the COVID-19 pandemic. In Europe, the process of placing public debt at below-market rates has arguably been underway for some time. Between 2007 and 2013, domestic banks in eurozone countries more than doubled their holdings of government debt, and it looks like the buildup has not been completely voluntary. “A common complaint I have heard from private bankers is that they were being leaned on by their governments to buy at debt auctions,” says Reinhart.

In the United States, banks are also holding vastly increased levels of government debt, largely due to the 2014 implementation of the Liquidity Coverage Ratio (LCR), which requires banks to hold certain levels of high-quality liquid assets. The LCR was mostly motivated by macroprudential considerations, but policies usually end up having side consequences, and one of the side effects of the LCR is that it has substantially increased banks’ demand for U.S. government debt obligations, including Treasury securities and reserves.

Has this contributed to a recent trend toward lower interest rates in the United States? Reinhart believes this to be the case. Other economists prefer a prominent alternative explanation — secular stagnation — which posits that low interest rates mostly reflect an aging demographic profile and disappointing productivity growth. To this, Reinhart counters that “they are not mutually exclusive.”

Regardless of the causes of recent low interest rates — and of course, the Fed’s countercyclical monetary policy is itself a major factor — in some ways today’s situation appears to be quite distinct from the early postwar period. “During World War II, it was different,” says Schwartzman. “Treasury rates were kept low with the explicit goal of facilitating deficit finance. I wouldn’t want to call today’s low interest rates financial repression. That would be a bridge too far.”

All old ideas keep coming back as a new package.

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