Many people will already be familiar with the term ‘financial repression’, but for most it will still be something unfamiliar – just another technical term in these times when we have learnt to talk quite naturally about subprime mortgages, deleveraging, the ‘new normal’ or the now overused term ‘stagflation’. The scenario in which we find ourselves – and in which we will continue to operate over the coming years – is one of ‘financial repression’. And this has been agreed upon by those who once dominated the economy but are now desperately trying not to drown in their own vomit – that is to say, their almost infinite debt: Europe, the USA and Japan.
The term ‘financial repression’ is nothing more than the acknowledgement of a somewhat Machiavellian strategy perpetrated by central banks and governments in perfect collusion, under cover of darkness and with malicious intent. It simply refers to the government’s control over the country’s financial and monetary system through a variety of means. The intended effects are varied; for example, controlling interest rates, controlling the flow of money between economic agents where it is deemed appropriate to boost or curb such flows, keeping creditors of the state’s own debt in check, and manipulating credit, amongst others. But at present, the main objective of the financial repression being perpetrated by the developed world is to inflate the economy unofficially whilst at the same time keeping official interest rates as low as possible (currently at practically zero).
We say ‘unofficially inflate’ because it would serve little purpose to acknowledge high inflation through the various – and increasingly imaginative – price indices, as this would force an upward adjustment of pensions and other public-sector financial commitments to society. In other words, the calculations of official inflation indicators are adjusted at the behest of governments to keep the official rate of price rises close to zero, whilst – in countries not experiencing outright deflation – official inflation is, year after year, eroding the purchasing power of all savers. For their part, central banks, with interest rates at rock bottom, are desperately trying to get real and effective inflation to take off, in order to achieve a spread of a few points between official and real inflation.
Some of you may be wondering what the point is of undermining savings through hidden inflation and rock-bottom interest rates. Well, it’s simple, What harms savers benefits debtors – in other words, the majority of people and governments in the developed world. The explanation is obvious: any balance sheet in difficulty needs its liabilities to be written down whilst it tries to ensure that its assets grow, or at least remain stable.
This is what the financial repression, the secret roadmap that governments and central banks have laid out with blood and fire for the coming years, whilst denying it in public time and again in the truest biblical style. Only in this way can debtors whose debts have spiralled out of control – and who could never repay their creditors – «pay off» their debts little by little, paying nothing more than the bare interest (which, let us remember, is at rock bottom), thereby reducing the real value of their debts year after year. Even if the spread between real inflation and official interest rates is only 2, 3 or 4 percentage points, the effect of paying off these liabilities, year after year, is very significant (try it for yourselves by deducting those annual percentages from any mortgage and you’ll see how, over time, the borrower’s financial situation improves dramatically). Or, to put it another way, by eroding the recurring deficits of countries which, like Spain, are still a long way from balancing their books. And if at any point inflation shoots up a little further due to the reckless and endemic laxity in central banks’ rate rises, the blow dealt to the debt of the country, a company or a household is even greater. It’s the icing on the cake for those in debt, but not for creditors or investors.
That is the unofficial course of action taken by central banks and governments in the world’s most indebted countries. In fact, it may well be the only way to avert disaster, the default of massive economies and the very collapse of the financial system. And although the official statements from central bankers and governments suggest otherwise, on some occasions they let slip small samples which give away their secret agenda.
The knock-on effects of this financial crackdown are, of course, equally brutal. Savers and investors face a few years in which it will be very difficult to achieve fixed, non-speculative returns that are sustained over time. This is even more true for fixed-income investments, where capital gains will be very scarce or even negative. Let us not forget that we are starting from interest rates at almost zero and that they can now only move in one direction: precisely the direction that undermines yields across the entire global fixed-income market, which is anchored to the risk-free yield or the risk-free yield on US Treasuries. Although these rates will remain at zero for as long as possible, they will have to rise gradually as inflation also rises and reaches levels that can no longer be ignored. In other words, interest rates will rise in proportion to the economic recovery and the pace at which real inflation accelerates, as this will in turn drive up the official inflation figures – though always with a substantial spread. A spread which, as we have already said, is precisely what debtors (households, businesses and the state) need to avoid default or bankruptcy over the years.
But there are also other variables at play (it was a bit too easy, wasn’t it?), such as the adverse effects of the distortion of the yield curve that will result from the start of tapering or the reduction in the pace of quantitative easing (QE) by central banks. In fact, the fixed-income markets are already being seriously affected simply by rumours and speculation about when this tapering – or turning off the tap – will begin. And these effects should not be underestimated, given that we are in uncharted territory; in other words, central banks have never before had to deal with such monetary inertia across such colossal balance sheets.
To give you an idea of the absurd headlong rush we’ve all got ourselves into up to our necks: the scale of the quantitative easing (QE) being carried out by the BoJ is on a par with that of the Fed. But bear in mind that the Japanese economy is four times smaller than that of the US! Abenomics is undoubtedly the Achilles’ heel of the financial system today. And it doesn’t stop there: just imagine for a moment the wide-ranging effects that the devaluation of the yen will have (and is already beginning to have) on Asian and German economies, which are clearly export-oriented… and we could go on like this until we feel quite despondent at the sheer scale of the uncertainty we face in the coming years.
Given such unprecedented levels of inertia, you can well imagine how extremely slim the chances are that central banks will manage to turn off the tap at exactly the right pace and at exactly the right time (something which, to make matters worse, they have never historically managed to do even in far simpler situations). They must manage nothing less than to inflate the economy just enough to scrape together those tiny bits of hidden real inflation that the indebted world needs, sustained over time, to avoid bankruptcy. And at the same time, they must keep interest rates as low as possible to prevent debtors from being bled dry by interest payments. All whilst gradually weaning themselves off injecting money with so many zeros that they’ve lost count.
Although it may be unsettling, I believe it is healthy for us to reflect and adapt to this scenario of financial repression into which our governments and central banks have been steering us, under cover of darkness and in secret, for a couple of years now. The paradox is that we continue to reward those who have performed poorly (insolvent debtors) and punish those who have performed well (savers/investors). The reason is surely that we have no alternative if we wish to prevent the collapse of the system.
The developed world is not doing the right thing, but rather the only thing it can do to avoid financial collapse, at least for the time being. And in the midst of this storm, we investors must be clearer than ever our priorities, and not let ourselves be swept up in the madness of the virtually bankrupt and other financial zombies.