Costs to savers will be high to stave off default

‘Financial repression’ may stave off default, but the cost to savers will be high

Inflation will probably still be higher than the paltry interest rates available on many savings instruments – particularly after tax.

Roger Bootle By Roger Bootle8:00PM GMT 27 Oct 2013CommentsComments

All being well, pretty soon workers will start to see the real value of their earnings rise as inflation falls back. And about time, too.

But sadly I doubt that savers will have much cause to rejoice. Inflation will probably still be higher than the paltry interest rates available on many savings instruments – particularly after tax.

This will continue for some time. The authorities are engaged in policies which inflict real losses on savers. This is nothing new. It is what happened in Britain and America after the war and it played a leading part in enabling both countries to reduce their debt burdens after they had been inflated by massive wartime borrowing.

The UK is again suffering from a serious problem with the public finances. Last week’s figures on the Government’s deficit at last showed a chink of light. But, make no mistake, the debt is still rising.

This year, it will probably be about 80pc of GDP. We will be lucky if it peaks below 85pc. In itself this is not a disaster, but we have to be careful. A prudent manager of the nation’s affairs would seek to reduce this ratio to well below 50pc.

The orthodox way of reducing the deficit, namely through fiscal austerity, has been implemented and still has further to run. But on its own it cannot make that much of a dent in the debt ratio. As long as there is any deficit at all, then the stock of debt still rises.

Some countries, including some in the eurozone, that are struggling with debt ratios above 100pc, will probably eventually default. But that route is not open to us. The British don’t do default. Or at least, not outright default.

In the past, British governments have done quite a lot of implicit default through inflation. I argued last week that Japan may be forced into taking the inflation route, but this would be resisted in the UK, at least initially.

Growth is our hope. It isn’t only that growth will produce higher tax revenues and thereby reduce the deficit, or even eventually turn it into a surplus, but also that a given amount of debt will represent a smaller share of GDP.

In this way, the debt burden can be reduced painlessly. But it will take decent growth rates, sustained long after Mr Osborne has left office, to bring the debt down to manageable levels. And there is a worry that the cost of servicing the debt – paying interest on it – could overwhelm the benefits of continued austerity and economic growth.

That is where “financial repression” comes in. The term is used to cover a variety of measures that have the effect of forcing interest rates and bond yields lower than they would be in normal free market conditions. This reduces the cost of government borrowing while not directly harming economic growth. Indeed, it should encourage it.

So far, neither the Government nor the Bank of England has openly said that it is engaged in a policy of financial repression. And, to the best of my knowledge, neither has any other government or central bank. Rather, financial repression has resulted from policies being justified in other ways.

The policy of Quantitative Easing (QE), which involves the Bank of England buying huge quantities of government bonds, is supposed to boost the economy by reducing long-term interest rates and flooding the system with liquidity, thereby increasing asset prices and encouraging finance to flow into productive uses.

But in so far as it has kept down the rates of interest on government bonds, which you would presume it has, it has also reduced the cost of financing the Government’s deficit, compared to what it would otherwise have been. This has been very welcome at a time when the Government has to finance a deficit of £120bn and is forking out £30bn a year in debt interest.
Similarly, banks, pension funds and insurance companies are obliged to hold a high proportion of their assets in safe form, ie government debt, for “prudential” reasons. Nevertheless, this has the effect of boosting the demand for this debt and thereby keeping the rates on it low.

The policy of holding interest rates at 0.5pc has the same result. The policy exists primarily for macroeconomic reasons, that is to say, it is believed to stimulate aggregate demand and hence boost the economic recovery. But it also has the effect of keeping down all short-term interest rates, including on government bonds.

We know that in economics there is no such thing as a free lunch. In economic policy, it is usually a matter of weighing up costs against benefits.

Of course, apart from economic growth, all ways of reducing the debt burden inflict losses on someone, but over and above this they can also be economically damaging. When a government defaults, it is obvious who bears the losses – the holders of government debt.

The economic costs of default are also pretty clear, namely that this may damage a government’s reputation and thereby impair its ability to borrow in future, as well as possibly inflicting serious damage on banks and other financial institutions that are vital to a healthy economy.

When a government lets inflation erode the real value of its debt, the losses are not so obvious – but they happen just the same. They are borne by all those who have assets that are not protected against inflation, including conventional government bonds. Inflation causes damage because it distorts the price mechanism and requires a recession to bring it down again.

A policy of financial repression does not involve any sort of default as such because no promise is breached. But the results are much the same. Anyone with savings in forms where the interest rate is flexible, and people doing new saving, will find that they receive less than they normally would. As umpteen pensioners know only too well, low gilt yields have caused annuity rates, which govern entitlements to pension payments, to come down, too.

The damage done by financial repression consists of the distortions to financial markets and the risk that low interest rates and bond yields will cause bubbles in asset prices that, when they burst, cause serious losses.

You can see this risk building now, especially in interest rate-sensitive assets such as residential and commercial property. For the time being, this is a risk worth taking – but not forever.

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