Is There A “Back Door” Method For The Government To Pay Down The Federal Debt Using Private Savings?
By Daniel R. Amerman, CFA
The United States government is currently about $18 trillion in debt. To place this number in perspective: if we assume that only the above-poverty line households will be making net contributions towards paying this enormous debt, this means that the national debt equals about $180,000 for each "able to pay" household in the US.
With traditional financial planning, the most common way of dealing with this problem – is to completely ignore its existence. Rather than try to incorporate the effects of this massive debt that could transform interest rates, economic growth and rates of return for decades – most investment plans for individuals simply pretend it doesn't exist.
However, if one is to make reality-based financial decisions over the long-term, then there is no substitute for understanding just how nations actually deal with massive debts in the real world, whether in the United States or in other Western nations with extraordinary levels of debt.
In practice, there are four primary methods which nations use to pay down huge government debts when they have borrowed in their own currency:
1) Decades of austerity with higher taxes and lower government spending. This painful choice can lower economic growth rates for decades, and fundamentally change investment returns. It is also overt and clearly understood by voters, and can thus have devastating political implications.
2) Defaulting on government debts. This radical option can devastate bond and stock portfolios, bank deposits and retirement accounts. It is also clearly understood by voters, and thus can have devastating political repercussions.
3) Inflating away the value of the debt through rapidly slashing the value of the currency. Very high rates of inflation rapidly reduce the value of savings, bonds, deposits and retirement accounts. Because collapsing the purchasing power of savings and salaries powerfully impacts the day-to-day lives of voters, this can have devastating political implications.
4) Using "Financial Repression", a process that is complex enough that the average voter never understands how it works, thus allowing governments to use this potent but subtle method of taking vast sums of private wealth, year after year, decade after decade, with almost no political consequences.
This fourth method that nations use to control or reduce the real value of debt is by far the least known or understood. Which is why if you are a senior government official in a nation that has a huge "sovereign debt" problem – like the United States and almost all of Europe – and you want to stay in power, this method is of keen interest and appeal.
Financial Repression has strong advantages for the government. First, it works in practice – and professional economists understand this very, very well indeed. As published in a working paper on the IMF website, Financial Repression is what the US and the rest of the advanced economies used to pay down enormous government debts the last time around, with a reduction in the government debt to GDP ratio of roughly 70% between 1945 and the early 1970s.
Second – and of crucial importance – is that there was almost no political damage, even while most major nations deployed it over a period of 25+ years to pay down the debts of World War II. So Financial Repression is proven not only to be effective, but in practice to carry very few if any negative political consequences, quite unlike the better known "high drama" solutions of austerity, default or high inflation.
This avoidance of any political cost is also proven by current events since 2010, for even while the major components of classic Financial Repression have been reappearing for the first time in decades in the United States and other nations – there has been relatively little media coverage or general discussion.
To understand this "miracle" debt cure for governments requires understanding the source of the funding. That is, the essence of Financial Repression is using a combination of inflation and government control of interest rates in an environment of capital controls to confiscate much of the purchasing power of a nation's private savings.
Rephrased in less academic terms – the government methodically destroys the value of money over a period of many years, and uses regulations to force a negative rate of return onto investors (in inflation-adjusted terms), so that the real wealth of savers shrinks by an average of 3-4% per year (in the postwar historical example).
Indeed, over time Financial Repression can be every bit as destructive to wealth building through savings and retirement accounts as is austerity, default or high rates of inflation.
And because of the sheer size of the problem – most of the population must be made to participate, year after year. Financial Repression therefore uses an assortment of carrots and sticks to ensure that investors have little choice but to participate – on a playing field that has been rigged against them as a matter of design – even if they are among the small minority who are aware of what is being done to them.
Understanding Financial Repression
Financial Repression and its devastating impact on retirement investors was the subject of a recent Bloomberg article, and it has also been previously covered by the Economist magazine, which included the following summary:
"... political leaders may have a strong incentive to pursue it (Financial Repression). 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."
The phrase "Financial Repression" was first coined by Shaw and McKinnon in works published in 1973, and it described the dominant financial model used by the world's advanced economies between 1945 and somewhere between 1970 to 1980 (the specific duration varied by nation). While academic works have continued to be published over the years, the phrase fell into obscurity as financial systems liberalized on a global basis, and former comprehensive sets of national financial controls receded into history.
However, since the financial crisis hit hard in 2008, there has been a resurgence of interest in how governments have paid down massive debt burdens in the past. And in 2011 a fascinating study of Financial Repression, "The Liquidation of Government Debt", authored by Harvard economics professor Carmen Reinhart and M. Belen Sbrancia, was published by the National Bureau of Economic Research.
The paper was circulated through the International Monetary Fund, and to understand why it has caught the full attention of global investment firms and governmental policymakers, take a look at the graph below:
The advanced Western economies of the world emerged from the desperate struggle for survival that was World War II, with a total stated debt burden relative to their economies that was roughly equal to that seen today. The governments didn't default on those staggering debts, nor did they resort to hyperinflation, but they did nonetheless drop their debt burdens relative to GDP by about 70% over the next three decades – and the very deliberate, calculated use of Financial Repression was how it was done.
What the IMF-distributed paper effectively constitutes is a Sheep Shearing Instruction Manual. The "way out" for governments is effectively to fence the world's savers and investors inside of pens, hold them down, and shear them over and over again, year after year. Uninformed and helpless victims is what makes Financial Repression work, and it worked very well indeed for 25 years.
On the other hand, if you understand what is truly going on, then you do have the ability to turn this to your substantial personal financial advantage. With a genuinely out of-the-box approach to long-term investment, the more heavy handed the repression – the more reliable the wealth compounding for those who reject "flock" thinking.
The Mechanics Of Financial Repression
The specifics of Financial Repression have taken somewhat different forms in each of the advanced economies, but historically they each come down to two fundamental components: A) creating a mechanism for "shearing", i.e., a way to transfer wealth from savers to the government on an extraordinary scale – but without ever explicitly saying that is what is being done; and B) using the government's control over laws and regulations to erect a series of "fences", making it very difficult for investors to escape the "shearing" pen, but again, without ever explicitly saying that this is being done.
As covered in the IMF working paper / governmental tutorial, this combination of shearing and fencing in the postwar era shared four to five core characteristics: 1) inflation; 2) governmental control of interest rates to guarantee negative real rates of return; 3) the funding of government debt by financial institutions; 4) capital controls; and 5) discouraging (or even outlawing in some cases) precious metals investment.
As further explored herein, most of these historical components have reappeared since 2010, in response to the extraordinary rise in government debt levels which resulted from the attempts to contain the damage from the 2008 crisis. The specifics for how the modern version works are in some cases quite different from the well studied postwar example, but they share the following features:
1) Inflation (Shearing #1). First and foremost, a government that owes too much money destroys the value of those debts through destroying the value of the national currency itself. It doesn't get any more traditional than that from a long-term, historical perspective. Without inflation, Financial Repression just doesn't work.
Historically, the rate of inflation does not have to be high so long as the government is patient, but the higher the rate of inflation, the more effective Financial Repression is at quickly reducing a nation's debt problem.
For example, per the Reinhart and Sbrancia paper, the US and UK used the combination of inflation and Financial Repression to reduce their debts by an average of 3-4% of GDP per year, while Australia and Italy used higher inflation rates in combination with Financial Repression to more swiftly drop their outstanding debt by about 5% per year in GDP terms.
2) Negative Real Interest Rates (Shearing #2). In a theoretical world, some would say that governments can't inflate away debts because the free market would demand interest rates that compensate them for the higher rate of inflation. Sadly, this theoretical world has little to do with the past or present real world.
For if we look at the current market, the substantial majority of US government debt is outstanding at rates that are less than even the official rate of inflation. This has been true for several years now, even as it was true (on average) for decades in the past.
In the past there were formal government regulations that determined the maximum interest rates that could be paid. As an example, Regulation Q was used in the United States to prevent the payment of interest on checking accounts, and to put a cap on the payment of interest on savings accounts.
Regulation Q is long gone, but government control of short, medium and long term interest rates has nonetheless been near absolute since 2010 in the United States. As described in detail in this article, the Federal Reserve has been using its powers to massively manipulate interest rates in the US, keeping costs low for the government while cheating tens of millions of investors.
First, creating inflation, and then second, holding interest rates beneath the rate of inflation, comprises the two blades of the shears. Working in combination, this transfer of wealth on a wholesale basis from savers to the government has created what has at times been a hidden $500 billion a year tax on savers in the United States.
So long as the Federal Reserve maintains control, there is no need for explicit interest rate controls – or even necessarily for ongoing Quantitative Easing (QE). However, should the Fed begin to lose control, there is a strong possibility that either interest rate controls or another sharp increase in QE will return to the US financial landscape, with similar controls or changes in monetary policy returning in other nations.
3) Funding By Financial Institutions (Fence #1). With this component of Financial Repression, the government establishes incentives for financial institutions such as banks, savings and loans, credit unions and insurance companies to hold substantial amounts of government debt. This can be publicly phrased as "mandating financial safety", instead of the more accurate description of mandating that investments be made at below-market interest rates to help overextended governments recover from financial difficulties.
This funding is sometimes described as a hidden tax on financial institutions, but let me suggest that this perspective misses the important part for you and me. Which is that as financial institutions operating within a country are effectively subsidizing this liquidation of government debt by accepting less than the rate of inflation on interest rates, the gross revenues of all financial institutions are depressed, and therefore less money can be offered to depositors and policyholders.
Then, because financial institutions make their money not on gross revenues, but on the spread between what they pay out and take in, then arguably, the guaranteed annual loss in purchasing power is not absorbed by the financial institutions, but rather passed straight through to depositors and policyholders, i.e. you and me, as further explained here.
The goal of this third element is to make sure that all savers are lending to the government at artificially low interest rates – even though the great majority of them never directly purchase a government security. One way of doing this is savers making deposits which pay very low rates of return, with banks using those very low cost deposits to purchase government debt that also pays a very low rate of return.
While little remarked upon, that is exactly what has been happening on a multi-trillion dollar scale in the United States, as part of the Federal Reserve's Quantitative Easing program. This can be clearly seen in the graphs below:
The Federal Reserve has purchased about $2.4 trillion in US Treasuries at extremely low interest rates – and it has financed these purchases by borrowing about $2.4 trillion from US banks at (on average) even lower interest rates. Which the banks are financing by paying virtually no interest rates at all to depositors.
On a net basis, the banks and the Fed drop out of the middle, and savers are left financing the US Treasury, with essentially no interest income gained, and an annual reduction in the value of the investment principal within an environment of ongoing inflation. This is a classic example of Financial Repression on an effective basis, even if the specific tools being deployed take a different form this time than they did in the postwar example.
4) Capital Controls (Fence #2). In addition to ongoing inflation that destroys the value of everyone's savings and thereby the value of the government's debts, while simultaneously making sure that interest rate levels lock in inflation-adjusted investor losses on a reliable basis, there is another necessary ingredient to Financial Repression: participation must be mandatory. Or as Reinhart and Sbrancia phrase it in their description / recipe for Financial Repression, it requires the "creation and maintenance of a captive domestic audience" (underline mine).
The government has to make sure that it has controls in place that will keep the savers in line, while the purchasing power of their savings is systematically and deliberately destroyed. This can take the form of explicit capital and exchange controls, but there are numerous other, more subtle methods that can be used to essentially achieve the same results, particularly when used in combination.
This can be achieved through a combined structure of tax and regulatory incentives for institutions and individuals to keep their investments "domestic" and in the proper categories for manipulation, as well as punitive tax and regulatory treatment of those attempting to escape the repression. A carrot and stick approach in other words, to make sure that investor behavior is controlled.
For a modern example, we can go back to the Affordable Care Act and one crucial element that was slipped in there with zero public debate. That is FATCA, which has been changing the flow of capital for US citizens on a global basis. FATCA makes it dangerous for foreign institutions to deal with US savers and investors.
They are forced into onerous reporting requirements on the financial activity of US citizens that could be administratively difficult to do, and require changing their internal procedures on a wholesale basis. If they don't comply in exactly the way that the US government wants – then these foreign institutions face potentially severe penalties.
So what are a lot of foreign institutions around the world doing?
They're not allowing US citizens to open accounts. The easiest and most risk-free thing for the bank to do is to simply not open the accounts. Which is effectively a form of capital controls.
Extraordinary Timing
The timing of events in the last few years is fascinating.
When did Quantitative Easing 2 (QE2) appear with the Federal Reserve's overtly taking control of US medium and long-term interest rates, forcing rates ever lower beneath the rate of inflation?
It was November 2010.
When did the surge in bank asset reserves begin with QE2, with an ever greater percentage of bank assets going to the Fed, which used the money to acquire very low- rate US government debts?
That was 2010.
When was FATCA made a matter of law, fundamentally reducing the ability of US citizens to move their money out of the country (albeit not to become effective until 2014)?
That was 2010.
With no press releases, and after an absence of about four decades, three of the core components of Financial Repression almost simultaneously were brought back into play (with the fourth component – inflation – having been there the entire time). Even while federal debt was soaring when measured as a percentage of the economy, returning to levels not seen in almost 60 years. Indeed, debt levels have not been this high since the last time Financial Repression had been used.
Coincidence?
5) Precious Metals Controls (Fence #3). Now there is a fifth component that is very important as well. This one's a little more optional, but it's part of classic Financial Repression in the United States as well as the UK and other nations.
And that is if the government is creating inflation, and as a matter of law it's not allowing citizens the ability to protect themselves from that inflation, then investors will be tempted to seek refuge in precious metals.
So the fifth component of classic Financial Repression is to either make illegal or discourage investment in precious metals. To some extent that's already true in the US when we look at our collectibles tax treatment as compared to other investments, which strongly penalizes investments in precious metals, as explained here.
At this stage, there have been fewer changes with regard to precious metals than with the other categories of Financial Repression. However, it is worth keeping in mind that the more successful precious metals investors are in dodging Financial Repression – then the more likely the return to Financial Repression for precious metals investors. After all, the underlying theory is based upon not allowing savers to escape the pen.
A "Low Drama" Approach To Systematically Cheating Investors
The governments of the world are in deep financial trouble, and would naturally prefer to avoid the "High Drama" approaches of overt global defaults, very high rates of inflation, or comprehensive austerity coupled with massive tax hikes – if possible. For each of those radical routes is highly unpopular, and could lead to political turmoil that would remove the decision makers and the special interests who support them from power. A more subtle approach sounds far more attractive, particularly since it has worked before over a period of decades, with an almost boring lack of political turmoil.
To get out of trouble by way of Financial Repression, the governments must wipe out most of the value of their debts, without raising taxes to the degree needed to pay the debts off at fair value. In other words, they must cheat investors on a wholesale basis. There is nothing accidental going on here, all that is in question are the particulars of the strategies for cheating the investors, meaning the collective savers of the world.
Again, the time-honored and traditional form that heavily-indebted governments use to cheat investors is to devalue the currency. Create inflation, and tax collections will rise with that inflation but the debts won't, and meanwhile the savers of the world will be paid back in full with currency that is worth less than what was lent to the governments in the first place.
Except that there is the technicality, according to one currently popular school of investment theory, that all-knowing and all-powerful free markets will demand that interest rates will necessarily rise above the rate of inflation, so that the value of savings is not eroded.
From the governmental perspective, this is demonstrably a rather absurd theory. The core point of the Reinhart and Sbrancia paper is that to pay down government debt, the advanced economies of the world quite effectively squeezed an average of 3-4% annually out of investor real net worth for a period of 25 years, using a wide assortment of overt and less overt controls over interest rates and investor behavior.
When many people think of inflationary dangers, they think of high rates of inflation, perhaps 10% per year or more. They take a "High Drama" approach, and think that if rates of inflation are more moderate, then there isn't that much to worry about.
Ironically, however, this belief could not be more mistaken, for what history shows is something else altogether. "Moderate" rates of inflation have historically been quite effectively used over a period of decades to redistribute wealth from individual savers to national governments on a massive scale with virtually no political costs – because the general public has no idea what is being done to them so long as it is done relatively slowly and subtly, and they aren't reading about it in the paper.
Leaving The Flock
Difficult though it may seem, there is a way to beat Financial Repression. How?
Succinctly phrased: the first step is to stop thinking like a sheep and start thinking like a shepherd.
Stop acting like a sheep, and change your financial profile so that it aligns with the objectives of the "shepherds", which are the governments of the world.
Instead of fighting the governments of the world, position yourself so that the greater the mispricing between inflation and artificially low interest rates – the greater your real wealth grows, in inflation-adjusted terms.
The fundamentals of Financial Repression are for governments to pin down their citizens, force them to take interest rates that are below the government-induced rate of inflation, and make it almost impossible for an older investor with a conventional financial profile to escape. This is a time to "fight the good fight" politically – but not with your savings or your future standard of living.
Instead, align your financial interests with the government. So that the more outrageous that government actions become in squeezing the value of investor savings from their populations, and the more unfair that low interest rates become and the longer they persist – the more reliable the compounding of your wealth becomes for you, and the greater the growth in your financial security.
So how does one stop thinking and acting like a sheep? This can be amazingly simple, or it can be impossibly difficult. It is you and the perspective you choose that will determine whether thinking like a shepherd will become simple or be impossible. How open are you – truly – to changing the way you view investments and financial security?
Can you change the personal paradigm that may have shaped your financial worldview for decades?
View the investment world in the conventional way that most of us have been taught, and then maintaining wealth over the coming years of inflation and Financial Repression is likely to be extraordinarily difficult, particularly in after-tax and after-inflation terms. Because everything around you really is set up for sheep shearing.
This is not conspiracy theory talk – it's how the world really worked between 1945 and the 1970s. As has been studied in-depth by economists around the world since then, for 25+ years most advanced western nations used Financial Repression, it worked, and it worked without the general public ever catching on. Policymakers around the world thus likely see variants of this subtle and proven debt reduction methodology as their best way out.
The Great Sheep Shearing of the early 21st century has already been in process since 2010; we're just using some different names and specifics this time around. And a very strong similarity with the previous round – indeed, an indispensable similarity from a political perspective – is that the average person in the street once again has no idea.
Oh, people are aware that the interest rates they are earning on deposits and money market funds are pathetically low. They also know that government debts have reached fantastic, almost incomprehensible levels. But the connection between those two – and how it may transform the value of their savings and their realized investment returns for decades – most savers likely have no understanding of that.
Lacking knowledge, they lack defenses.
This lack of knowledge and lack of defenses means that Financial Repression will likely succeed with the overwhelming majority of investors – much like it did before only on a more thorough basis, because the problems are far larger this time around.
Whether Financial Repression will successfully prevent another and perhaps even larger round of financial crisis is a different question. But regardless, the attempt is still likely to dominate markets as well as government regulations and policy for years and possibly decades to come.
Your alternative is to accept the world as it is, take personal responsibility for your own outcome, and educate yourself. You can seek to fundamentally change your paradigm, even turn it upside down – and personally turn that same world of interest rates being held below the rate of inflation into a target-rich environment of wealth-building opportunities.
It is all up to you.
What you have just read is an "eye-opener" about one aspect of the often hidden redistributions of wealth that go on all around us, every day. In this case, it was about governments using the 1-2 combination of their control over both interest rates and inflation to take wealth from unsuspecting savers every day, on a massive scale.
Retirement lifestyle is determined by both benefits and savings, and a related "eye-opener", linked here, examines retirement benefit decisions. As this step-by-step analysis explores, when we include even a low rate of inflation, the most common advice about what age to start claiming benefits, which millions are relying on ─ just could be dead wrong.
A related personal retirement "eye-opener" linked here shows how the government's suppressing interest rates can reduce retirement investment wealth accumulation by 95% over thirty years, and how low interest rate policies are profoundly reducing standards of living for those already retired.
Another "eye-opener" tutorial is linked here, and it shows a quite different redistribution of wealth, which is how governments use inflation and the tax code to take wealth from unsuspecting precious metals investors, so that the higher inflation goes, and the higher precious metals prices climb - the more of the investor's net worth ends up with the government.
If you find these "eye-openers" to be interesting and useful, there is an entire free book of them available here, including many that are only in the book. The advantage to the book is that the tutorials can build on each other, so that in combination we can find ways of defending ourselves, and even learn how to position ourselves to benefit from the hidden redistributions of wealth.
