We live in a strange time that seems to be confounding even many financial experts. What I mean is that in a time of 7% annual inflation, long term interest rates haven’t seemed to budge. With the ten year treasury note yielding 1.4%, well below the 2% long term target inflation of the Fed, investors seem to be happy to experience a real loss.
There have been a number of explanations for this and it isn’t just a US phenomenon. Most wealthy countries find themselves today in a situation where savers face real negative rates. Some of these explanations include the fact that savers are anticipating even more negative rates in the future or that a loss long term of roughly 0.6% annually is better than holding cash and losing 2% a year. Yet investors who want to hold fixed income securities could easily just shift savings to higher yielding government securities. These could be from places like Brazil or China. Currency and credit risk could easily be mitigated in these countries by investing in the local currency. It would be a win win from an investor point of view, high yielding investments which likely will include an appreciating currency due to the capital inflows over time.
This is how the world would work if it acted according to orthodox economic theory but the reality is always a bit more complicated. When a country like the US or Japan for that matter pushes its debt level up, it’s perceived risk tends to increase. To pay this debt off there are 2 ways currently to do it. One option is to inflate their way out of the debt. This was essentially what happened in the US in the 60’s and 70’s. Monetary independence was not firmly established and money printing was prodded a long by a heavy hand from the White House.
Yet you can look at any economic textbook to start to understand why inflation is a bad thing. It creates uncertainty in future prices, it rewards the financially savvy and punishes the poor. It recklessly rewards the profligate like those that have accumulated debt and punishes savers for no hood reason. This is why governments now tend to be committed to fighting it.
The Other Way Around Debt
Less talked about at the time was financial repression which was used to pay down the national debt built up during WWII. Interest rates were capped in the late 1940’s after the war at 2.5%. One of the ways the government was able to do this was to force institutions to buy its debt at these artificially low rates. How did they do this? They simply changed the rules. They forced banks and government institutions to hold their debt and used an accounting trick to do it. That accounting trick was making government debt the “safest” asset that an institution could hold on their balance sheet, as good as cash. Doing this on a system wide basis enabled the market for debt to be liquid. To add good measure, the US used its post WWII global position to fix exchange rates and have other countries hold its debt as well through the Breton Woods system.
Although exchange rates were floated when the US suspended dollar convertibility in 1971, the legacy system still left the dollar as the de facto international reserve currency. Yet foreigners don’t dominate interest rates in the US as you may expect, US institutions do.
In fact, after the pandemic related QE measures, the Fed now owns almost a quarter of all net US debt outstanding or $5.46 trillion. Only $326 billion of this is in T-Bills (short term debt) and the rest is in long term bonds.
Spreading out from the Fed and the Social Security Trust, the government can also require banks, insurance funds and pensions to hold more “safe” liquid bonds. Again here, you can see why with the stroke of a pen they can get those US investors, banks and the Social Security fund to all pitch in and pretty much abide by the interest rate they say. This way the government can keep borrowing costs low. It also supplies and almost unlimited market for their securities so that they don’t have to abide by and sort of fiscal restraint, something that both parties are guilty of in the past few decades.
What is the Result?
Now that we know one of the reasons behind why rates are remaining so low and why government has an incentive to do so, it is important to look at what the financial repression and quantitative easing of the Fed is producing.
The Fed has a justification to keep long term rates low so that it can stimulate the economy. This is done through lowered mortgage costs, which tend to be priced with a spread to the 10 year treasury note. It also makes debt cheaper for consumers and business and lowering the cost of debt for things like attending college, the latter of which is already subsidized by the government to achieve ultra low interest rates.
The rhetoric is that most of this spending was going to help people suffering through the pandemic due to the lockdown. Some of that money indeed made it through. The government can’t just bar people from going to their jobs without compensating them for it. Yet a lot of this money goes towards kicking the can on hard decisions down the road and subsidizing favored industries, which are producing spectacular bubbles.
These include the housing market, of which the Fed is currently also holding $2.6 trillion of MBS as well as the student loan market, which has ballooned to $1.57 trillion. Student debt has eclipsed auto loans to be the second largest source of debt for consumers after mortgages.
The government used to just subsidize the interest rate and guarantee repayment for the debt holders but in order to pay for Obamacare they went ahead and cut out the private bank and student lender middle man. As of Q1 2021, student loans now account for 45% of total government financial assets.
The laws of supply and demand don’t disappear just because the government is involved. Subsidizing education has produced runaway inflation in university costs for almost 30 years now. The Fed’s repression of long term interest rates also send housing prices up as it gets cheaper to borrow to purchase a home.
Crowding Out Good Money
Gresham’s law in economics says that bad money will chase out good money. This is exactly what we are seeing on a vast scale in the US consumer market. A parallel to this was what Latin American and emerging market governments tried in much of the 60’s, 70’s and 80’s.
At that time, states thought they knew better than consumers and they used some of the same tactics being used today to favor them. This was done by forcing banks to make loans to the government and declare these “safe” assets on their balance sheets. They also encouraged banks to lend to their favored state industries such as oil or copper production. When commodity prices collapsed in the 80’s and 90’s, many of these companies and their governments had financial crises and were forced to divest their state ownership and leave more companies to function privately.
The result which can’t easily be measured was how those government loans kept money away from entrepreneurs and other growing private companies that could have used the capital and moved these countries away from state led industry. To a lesser extent we are seeing the same result today as consumers are hampered by high mortgage debt, due to those higher prices as well as now higher student debt.
You can then break this down to a micro scale and start to see why it causes problems. More money is eaten up in our daily budgets by mortgages and student loans that it crowds out opportunities in other areas we may want to spend on. These could be starting our own business, or saving and investing. Any of which could add to the quality of our lives.
The intentions of financial repression were good and Nobel, but like many things the government gets involved in, the results are a mess. Lyndon Johnson, who benefitted from student loans himself and was one of the few presidents who actually grew up poor, started the government backing student loans so that the US could compete with the Soviets in terms of education by having a greater proportion of its population attend college. Yet the Soviet Union and the space race are long gone and yet we still have these student loans getting ever larger. Universities are happy to benefit from this and continue to raise the price of school, even when the costs start to make little economic sense. As long as the government subsidizes it, they will keep raising prices.
Likewise the new housing bubble is entirely government created. With QE, US borrowers can borrow cheaper for 30 years than many national governments can around the world. The same dynamics are at play, cheap lending fuels the price boom across the country.
What the Future Holds
Japan has a long history of supporting strategic industries and of high debt. While slow growth Japan was an outlier for much of the 90’s and 2000’s academics are starting to come around to the fact that Japan may be just the first of a new normal for rich countries, not an outlier. Japan was one of the first wealthy countries to have its population shrink and was the first to try QE. None of this has helped the country escape high debt, deflation and low growth, a future which is seemingly more and more likely for the US and other rich countries.
We can see what the future holds if we continue on the same path as Japan: stopping immigration will produce a shrinking population, less people to produce the same number of goods and services. Extremely high government debt almost fully owned by domestic institutions (this is the case now in Japan) punishing savers and retirees and a normal functioning market for government bonds disappearing as the Fed hoovers up all new issuance.
As the US population flatlines or shrinks and debt balloons, we face a future similar to that of Japan with the occasional bubble here and there due to that financial repression. The way out of this trap is to stem the ever-climbing national debt, cut the QE, raise interest rates and start to retract the subsidies for higher education which send prices skyrocketing and saddle students with crushing levels of debt. This will also effect the housing market and would likely produce a recession. Yet if artificial support is continued and inflation is not checked, we face a bleak reckoning not disimular from the late 70’s and early 80’s with multiple recessions and sky high interest rates as well as even more debt for everyone. The public narrative on these topics needs to change and start pointing out the truth behind the current state of affairs.
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