When a central bank keeps its base interest rate low, financial repression can manifest. Well… how does it manifest? What changes do we see in the economy? And what happens when you combine low interest rates with a falling labor share? How might low labor share resemble financial repression?
Part 1, a basic model … Part 2, Is there evidence of financial repression in the US?
There is an implicit transfer of funds from net-savers to net-borrowers.
The natural real rate of interest is a balanced interest rate between saving and borrowing. Savers receive a real return on their money that matches real economic growth. and The real cost of borrowing money is balanced with real economic growth. There is “economic” balance when the current real interest rate equals the natural real interest rate.
Yet, the current real interest rate does not always stay on the path of the natural real interest rate. In financial repression, the current real interest rate is below the path of the natural real interest rate, which has a positive slope with respect to the utilization of labor and capital,
When the current real interest rate is below the natural real rate, savers receive less real return than what real economic growth would give, while borrowers pay less real cost than the true cost of growth. In effect there is an implicit transfer of funds from savers to borrowers. The lower return for savers subsidizes the cost of borrowing. Firms that want to borrow to increase productive capacity receive funds at lower real cost. Normal economic growth gives borrowers an instant profit over the cost of borrowing. Thus, investment in productive capacity is subsidized by savers.
When interest rate policy enters the area of financial repression, productive capacity can increase faster.
Speeding Up Productive Capacity needs Extra Demand
Let’s take a situation where production is in balance with demand. Then we start investing to increase productive capacity. If domestic demand is not able to grow as fast as production increases, then foreign demand must exist to buy the excess production. If neither domestic demand nor foreign demand exists for the excess production, then the aggregate utilization rate of capital will decrease.
(note: Since the crisis, China has exploded with investment in productive capacity, especially in certain sectors. The explosion in investment kept their GDP expanding. Yet now, their capacity utilization rates are dropping from lack of demand. They are now looking for ways to shut down some of the firms so that capacity utilization can rise back up to more efficient and profitable rates.)
When Domestic Consumption does not keep up with Production Growth
Financial repression from low interest rates can weaken domestic consumption when consumers are net-savers, because they receive less return on their savings. Consumers end up having less relative purchasing power. This happens more in China than in the US, because households in China are primarily net-savers. In the US, younger generations tend to be net-borrowers while older generations tend to be net-savers.
Increasing production faster than domestic consumption increases national savings (national savings is equal to production minus consumption). More national savings creates more relative funds for investment in capital formation, which can lead to even faster growth in productive capacity. Low interest rates are instituted to create more investment.
(note: If labor share is low or drops, domestic consumption is even weaker and national savings even greater. Even wage growth in China over the years has not kept up with productivity. More on labor share below.)
Raising Interest Rates raises Consumption
Under financial repression, an increase in the central bank interest rate would lower investment, but raise consumption by net savers. Investment is already pushed higher from an interest rate below economic balance. So in effect investment falls toward “balanced” levels. On the other side, net-savers who consume already consume less than economic balance due to lower returns on their savings. So in effect, consumption rises toward “balanced” levels.
With a rise in interest rates under financial repression, funds are in effect transferred from borrowers back to savers. And if the savers are consumers, consumption rises.
It is important to determine the level of financial repression in the US due to a low Fed rate, because it may be that raising the Fed rate would actually increase consumption.
Export Industries are Boosted with Financial Repression
When production grows faster than domestic consumption, the increased national savings translates into increased exports through the international Balance of Payments mechanism. The excess production then becomes more competitive in the global markets. Consequently, the extra investment created by financial repression will usually be put into export industries. This is common in emerging countries.
The opposite of financial repression occurred in the US during the 1980′s. The current real interest rate was far above the natural real interest rate. Imports started to grow. The trade deficit started to grow. The cost of domestic investment rose. Borrowers were in effect subsidizing savers. Economic gains were more likely to be spent on production from abroad because of the extra cost to increase production domestically. The extra demand created among savers opened up markets for imports.
The cozy relationship between Labor Share and Financial Repression…
Financial repression benefits from labor receiving a lower share of national income. As labor share falls, domestic consumption is reduced, which increases national savings, and increases accessibility to funds for investment. Financial repression manifests the same.
Low labor share benefits export industries by reducing direct labor costs, so that exports can be more competitive globally.
Germany increased exports by increasing production and weakening domestic consumption through lowering labor’s share of output. The mechanism of lowering domestic consumption so as to raise national savings creates a trade surplus, all the while increasing funds for investment.
China has an extremely low labor share rate combined with financial repression. In China especially, low labor share compounds the effects of financial repression to shift funds from consumers to investors in capital. Such weakening of consumer purchasing power actually controls inflation tendencies in China. (see below)
The United States has lower labor share since the crisis, and firms are benefiting from that. However, low labor share is creating an opportunity for financial repression with low interest rates. Case in point, if there was just low labor share without low interest rates, the US government would not enjoy lower interest payments, as tax revenues fall as a share of GDP. Therefore, there must be pressure to keep the Fed rate low so that the government gets its “piece of the action”, so to speak. Instituting a policy of ultra-low interest rates, as seen in financial repression, would be tempting for the US government, and any other advanced country with growing public debt.
Yes, Governments like Financial Repression
The US government, as well as other governments, have debt that they make interest payments on. A government that borrows to meet its obligations enjoys financial repression due to lower interest payments… A powerful reason for any country, advanced or not, to institute financial repression.
Usually a policy of financial repression is not used in an advanced country. It is ultimately unstable. However, it is very possible that the US government would like to have a low Fed rate for years and years, so that the government’s debt burden can be lowered… especially if the interest rate of servicing the debt is lower than the real rate of economic growth.
Low Inflation
China should have roaring inflation. There is investment money coming from abroad. There are huge export funds. Yet, inflation in China is under 3%. Why is there little inflation?
When consumers are net-savers, financial repression weakens domestic consumption. Combining financial repression with very low labor share creates such weak domestic demand in China that inflation of prices for consumer goods is not an problem… and China wants it that way.
For instance, if there is a nominal increase in the supply of money, whether created by a central bank or generated from foreign funds, this would normally generate some inflation. However, under financial repression, it leads to more liquidity for production and capital purchases and less liquidity for consumption. The result is rapid GDP growth with healthy investment but with low inflation at the consumer level. But asset prices is the other side of the inflation coin.
Rising Asset Prices
On balance, when it is less costly to borrow money, asset prices increase, for example housing prices. When you combine low interest rates with low labor share, as in China and the US, asset prices receive an ordinate amount of price support. Where you might expect to see inflation in consumer goods, you end up seeing inflation in assets, such as houses and stocks.
In conclusion, why do countries have Financial Repression?
- Investment increases.
- Productive capacity increases faster.
- Capital formation increases.
- Owners of capital are implicitly subsidized by savers.
- Exports increase.
- Governments pay lower debt interest costs.
- Economic growth can increase more rapidly.
In the next part, I will look at the problems that financial repression can experience and how it is ultimately creates instability.