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Wednesday, June 1, 2011

The New Lexicon: "Financial Repression", Good For The Government Bad For Your Wallet..No Surprise There!


As a person living in today’s world we have to keep expanding our lexicon of terms since there appears to be a new one created every single day. Some of the terms are manufactured out of “Political Correctness” while others are a result of obfuscating what is really going on like Quantatative easing, which is in its simplest form money printing. A topic that has been getting increasing play in the media most notably due to high profile people like Mohamed A. El-Erian and Bill Gorss of Pimco Investments fame bringing the topic to the fore is “financial repression”. To most Americans myself included when we hear the word repression images of Idi Amin or Kim Jong Il come to mind as they use true repression to enrich themselves and control their populations, but “financial repression” is a completely different animal.

The idea of financial repression is not new and in fact in the post World War II period it has been used quite extensively by developed and developing countries Even the US itself engaged in a form of financial repression to deal with the large scale deficits left from WWII. The concept was given a name in 1973 by then Stanford economists Edward Shaw and Ronald McKinnon, although they were using it to describe the financial systems of emerging markets. During the Ronald Reagan era the practice of direct government intervention in the markets along the lines of financial repression was supplanted by more invisible hand type machinations of the “plunge protection team” and the FOMC. The financial environment had changed and the debts in the US while still large had fallen to a much smaller percentage of GDP making repression fall out of favor with the power crowd.

Today we as a nation find ourselves in a unique point in history and the rules of old don’t apply exactly as they used to as evidenced by the massive dislocations and intervention in all markets. In the recent past I had read the book “This Time is Different” by Carmen Reinhart and Kenneth Rogoff which documents 800 years of financial mishaps and their aftermaths, that occurred as a result of one form or another of financial mismanagement. The book is a very detailed analysis of the world from a monetary perspective and if you have the time I might suggest that you pick up a copy and read it; surely you will find that Mark Twain was correct when he said “History does not repeat but it sure does rhyme”. Reinhart who coauthored the book also co-wrote a “working paper” this year for the NBER (National Bureau of Economic Research) with M. Belen Sbrancia that carries the inauspicious title “The Liquidation of Government Debt”, but details the mechanics of “financial repression” and the history of debt booms and the busts.

Without going in to the long and drawn out history like the paper, let’s stipulate that the US is in the midst of one of these historic debt busts. The paper outlines five methods by which historically the debt to GDP ratio, a critical economic health measure, can be brought in to line making the debt more manageable.

The first method is for an economy to grow its way out by having a strong business environment where GDP grows faster than debt accumulation. Unfortunately ,the growth scenario does not appear to be in the cards as an economy needs some sort of paradigm shift that will generate economic growth on a large scale, think about the introduction of the automobile or the internet creating whole new industries and jobs.

The second method is utilization of fiscal methods like austerity measures being imposed upon Greece and Portugal. The issue with austerity measures is that they do not work for longer periods of time and given the size of our debt we are not talking about a “weekend at Bernie’s” to resolve this matter.

The third method is defaulting and or restructuring on the public and or private debt. Given the political rhetoric regarding outright defaulting or even restructuring our debt this option seems unlikely under current circumstances. Of course if more time passes before the US can get is house in order it is possible that views towards default or restructuring may change. It is not like it is without precedent that countries have defaulted and continued onward after the default or restructuring; modern day examples are Argentina and Iceland. In fact history is replete with examples of countries defaulting or restructuring debt including the US, UK, and France to name a few. At the moment however, it seems that default or restructuring would be a path not taken for better or worse.

The fourth situation that could have meaningful affect on reducing the debt to GDP level is a surprise sudden burst of inflation. Of course we all know that “B52 Ben” is deathly afraid of deflation and has been busy pulling all the magic levers to push inflation in to the system. I personally believe that inflation is baked in to the cake at this point and we have been fortunate enough to export it to the developing world, but at some point it will come back home to roost. That said, it is not part of the FED’s mandate to create a huge inflation quite to contrary it would not bode well for price stability.

The fifth method which is described in the paper and is effectively a “trial balloon” for what is more than likely coming down the pike is a cocktail of 1 part financial repression and 1 part steady inflation(in the 3 - 5% range). If you read the paper you will note that the authors specify that options 4 and 5 are only viable for domestic currency debts of which our debts are since they’re denominated in US dollars. Moreover, the authors note that all the methods have occurred at one point or another throughout history, but they do send up a flare for options 4 and 5.

So what is financial repression? Financial repression is a method by which markets are controlled to create a dynamic that forces the debt to GDP ratio back in line. Financial repression is essentially a slow motion restructuring and taxation method that reduces the debt over a longer period of time.
The US and much of the world engaged in various forms of financial repression from the conclusion of WWII in 1945 until “the peace dividend” of the 1980’s. The components necessary to implement financial repression are outlined in the working paper and I will try to break them out below.

Part of financial repression is to cap interest rates on debt especially government debt but there is the ability to impact private debt as well. In the US there is regulation know as “Regulation Q” by which the government can prohibit banks from paying interest on demand deposits or setting a limit to what can be paid on savings deposits. Additionally, the FED can continue to set short term rates and banks would have to follow. This “capping” of the rates effectively gives the government borrowing ability at a much reduced rate so the net effect is that the saver and the banks are forced to continue subsidizing government spending. In essence what we see going on today with rates will continue and savers and retirees will continue to be punished so the government can keep borrowing at a reduced cost.

One might think logically that if the interest rates are capped at artificially low rates who in their right mind would be out there buying the bonds that “Turbo Timmy” and the US treasury wants to peddle? There will be a market for the bonds because the second part of financial repression is to create and maintain a captive domestic audience for the bonds. In other words the government will force by law the purchase of these mispriced junk assets to keep the money flowing. The government will make use of laws and regulations that will both force certain entities to have to buy the bonds as well as implement capital controls or tax measures to cajole people for tax reasons to buy the instruments. The government can force institutions like banks, insurance companies, and pension funds via high reserve requirements, “prudential” rules or other tax levies to have a certain percentage of their assets invested in these securities there by creating demand. This also ties in to the idea of the government confiscating your IRA or 401K that I have written about on my own blog here. What is to stop the government from saying that all 401k’s and IRA’s have to have a percentage of their assets in these securities, which is a defacto confiscation of your own money. Additionally, fees could be levied on financial or equity transactions driving up the cost to you and lowering the return and used to direct investors to preferred government instruments. Lastly, the report notes a prohibition on gold transactions almost as if they want to make sure that everyone goes down with the ship by removing all life rafts.

So the scenario presented is one of artificially suppressed rates, forced investment in to the rate bearing instruments and the icing on the cake will be a surprise burst and then steady dosage of inflation. Of course this scenario could work assuming the knuckleheads in Washington don’t continue to increase spending and out strip the intent of this “repression”.

A “financial repression” that caps rates and forces investment in to non performing government assets I am sure will not be the only tact taken especially given this administration’s and the Democrats penchant for raising taxes. I can foresee a slow to no growth economy with increasing inflation and continued mal-investment in to unproductive government assets. This plan while it will probably reduce the debt to GDP ratio over time the inefficient use of capital will cause us a decade or two of essentially stagnation. The only thing that would change this scenario and what I hold out hope for is some new disruptive type technology that causes a huge boom. I don’t know what sector the technology will come from, but even in the great depression there were technologies that spurred booms coming out of that period.

Given that the trial balloons have been sent up indicating that we will be entering a period of low and capped interest rates, capital controls and other impacts on investment vehicles and choices what is one to do? For starters I don’t think I would be buying government debt at this point if I could avoid it. Second, given the fact that a likely outcome is “doses” of inflation going forward it seems that you still want to follow the basic guidelines of buying equities of companies that are growing their dividends able to retain pricing power and are less impacted by inflation. The additional money pumping that will be required to get the sustained dosage of inflation will keep the “risk” trade going therefore growth stocks especially in technology and emerging markets like Asia should also do well.

There are those who feel that they would do just fine by investing in the safety of TIPS or treasury inflation protected securities. The flaw in this logic is that the government has continually changed the way that inflation is measured by hedonic indexing and ignoring the “core rate”. These TIP debt instruments while getting a raise in rates when the CPI goes up will be marked to a measurement designed to suit the government and remain below the true inflation rate. In essence while you would be getting a raise you are actually losing since they don’t keep pace with real world prices. The government jiggers the inflation numbers for a number of reasons, one of which is to limit the amount that it has to spend for various programs to give COLA (Cost Of Living Adjustments) as well as other expenses impacted by the inflation rate.

In my opinion, you still want to have exposure to the precious metals and their shares. I know the paper mentions prohibiting transactions in gold (silver too I am sure), however, I do not believe that the government is going to confiscate your gold or silver. If the confiscation scenario does worry you and you wish to take the excess out of your “doomsday” stash one can look at quite a few funds that hold physical metals most of which are outside the US borders. Moreover, even under FDR when gold was confiscated the shares of mining companies did very well in the midst of the great depression, Homestake Mining (now part of Barrick Gold (NYSE: ABX) went up some 600%. Once again though with the money pumping that will accompany the capped low rates you have a situation where inflation and capped rates work together to create a perfect environment for the metals. The metals tend to thrive in a “risk on” money printing environment and if real rates are negative after inflation there is no carry cost associated with the metals so they tend to run.

Another Idea is to buy what some have called virtual banks or Mortgage REITS. These banks borrow from the government at low rates (which will be capped) on the short end and then purchase government guaranteed mortgages on the long end, essentially making the vig. At the present time many of these virtual banks are paying in excess of 13% and if rates are held in check these REITs will continue to payout. Presumably when the government caps rates they will do it near today’s historically low rates, but I guess they could force them lower. Additionally, REITS do not fall in to the category of entities that would be required to purchase government securities unlike a bank or pension fund.

Yes, inflation will have an impact and at some point that will be a drag on the REITs but in a world where yields are capped, options are few and income investors are desperate for yield they will be willing to pay more and accept yields that are still well above the caps especially on the short end. In other words rather than chasing yield toward the long end of the treasuries they can buy a mortgage REIT paying a better rate which is also highly liquid, what’s not to like. If you take a look there are probably about 10 companies that play in this space but I favor Annaly Capital Management (NYSE: NLY) and Chimera Investment Corp (NYSE: CIM) which pay 13.7% and 14.4% respectively. As always you should do your own due diligence before investing any money.

Disclosure: I am long Annaly (NLY) but do not currently have a position in Chimera (CIM).


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