Monetary Policy Under Financial Repression

Posted on December 26, 2020 by Florian Buschek

Monetary Policy Under Financial Repression is a great blog post by Michael Pettis, in which he explains the nature of financial repression (although I believe there are different interpretations/definitions) and puts it into historical context. Financial repression is one of the tools that generated enormous GDP growth in China in the past decades, similarly though for example in Japan in the 1980s. It can be explained as interest rates being set artificially too low. The so called natural rate of interest is never easily or clearly possible to determine, especially in very low interest rate environments. But a reasonable assumption is that it is close to nominal GDP growth, in China’s case historically then easily above 10%, more likely between 15-20%. But they were set much lower in fact, around 6-7%.

In a free market, the idea is then that savers would save less, because the incentive or the reward years ahead is low and consume more. Equally businesses would invest more as the reward is high and the cost is low. That process should then equilibrate the interest rate and the natural rate. However, China is not a free economy for one, the interest rates are centrally set. Even beyond that, savers don’t always save for the interest payments, but mostly to have savings for bad times and retirement. So the disequilibrium could easily persist.

The effect is a transfer of income from the savers to the borrowers. If the discount rate is say 14% then the NPV of a loan at 7% is much lower than the nominal amount. This difference is wealth that accrues to the borrowers (mostly businesses and the state) from the savers (mostly households). For that reason, the consumption part of GDP stayed low and investment stayed extremely high, driving GDP growth. Financial repression is like a tax on savings and subsidy to borrowers and investment.

Why was there no inflation then? There was partially, in the form of some investment goods, especially housing. But more investment and thus productive capacity is generally deflationary unless consumption also rises strongly, which it did not due to the described income transfers. Excess production has historically been exported. The idea that low interest rates cause consumer price inflation is based on a free market where consumers will borrow so that the consumption part of GDP goes up, forcing savings and therefore investment down. As a result, consumption will exceed capacity and increase costs, generating CPI inflation. Even if there was inflation, it would only exacerbate financial repression and lower consumption by itself, so that there is a sort of balance from this self correcting mechanism. Equally if there was strong deflation, consumption could rise, an inflationary counter force.

As long as investment is productive, this system can work fairly well. But if not, as is the case in China today, the real debt burden will rise quickly and moreover, the current account surplus will strain the world economy to absorb all those exports. Inequality will also increase quickly and assets bubbles are likely. At high real growth rates inequality was not a problem, because even the poor became more wealthy in the process, only comparatively slower. Today though as the real (and true) GDP growth slows, inequality becomes a serious issue on top of exploding debt, a major sign of macro economic imbalances of which financial repression is one.

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