Historically, periods of high indebtedness have been associated with a rising incidence of default or restructuring of public and private debts. A subtle type of debt restructuring takes the form of “financial repression.” Financial repression includes directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks. In the heavily regulated financial markets of the Bretton Woods system, several restrictions facilitated a sharp and rapid reduction in public debt/GDP ratios from the late 1940s to the 1970s. Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real of government debt. Thus, financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation. Inflation need not take market participants entirely by surprise and, in effect, it need not be very high (by historic standards). For the advanced economies in our sample, real interest rates were negative roughly half of the time during 1945-1980. For the United States and the United Kingdom our estimates of the average annual liquidation of debt via negative real interest rates amounted 2-3% of GDP a year. We describe some of regulatory measures and policy actions that characterized the heyday of the financial repression era.
"Financial Repression Redux" [with Carmen M.
Reinhart and Jacob Kierkegaard]
Finance & Development, Vol 48 No2 June 2011[Download]