In ‘The Coming Greater Depression of the 2020s’, Nouriel Roubini lists ten reasons why the world is about to experience a total meltdown. Fiscal deficits, demographics in the West, deflation, currency debasement, digital disruption, de-globalization, populism, the US-China stand-off, an upsurge in clandestine cyber warfare and climate change are together creating a perfect storm in a world made vulnerable by COVID-19. Mr. Roubini concludes: ‘Any happy ending assumes that we find a way to survive the coming Greater Depression.’ Seriously? Just when the world craves an adult conversation.
In a recent article published in Project Syndicate, Ken Rogoff acknowledges that the world is in trouble too. Unlike Mr. Roubini, however, he proposes a solution: deeply negative interest rates. What Mr. Rogoff is advocating is commonly called ‘financial repression’, a circumstance under which governments implement policies to borrow more cheaply from the private sector than it otherwise could under free market conditions. The concept is far from new. In fact, it was used by most countries on the back of World War II until about 1980 to bring government debt levels to a more acceptable level as analyzed in an influential NBER paper co-authored by Carmen Reinhart and entitled ‘The Liquidation of Government Debt’ (2011).
Financial repression can be enforced using a broad array of mechanisms. It includes the engineering of artificially low interest rates through central bank purchases of government bonds (e.g. via quantitative easing, a policy which was aggressively expanded by the ECB this week) or through yield curve control, a tool which is now expected to be used by the Fed in the near future, inspired by a Bank of Japan policy introduced in 2016; and the creation of a ‘forced home bias’ whereby financial institutions are compelled to invest in government bonds (e.g. bank regulation allowing for a zero risk weighting of sovereign debt). Note that creating hurdles for U.S. pension funds to invest in Chinese stocks, as currently promoted by the Trump administration, is consistent with a home bias policy.
Fundamentally, financial repression represents a huge tax on savings. Consider individuals planning their pension: Compared to a free market scenario, they will either have to accept a lower return on investment and thus a lower pension annuity at retirement; or they will need to invest in a higher risk asset class to earn the initially targeted annuity at retirement. This plainly represents a net transfer of wealth from savers to capital seekers, including governments.
When it comes to reducing government debt levels, financial repression has the merit of being pro-growth, stealthy and highly effective – qualities which contrast with fiscal austerity measures or tax hikes. While financial repression was used in the last decade to deal with the consequences of the Great Financial Crisis, it will now be brought to a totally new level as COVID-19 has not only shattered fiscal deficit and debt level taboos, but is also providing moral air cover for looser fiscal policies as governments deal with the aftermath of a natural disaster for quarters, if not years to come. The monster stimulus package announced by a typically fiscal conservative Germany this week exemplifies this trend. And if financial repression causes a rise in inflation, it will conveniently contribute to solving government leverage issues through even deeper negative real interest rates.
In ‘Building Consensus’ last month, it was argued that valuation multiples may be mechanically higher in the future than in the past decade, thereby boosting equity value levels. The attached document (picture below) illustrates the impact of financial repression on equities: All other things being equal (i) Multiples and valuation levels do increase in a lower growth or less certain growth environment if the discount rate declines by more (in bps) than the expected growth rate; and (ii) The same conditions mathematically lead to a higher premium for Growth (Quality) stocks over Value stocks. As an important aside, under the assumption of a new regime of extreme financial repression as anticipated in this note, it will be critical for firms to reassess internal hurdle rates and to update weighted average cost of capital assumptions for acquisition targets in the sector.
Mr. Roubini, if you want to worry about something, it should be about the impact of financial repression on long term productivity and thus economic growth potential as capital gets misallocated as a result from market distortion. As far as the 20s are concerned, they are set to roar…