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The most Efficient Toolkit for Liquidating Government Debt is the Financial Repression Tax

In 2015, the IMF published a working paper with an overview of financial repression that was implemented during the last century to systematically, methodically and quietly liquidate government debt over time. Now that public debt has exploded many folds since 2015, this paper has become even more relevant.

Financial repression includes negative real rates, taxes, capital controls, moral suasion, etc., and is a key characteristic of all political economies.

The financial repression tax has some interesting political-economy properties. Unlike income, consumption, or sales taxes, the repression tax rate is determined by financial regulations and inflation performance that is opaque to most voters. Given that deficit reduction usually involves highly unpopular expenditure reductions and (or) tax increases of one form or another, the relatively “stealthier” financial repression tax may be a more politically palatable alternative to authorities faced with the need to reduce outstanding debts.

Political economies completely disrupt the appropriateness of traditional 60-40 portfolio allocation in financial markets. The conflicted and financially repressive nature of such economies highlights the importance of preserving capital with a multi-asset diversification strategy beyond domestic jurisdictions.

As pointed out in the paper, capital controls kept many potential high yield investment possibilities off limits in the domestic market. Finding the right asset allocation framework through relative performance and risk management analysis across multi-jurisdictions becomes extremely crucial in such context.

Furthermore, active management with regular profit taking may offer a substantial edge over passive investment approaches.

That`s what the Macro Edge is all about.

Here are a few relevant charts from Lyn Alden on US Broad money creation vs CPI covering the last 100+ years of money creation. As you can see, money growth, as a % of GDP, has recently reached the peak (near 10%) seen during WWII:

Paper Abstract:

High public debt often produces the drama of default and restructuring. But debt is also reduced through financial repression, a tax on bondholders and savers via negative or below market real interest rates. After WWII, capital controls and regulatory restrictions created a captive audience for government debt, limiting tax-base erosion. Financial repression is most successful in liquidating debt when accompanied by inflation. For the advanced economies, real interest rates were negative ½ of the time during 1945–1980. Average annual interest expense savings for a 12—country sample range from about 1 to 5 percent of GDP for the full 1945–1980 period. We suggest that, once again, financial repression may be part of the toolkit deployed to cope with the most recent surge in public debt in advanced economies.

It is worth noting that CBDC, when they become prevalent, will be the most powerful economic feature ever invented to implement any type of financial repression.

As a final note, former Fed chair Ben Bernanke and Olivier Blanchard recently published a paper on the causes of inflation during the recent pandemic.

The authors state:

We find that, contrary to early concerns that inflation would be spurred by overheated labor markets, most of the inflation surge that began in 2021 was the result of shocks to prices given wages, including sharp increases in commodity prices and sectoral shortages. However, although tight labor markets have thus far not been the primary driver of inflation, the effects of overheated labor markets on nominal wage growth and inflation are more persistent than the effects of product-market shocks. Controlling inflation will thus ultimately require achieving a better balance between labor demand and labor supply.

With all due respect, controlling inflation goes far beyond a simplistic view of controlling the imbalance between labor demand and labor supply. Yet, the narrative from central banks is pretty much aligned with such point of view, as Jerome Powell pointed out in the FOMC meeting of June 13, 2023. That is a cause for concern.

Now, I invite you to read the IMF paper.

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