Is there financial repression in the United States? Are some people repressed economically, while others have inordinate advantages? Is there a similarity between financial repression and falling labor share? Is financial repression something to be feared or criticized? What the heck is financial repression anyway?
This post begins a 5-part series on financial repression with a new post scheduled everyday until Friday.
A basic model of Financial Repression
I start with a model that I developed to put financial repression into a visual perspective. Some readers like a visual to better grasp concepts.
Basic definition of financial repression…
A central bank keeps its interest rate low enough so that the current real interest rate stays considerably lower than the natural real interest rate for a considerable length of time.
There are normally institutional constraints in financial repression too. Such as savers are primarily households who are limited to receiving returns on their savings from banks, and borrowers are firms who borrow primarily from banks. The banks set interest rates according to the base interest rate of the central bank. However, the model below just looks at financial repression from the viewpoint of low interest rates without the institutional constraints.
The following graph is a rough simulation of China at the moment assuming a natural real GDP at a composite utilization of labor and capital (TFUR) of 80%. Let’s look at the horizontal lines first. The horizontal line at 6% is where China’s central bank has been holding its base interest rate for the past year. To get the current real interest rate of 3.5%, you subtract the inflation rate of 2.5% from the central bank interest rate (“Fed rate” in graph).
Graph #1… Basic model of financial repression.
The path of the nominal central bank rate crosses the natural level of real GDP at 11%, which implies a stable real GDP growth of 8% plus an inflation target of 3% at full-employment. The natural real interest rate (blue dashed line) is the nominal path minus the inflation target of 3%… It crosses the natural real GDP at 8% to correspond to the stable real GDP growth.
The natural interest rates decline to the left as the utilization of labor and capital falls below full employment… or in other words, as spare capacity increases. It is normal and proper for the central bank interest rate to be lower when there is more spare capacity.
Ideally a central bank would set the interest rate so that the brown and blue dashed lines cross as equals at the current TFUR on the x-axis. The nominal central bank interest rate coordinates the return on savings and the real cost of borrowing to the natural real growth of the economy. On balance, savers can expect a return true to economic growth… and Borrowers can expect real growth to support their real base cost of funding. There is “economic” balance.
However, in financial repression, the nominal interest rate is pushed lower so that the current real interest rate is held below its balance with the natural real interest rate. The area of financial repression corresponding to a 6% base interest rate is highlighted in blue. The area is bordered by the current real interest rate below and the natural real interest rate above.
If the base interest rate was raised above 6%, the area of financial repression would shrink to the right. Higher interest rates lessen the effect of financial repression. (note: the sloping lines of the natural interest rates usually do not move much during a business cycle.) Here is a graph showing a rise in the base interest rate to 8% with no change in inflation.
Graph #2… Raising to an 8% base interest rate by the central bank. Area of financial repression shrinks.
As an economy recovers from a recession (moving left to right in the graph), at first lower interest rates are used so that firms borrow to employ more labor and capital. These low interest rates do not reflect financial repression. Then as more labor and capital are employed, nominal interest rates should rise gradually up the slope to the stabilization point, where the natural nominal interest rate crosses the vertical line of the natural level of real GDP. However, if the nominal interest rate stays low, financial repression can develop…
The intensity of financial repression depends on the position of the composite utilization of labor and capital (TFUR) on the x-axis. With a 6% interest rate, a TFUR of 73% implies low intensity financial repression. However, it appears that the Chinese central bank is holding the interest rate at 6% as the TFUR rises all the way back to the natural real GDP (simulated as 80% in graph #3). As a result, the intensity of their financial repression will increase. (See graph #3 below)
Graph #3… Intensity of financial repression for a given interest rate of 6% depends on how close the economy is to full employment. Graph #3 would apply to the US too. Any trace of financial repression from ultra-low interest rates would also increase in intensity, if the Fed were to hold the base rate at the zero lower bound all the way to the natural level of real GDP.
note: Eventually the nominal interest rate would have to spike up quickly at the natural level of real GDP or an economy would overheat in a destabilizing way. There are market pressures to raise the interest rate at the natural level of real GDP.
Keep in mind that interest rate policy can enter the area of financial repression to varying intensities and for varying lengths of time. The point at which interest rate policy “officially” becomes financial repression is a “judgement call”.
The following post uses this model to look for evidence of financial repression in the US. Later posts explain how financial repression manifests and why some countries like it.