A study of Financial Repression, part 4… Ultimately Unstable

From part 3, financial repression expresses in positive ways. Examples, relative government debt is reduced, economic growth speeds up and exports become more competitive. Then why do most advanced countries steer away from it? Or at least why did they in the past? …Financial Repression eventually leads to an Unstable Economy. Advanced countries know better than to go down this road. But as we will see in tomorrow’s post, the United States is moving down the financial repression road.

Weak Domestic Demand creates Unrest

Financial repression weakens domestic demand. Ultimately this is socially unstable, especially for a country like the United States. There is even concern of unrest in China.

Financial Repression is Dependent upon Extra Demand Somewhere

Financial repression increases production beyond domestic consumption. So then, who buys the extra production? There needs to be healthy foreign demand somewhere. Normally emerging economies find the extra demand from advanced countries with more purchasing power.

So as long as the advanced countries stay stable economically, the financial repression in the emerging economies flourishes. But like the old saying, “When the United States sneezes, the world catches cold.” Recessions in advanced countries have a strong impact on emerging economies with financial repression.

In the case of China, they depend on foreign demand, because domestic demand is so weak. China faced a big problem during the crisis when demand collapsed in Europe and the United States. What did China do to avoid its own economic collapse? It ramped up investment with easy credit flowing at low costs. Their economy kept growing.

For China, they see foreign demand as limitless. They can’t see it any other way. So when the crisis hit, they figured that the United States would recover and start buying again like before. So they took advantage of the moment and increased their productive capacity by an enormous amount.

China is planning on 2014 being a big year to get exports back on track to the US. The recent economic progress in the US motivated China to ramp up production in 2013. Yet, the situation is simply unstable, because if the economy in the United States does not flourish, …oh say from weak effective demand… then China is going to be in trouble.

Asset Bubbles

As an economy improves, financial repression intensifies. Money is implicitly transferred from savers to borrowers. Asset bubbles result from borrowers being implicitly subsidized. Eventually the asset bubble is unsustainable and increasingly fragile.

Financial Repression is a Ponzi Scheme

Financial repression is a trick where production can be increased at the expense of domestic demand. So as domestic demand is kept weak, financial repression must race ahead of a tendency for slower growth. At all costs investment and growth must be maintained at a faster pace than debts come due. Just as we now see in China debt payments are being rolled over to the next year. Demand has to catch up to production for debt payments to be made. But as time goes on, debt payments start being rolled over for two years, then three years, then a bail-out has to come.

More companies in China would default. Their economy would verge on collapse.

Economic growth needs to be guided by viable and reliable demand, but under financial repression, weak consumption becomes a weak guide to economic growth. Growth is not properly market driven. Resources become poorly allocated. Investments eventually become non-performing loans. The situation grows more unstable as loan defaults mount.

Low inflation reduces Financial Repression

Low inflation, and especially deflation, will raise the current real interest rate closer to the natural real interest rate. Low inflation reduces the intensity of financial repression. So the current low global  inflation is suppressing financial repression tendencies. If inflation was to rise, financial repression would manifest more and more.

Slow GDP Growth reduces Financial Repression

Just like low inflation, if medium-run GDP growth slows down, the current real interest rate moves closer to the natural real interest rate reducing the intensity of financial repression. So at all costs, GDP growth must be increased or the countries with financial repression will become noticeably unstable.

In part 5 of the series tomorrow, I criticize Larry Summers for promoting policies of financial repression. As well, I make a case that the United States is already drinking the financial repression foul brew.

Previous Parts of this series on financial repression…

Part 1, a basic model.
Part 2, looking for evidence of financial repression in the US.
Part 3, how financial repression manifests.