Financial Repression & Gold

For the 10 largest mature economies (Australia, Canada, France, Germany, Italy, Japan, Spain, South Korea, UK and US), total debt stood at nearly 350% of GDP in 2011 (GlobalFinance August 2012). As the private sector deleverages and consumption falls government borrowing will likely increase to prevent a deflationary recession, as evidenced by Japan’s public debt-to-GDP ratio rising from 91.2% in 1995 to 226% in 2012 (TradingEconomics 2012).

With the public component of national debt burdens rising, the majority of developed nations are faced with a choice of rigid austerity measures, massive tax hikes, national bankruptcy, or extensive financial repression. Given the political implications and social upheaval that would result from the other alternatives, financial repression is the option being pursued. Central banks create new money to buy government bonds (via the banks), simultaneously funding budget deficits and controlling sovereign borrowing costs by supporting bond prices and therefore suppressing interest rates. Given the resulting monetary inflation tends to raise certain prices in the economy, real interest rates become negative. Financial repression therefore constitutes a transfer of wealth from savers, who receive artificially low interest income, to Governments, whose debt burdens reduce over time relative to nominal rises in GDP and who receive and spend new money before inflation erodes its real value (ErsteGold Report 2012, p16).

Financial repression played an important role in debt reduction after WWII, when between 1945 and 1955 the US and UK cut their debt in terms of GDP from 116% to 66%, and from 215% to 138% respectively. The average inflation in the US was 4.2%, real interest rates were -0.8%. In the contemporary period, real interest rates are now negative in a growing list of countries, including Turkey, USA, UK, the Euro area, India, South Africa, Canada, Mexico and Japan (ErsteGold Report 2012, pp46-47). The implications for gold are twofold:

1)      Negative interest rates benefit gold as a store of value.

During the 20 years of the gold bear market in the 1980s and 1990s, the average real interest rate level was around +4%. Since 2000, real interest rates have been negative 51% of the time. In this environment depositors less and less see cash as a store of value and seek alternatives, typically benefitting gold. This has been the case in China which fixed interest rates at 0.72% in 2002 and kept them there for seven years as official inflation rose to 7.9% by 2008, translating into a negative real interest rate of -7.2%. While Chinese consumption collapsed and the public sector share of the economy grew, China became the leading country for private gold ownership, overtaking India during the period (ErsteGold Report 2012, p47). The fact that the Federal Reserve will maintain its zero-interest policy until 2014 should result in prolonged negative real interest rates and thus create a positive foundation for further increases in the gold price.  

2)      Increased long run risk of critical failure of global monetary-financial system

Financial repression undermines efforts made towards consolidating national finances, while the gradual and at first invisible transfer of wealth entrenches rather than clears misallocations of capital, making economies increasingly vulnerable to collapse from unaddressed problems of surplus capacity and over supply. In any event, financial repression can only ease debt burdens if prices (and therefore nominal GDP) increase at a greater rate than the new money created to fund budget deficits. However, in the long run those deficits should increase at a faster rate due to Tanzi’s Law. This postulates that in an environment of rising inflation rates government fiscal positions are additionally burdened by the fact that increases in public revenues do not keep pace with inflation, eroding their value in the time elapsing between the incurrring and the payment of tax (ErsteGold Report 2012, p17).  Financial repression, therefore is a ‘die later’ rather than ‘die now’ solution.