The financial-repression levy
There is more than one way for savers to lose out
Mar 23rd 2013
EUROPE’S leaders have once again managed to make a drama into a crisis by, at least at first, agreeing to a 6.75% levy on insured Cypriot depositors as the price of a bail-out. The plan to rescue Cyprus has quickly turned into another botched job.
An overnight raid on savings is a shock. But savers in other developed countries have also seen a hit to their purchasing power in the form of negative real interest rates, a type of financial repression. The clever thing about this approach is that it erodes the purchasing power of savers’ capital slowly but steadily, rather than dramatically, and thus tends not to provoke much protest.
Americans who invested in six-month bank certificates of deposit earned 3.2% between 2009 and 2012, before tax, whereas consumer prices rose by 6.6%. The financial-repression levy was therefore 3.2%.
In Britain even savers who put cash in the best tax-free “individual savings accounts” (which have modest annual limits) would have earned a cumulative 11% between 2009 and 2012, during which time consumer prices rose by 13.4%. Outside that tax shelter, middle-class savers who pay a marginal tax rate of 40% would have earned a net return of 6.6%. In real terms, their savings would have declined by 6%, not far short of the original Cypriot deposit levy.
True, British and American savers have had the option of putting their money in the stockmarket (which has rebounded since 2009) or into property. But most people like to keep their rainy-day money in a savings account. And many investors are highly suspicious of the stockmarket, which has suffered two big bear markets this century, and of property, which took a hit in 2007 and 2008.
You could also make the case (although best not to try it in a bar in Nicosia) that Cypriot savers could have taken evasive action. The problems of the Cypriot banks have been known for a long time, and a deposit guarantee is only as good as its guarantor: the Cypriot state needs foreign help to make good on its pledge. If British or American savers were supposed to be far-sighted enough to switch money into the stockmarket, prescient Cypriots should have bought German shares, or gold, or simply stuck their money under the mattress. All those approaches would have avoided any levy.
In the developed world total debt (including that of the financial sector, consumers and companies, as well as governments) is so high that it is implausible that it can be repaid via the fruits of economic growth. The debt must either be written off (defaulted on) or slowly inflated away. That means inflicting pain on someone: sorting out the crisis has been so difficult because no one wants to take the hit.
The Cypriot deal is a very clumsy attempt at a write-off. Your humble deposits are banks’ debts. So taking the deposits and using the proceeds to recapitalise the banks is a roundabout way of defaulting. But any form of outright default creates the potential for contagion.
Because it is more subtle, financial repression is more successful. It was the way that many countries reduced their debt burdens after the second world war. It takes advantage of the phenomenon of money illusion: people get confused between nominal and real numbers.
The danger is that savers will eventually get wise to the erosion of their spending power. In the post-war era capital controls stopped them from moving their money abroad. Now there are no such controls, but with most developed countries having the same rock-bottom interest rates, there is little incentive to shift.
Will savers instead indulge in a portfolio switch, putting more of their money into risky assets? Or will they regard saving as a waste of time and help the economy by going on a spending spree? The evidence from the 1970s—the last prolonged period of negative real rates—is “no” on both counts.
Britons ended the decade with more of their savings in deposits (40%, compared with 33% in 1969) and increased their savings rate relative to the 1960s, when inflation was lower and real rates were positive.
There are two plausible explanations. Perhaps savers have some ideal figure for a nest-egg in mind, and step up their savings if they are eroded by inflation. That, however, would suggest they are immune to money illusion.
Alternatively, since negative real rates tend to occur at times of turmoil, people may simply become more cautious and save more. Government raids on bank deposits will only fuel their fears, another reason why the Cyprus deal was so misguided.