REPRESSED MEMORIES / THE ECONOMIST ( A MUST READ )

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Repressed memories

The difficulty of deciding how to invest during a time of financial repression

Feb 25th 2012               

SAVERS beware. Governments have huge deficits to fill and are worried about the fragile finances of banks and consumers. Policies are being designed to help borrowers, not creditors. A similar approach was followed after the second world war, when a period of “financial repression” reduced the debt burden by delivering poor returns to savers.


This effect can be achieved in a number of ways. Investors can be forced into holding bonds, either by law or by regulation. Current accounting rules, solvency requirements and liquidity provisions may have already done the trick for pension funds, insurance companies and banks, respectively.

An even simpler approach is for central banks to depress interest rates so that real returns to investors are negative. The Federal Reserve and the Bank of England have been very successful at achieving this feat over the past three years. Nominal rates are at record lows in both America and Britain.


Central banks have also held bond yields down, both directly and indirectly. The direct route is quantitative easing, which involves the purchase of government bonds from the private sector. But bond yields also in part represent the market’s forecast for the future level of short-term rates. By indicating that short-term rates will stay low until the end of 2014, the Fed is also having an effect on medium-term bond yields.


All this means that the risk-reward ratio for holding government bonds looks pretty skewed. Towers Watson, a consultancy which advises many a pension fund, rates government bonds as “highly unattractive” at current levels.


At best, bond investors will earn modest returns in a Japanese-style stagnation. At worst, governments might opt for outright default: note that this week’s Greek restructuring has been designed to punish private-sector creditors, leaving official creditors untouched. Even default by the world’s largest economy is no longer unthinkable. In a series of papers for the Mercatus Centre at George Mason University in Washington, DC, Jeffrey Rogers Hummel and Arnold Kling argue that the American government will eventually default, if only because politicians will never agree on a serious deficit-cutting programme.


Financial repression would chart a middle course through these outcomes, in which the real value of holdings in government bonds was steadily eroded by inflation. The same would be true for cash. So what would be the right asset to hold in such an era?


The temptation is to think that equities are the answer. After all, many analysts think shares look cheap relative to government bonds. Dividend yields are almost as high as bond yields (in some places they are higher), and equities also offer the prospect of income growth. Since equities are a claim on corporate revenues, surely they ought to be a hedge against inflation risk?


But Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School, writing in Credit Suisse’s latest “Global Investment Returns Yearbook”, find that equity returns were negatively correlated with rising prices. Worse still, equities perform badly in periods of high inflation, and governments will need quite a lot of inflation if they are really to erode their debt burdens. Messrs Marsh, Dimson and Staunton calculate that if you divide annual inflation rates into quintiles, real equity returns in the years with the highest inflation averaged –1.7%. Real equity returns in the lowest quintile for inflation were 11.7% a year.


Just as surprisingly, perhaps, the professors find that returns from commercial property and residential housing are also negatively correlated with inflation. The only asset class they could find with a positive correlation was gold but the long-term real return of gold has been just 1% a year, barely better than cash. Inflation-linked bonds also offer protection but their current real yields are very low or even negative.


If the prospects seem bleak for savers, there is at least some good news. The post-war period of financial repression occurred under the Bretton Woods system of fixed exchange rates, which was marked by tight capital controls. It was very hard to escape the squeeze.


Now savers have the freedom of the globe and there are plenty of countries where real interest rates are positive and growth prospects are more attractive than in the developed world. There are risks in these places, of course, but they need to be set against the certainty that rich-world central banks are trying to make savers lose out.