Is there financial repression in the United States? Are some people repressed economically, while others have inordinate advantages? Is it something to be feared or criticized? What the heck is financial repression anyway?
A basic model 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.
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%. 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 real interest rate declines to the left as the utilization of labor and capital fall 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 monetary policy 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 growth to support their base cost of funding. It is a balanced equilibrium.
However, in financial repression, the nominal interest rate is pushed lower so that the current real interest rate is held below its balanced equilibrium 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. Here is a graph showing a base interest rate of 8%.
Graph #2... 8% base interest rate from the central bank.
As an economy recovers from a recession (moving left to right in the graph), at first low interest rates are ideal 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 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... and later the nominal interest rate will have to spike up quickly at the natural level of real GDP or the economy will overheat in a destabilizing way.
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, if the Chinese central bank held the interest rate at 6% as the TFUR rose to 80%, the intensity of the financial repression would increase. (See graph #3 below) The same would apply to the US, if the Fed were to hold the Fed rate at the zero lower bound all the way to the natural level of GDP.
Graph #3... Intensity of financial repression for a given interest rate of 6% depends on how close the economy is to full employment.
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 find evidence of financial repression in the US. Later posts explain how financial repression manifests and why some countries like it.