Hoover Daily Report

The 'Financial Repression' Trap

via Wall Street Journal
Tuesday, December 6, 2011

Financial markets are in a precarious place, with European banks and sovereign balance sheets in the cross-hairs. Bank regulators are becoming increasingly aggressive, and euro-zone borrowing costs are rising as the debts of years past are coming due.

In this environment, policy makers are finding their authority, credibility and firepower being tested. In turn, they are finding it tempting to pursue "financial repression"—suppressing market prices that they don't like. But this is bad policy, not least because it signals diminished faith in the market economy itself.

Markets are not always efficient, but the market-clearing prices for stocks, bonds, currencies and other assets (like housing) are critical to informing judgments, in good times and bad. Market-determined asset prices often reveal inconvenient truths. But the sooner the truth is revealed, the sooner judgments can be rendered and action taken.

By contrast, government-induced prices send false signals to users and providers of capital. This upsets economic activity and harms market functioning. Markets that rely on governmental participation will turn out to be less enduring indicators of value.

In environments of financial repression, businesses are keener to retrench than recommit their time, energy and capital to new projects. Trillions of dollars of private capital remains on the sidelines. And the private-sector engine that drives prosperity sputters.

Consider a few recent examples of this policy in practice:

In Europe, share prices are falling among the largest banks, but these prices are little more than a symptom. European banks suffer from a lack of capital to offset future losses, and a lack of transparency that makes it futile to try to judge their financial wherewithal. The bank problem is not some unfounded attack by greedy speculators, so a leading proffered solution—extending the ban on short-selling shares in big banks—obfuscates rather than informs. It also delays the necessary private-sector recapitalization.

Second, when firms buy insurance to reduce risks in their portfolio, the insurance has to be worth the bargain or else hedging becomes unreliable and risks are exacerbated. That's what happened with the negotiated settlement in the Greek market for credit-default swaps, when negotiators "voluntarily" agreed on principal reductions. Such policies give rise to default by another name. Counterparties aren't fooled. Neither should policy makers be. Firms' exposures to their counterparties require more transparency and better tools for risk-reduction.

Third, ratings agencies have been rightfully criticized for assigning higher ratings to various financial products than were justified by their fundamentals, yet now we see a dangerous irony: Governments are trying to persuade ratings agencies to assign higher ratings to sovereigns than deserved or justified by market prices. Blaming the ratings agencies for the dysfunction in funding markets will not lower funding costs. After all, the largest global economies do not have debt-rating problems. They have debt problems.

Financial repression is sometimes the effect of policy even if it is not the intent. It manifests itself, for example, when policy makers react more forcefully to declines in asset prices than to increases. Price increases tend to be treated with benign indifference. But declines often lead policy makers to respond with force, deploying fiscal stimulus and monetary accommodation. Market participants then conclude that governments have their backs.

Consider the fiscal trajectory of the United States. However well-intentioned, the Federal Reserve's continued purchase of long-term Treasury securities risks camouflaging the country's true cost of capital. Private investors are crowded out of the market when the Fed shows up as a large and powerful bidder. As a result, the administration and Congress make tax and spending decisions—with huge implications for our standard of living—with heightened risks around future funding costs.

As measured against the administration's budget, every one-percentage-point increase in interest rates above the current baseline would translate into another $1 trillion of debt service over 10 years. And with financial repression at play, we risk missing early warning signs from markets that our debt burden is intolerable.

Efforts to manage and manipulate asset prices are not new. But history provides little comfort that these practices work. Interfering with market prices occasionally buys time, but rarely do policy makers seize the window of opportunity to enact structural reform. Financial repression embeds the wrong incentives—obfuscation begets delay, and a robust recovery becomes unattainable.

The path to prosperity requires taking the long road. It requires policy reforms that make the economy less reliant on the preferences of government and more responsive to the market. That means prioritizing long-term growth over fleeting market stability, and giving precedence to structural reforms over temporary stimulus and market manipulation. Financial repression is a tactic that may help get us through the week or month or year. But it will come at a substantial cost to our long-term prosperity.

Mr. Warsh, a former Federal Reserve governor, is a distinguished visiting fellow at Stanford University's Hoover Institution and a lecturer at its Graduate School of Business.