The Importance of Financial Repression

 by Samuel Zhou

Mervyn King

In this article I will explore the importance of financial repression for economic development and offer the perspective of Mervyn King. 

Firstly, what is financial repression?

It is a set of policy measures that the government employs in order to control the financial system and the economy. This method is very versatile and can be used to achieve a variety of goals, for example, controlling inflation, reducing public debt or promoting economic growth.

In the book “The End of Alchemy: Money, Banking, and the Future of the Global Economy”, Mervyn King presents a critical view, arguing that it is a policy tool that is often used to achieve short-term macroeconomic goals. Consequently, it has negative long-term effects for the global economy. 

Expanding on the short-term benefits, King states that financial repression would mean a reduction of government debt. This can be done by Governments instilling a cap on interest rates which would make it cheaper for the government to borrow and reduce the burden of debt on the government’s budget. Furthermore. King goes on to describe the concept of directed lending, where banks are required to hold a certain percentage of their assets in bonds. This forces an increase in demand for government debt and in turn makes it cheaper for the government to borrow. Low government debt indicates that the government is able to manage its finances responsibly which gives an image of stability and growth potential of their economy. This in turn will inspire confidence in investors to continue to invest their money into their economy which may lead to more jobs created, boosting production and consumption. 

Another method of financial repression that King covers is the restriction of capital movement. This can reduce the burden of government debt by making it more difficult for investors to move their money out of the country and into safer investments, such as foreign currencies or gold. When investors are unable to move their money out of the country, they usually turn to domestic investments which in turn will stimulate economic growth. 

On the other hand, King argues that the long-term consequences of financial repression outweigh the positives of the short-term achievements. Low interest rates may lead to financial instability by creating bubbles in asset prices and misallocating resources. Furthermore, low interest rates are a key component of financial repression, this policy encourages borrowing and investments in assets, for example, real estate and stocks. Loans become more desirable as there is very little interest on them, which makes it easier for investors to purchase assets and drive up prices. If this occurs over a long period of time, this may lead to a bubble where prices become detached from the underlying value of the assets. When interest rates eventually rise, the artificial bubble can burst, leading to a fall in asset prices which can cause a financial crisis. King goes on to argue that low interest rates may lead to the misallocation of resources, investors may put their money into artificially inflated assets rather than the more productive areas of the economy. This will lead to a lack of competition and a lack of innovation in the financial sector which would limit economic growth. 

To put the long-term negatives into perspectives, the 2008 financial crisis can be used as an example. Financial repression was used to stimulate economic growth and stabilise financial markets, the main idea was to encourage borrowing and investment in the domestic economy, and to reduce the burden of debt on households, businesses and governments. King argues that the use of financial repression led to a “debt supercycle” where debt levels have continued to rise rather than being reduced and interactions of boom and bust cycles. 

But to address these problems, King has put forward a new monetary system based on “narrow banking” and “sovereign money”. Narrow banking would involve limiting the amount of money that banks can lend out by requiring them to hold a certain percentage of deposits as reserves. This would prevent excessive lending and speculation and provide capital liquidity to potential depositor demands. The advantage of King's proposed sovereign money would mean a stable store of value is provided which would reduce the risk of inflation. Furthermore, this would prevent banks from creating new money out of thin air. 

In conclusion, I feel financial repression’s long-term negatives outweigh the short-term positives and should not be relied on for economic growth. Even though it reduces government debt and brings confidence to investors which in turn leads to the cumulative effect with the end goal of economic growth, there are great negative ramifications that should not be ignored for quick relief. Low interest rates which is a key component of financial repression has a large risk of causing artificially inflated prices which I feel is a key mover towards a financial crisis. Furthermore, Mervyn King’s proposal of a reformed monetary system would require deeper understanding of laws and regulations before its implementation but I would argue it is a radical way of thinking.