Many market participants believe the end of the Federal Reserve’s quantitative easing program in June will signal the government's exit from the extraordinary interventions made during the financial crisis. After a healthy earnings season, they say, it is time now for our free market to stand on its own two feet.
Not so fast, says Marc Chandler, global head of currency strategy for Brown Brothers Harriman. He and others believe that the incredible amount of borrowing by the U.S. and the European Union to get out of the credit crisis will force governments to stay involved to ensure an orderly decline of this debt load.
It's a concept called “financial repression,” akin to what occurred after the Great Depression and WWII.
“Financial repression refers to official actions that run counter to the market-based incentive structure,” said Chandler in a note to clients. “The ostensible goal is to support the government bond markets. Moral suasion, the cajoling of investors are soft forms of financial repression, where the government can impose such cooperation by fiat.”
The Federal Reserve’s second round of quantitative easing, the purchase of $600 billion longer-dated Treasury securities, is scheduled to end June 30. Despite successfully keeping interest rates low, the program didn’t stop housing prices from hitting a new post-recession low, according to Case-Shiller data released Tuesday.
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“Bernanke, Paulson and Geithner had visions of Tina Turner in a burlap outfit and cage matches in Thunderdome – especially when the AIGsituation exploded on them right after the Lehman bankruptcy,” said Alec Levine of WallachBeth Capital. “The hindsight lesson is not that we overreacted, but that we were this close to the abyss. So-called free market countries will be much less free for a longer time than people realize.”
Over in Europe, a second aid package to Greece is being put together to avoid the default of Greek bonds, which could set off a catastrophic domino effect for the European banks holding the debt.
The US debt hit its legal limit of $14.3 trillion last month. Congress is currently fighting over an increase in the so-called debt ceiling, with Republicans wanting such a vote linked to heavy spending cuts. Congress has no choice, but to ultimately pass the increase in order to avoid a U.S. default.
Spending cuts, tax increases…even organic growth won’t do much of anything to solve a debt load of this magnitude, according to an NBER working paper referenced by Chandler on financial repression.
Earlier this year, Standard & Poor’s put America’s triple-A rating on negative watch in part because of concerns about Congress not having the political will to instill strict austerity measures. It may all be a moot point.
“Hoping that substantial public and private debt overhangs are resolved by growth may be uplifting, but it is not particularly practical from a policy standpoint,” states an NBER Working Paper by Carmen Reinhart and M. Belen Sbrancia entitled “The Liquidation of Government Debt.” “The evidence, at any rate, is not particularly encouraging, as high levels of public debt appear to be associated with lower growth.”
Once QE2 has ended, regulation may be used to “force large institutions to reduce risk and hold more of the ‘safest’ assets (i.e. Treasurys)”, said BBH’s Chandler. Economists have been downgrading their second half growth estimates recently on fears that high unemployment may be here for a while and that manufacturing growth is slowing.
This makes it all the more likely that the government’s hand, and not an invisible one, will stay involved in this market to keep interest rates low and allow for the country to refinance this debt load.
The U.S. could still win under this scenario as long as it doesn’t get too drastic in its continued intervention efforts and inflation doesn’t explode, some investors said.
“Despite this, the U.S. is still running at a much more ‘free market’ mechanism vs. other market regulations, namely those in Europe and Asia where official controls and quotas are even more comprehensive and daunting and effect all asset classes,” said Ron Shah of Jina Ventures in an interview from India.
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