Financial Repression and Savings Gluts

A Less Productive Open Economy

Suppose that purchasing the global capital stock earns a higher return than the domestic stock.  Then investors will sell domestic bonds and purchase foreign bonds, until the domestic interest rate increases, in real terms, sufficiently to match the foreign rate plus the rate of (domestic) currency appreciation vis-a-vis the global currency.

Forex adjustments cannot help here, as the outflows lead to depreciation, not appreciation of the currency.  As a result of the higher real rates, the domestic capital keeps being reduced up until it is as productive as the global rate. But suppose a reducion in the capital stock does not make it more productive?

In that case, the capital shrinks to zero. One can imagine that developing nations are less productive than industrialized nations, as there are positive spillovers to investment, infrastructure is important, a skilled workforce, etc.

The nation needs some way to climb up the hill while it is industrializing, and this will be via net exports and domestic financial repression.

The Case for Financial Repression

Financial repression means many things, but in this post, I want to define it as bank dominated finance in which banks are not subject to market discipline on the liability side of their balance sheets. They do not compete for deposits but fix the price of all deposits, and likewise they do not need to sell bonds to the public.

If households are not willing to hold low interest deposits, this will be inflationary, but not if they can sell their excess deposits for higher interest bearing foreign assets.The excess savings — the difference between the savings demanded at the domestic deposit rate and the savings demanded at the foreign rate — is equal to the change in current account — primarily net exports. By forcing households to hold deposits instead of bonds, the result is that sale of deposits for foreign capital shows up as net exports and not as rising domestic interest rates. If households held bonds, then sale of bonds together with purchases of foreign capital would give rise to both rising interest rates and forex devaluation. Financial repression effectively allows a nation to make the bulk of the adjustment via net exports.

In effect, the higher (foreign) interest rates are subsidizing domestic investment, via net exports. As net exports can be viewed as a tax on consumption, this is equivalent to taxing consumption in order to subsidize investment.

Development Lifecycle

With repression, the country can climb the hill, until the domestic returns exceed the global return, at which point the rest of the world will purchase its capital and the nation swings to being a net importer.

Once the domestic returns are equal to the global returns, the current account is balanced.

However, the repression comes with a cost of misallocation of capital. If, as a result, the capital stock becomes less productive, so that even the peak falls below the global rate, then the nation cannot exit the policy. As the domestic capital stock becomes less productive, the natural rate declines, requiring even more exports. If at some point, the rest of the world is not willing to absorb the increasing level of exports, then the nation will be pushed into deflation.


This is how I think about the global “savings glut”. As the global investment rate is set not by population but by market size (and depth), it makes a difference who was first. The U.S. did not develop by being a net exporter, neither did the U.K, nor europe. There was a period of mercantilism, but that period did not correspond to rapid economic growth. Rapid growth came with industrialization, during which the current account of most nations was roughly in balance.

However once those incumbents became established with highly productive industries, it became much harder for subsequent nations to industrialize, given their (initially) lower returns.

Trade barriers were in vogue to prevent foreign competition, but this does not solve the productivity problem. Low productivity means low natural interest rates, and as it is difficult to prevent capital outflows, a nation will be forced into adopting some form of financial repression if it wants to maintain the appropriate level of investment.

But if it does have financial repression, then it can lower the trade barriers, because the most productive industries are not the ones who gain global market share — the ones who gain global market share are those with the lowest funding costs relative to their productivity.

Update: rewrote the first paragraph for clairity

Financial Repression and Savings Gluts

2 thoughts on “Financial Repression and Savings Gluts

  1. Sergei says:

    I am very confused by your opening paragraph. What is real, what is financial? Obviously real capital can not flow. But financial capital also does not “flow”. What flows instead (or rather what is created) is the fx risk.

  2. OK, in our country — and specifically I was thinking of Japan and some of the other asian nations — they can purchase foreign (U.S.) bonds. That is what I meant by capital outflows. Perhaps I’ll re-write this to “financial” capital outflows.

    But the argument is not that physical equipment is packed up and shipped out, but that savings demands increase when savers have the option of purchasing the higher return foreign bonds, and this allows the domestic nation to (via financial repression) also increase investment as well by granting domestic investors low rates, even as domestic savers are paid in higher (foreign rates). This is made possible by the swing in current account — net exports.

    Exports are a real cost, but this cost “pays for” subsidies to investment. In this case, it is a tax on consumption and a subsidy to investment.

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