Financial Repression?

This is a longer version of a piece published 18 May in the Irish Examiner. I cant find a link as of yet but…

The jobs initiative, revealed last week, is something that I have previously welcomed. It’s not so much that the jobs initiative is in and of itself going  to create hundreds of thousands of jobs per se, it’s rather that it indicates that the government are fully aware of the seriousness of the unemployment situation, and that unlike the late unlamented predecessors are willing to actually begin the process of public engagement.

For all the good things that are in the jobs initiative, it rests upon a foundation, which I cannot but think is an extraordinarily retrograde step.  To fund the VAT cut which is at the heart of the jobs initiative in terms of its most costly element, the government have decided to impose a levy of 0.6% upon the assets of individual pension funds.  Its curious to read the reaction of the proponents of the plan  to the reaction of the population to the plan. It appears to me to revolve around the arguments  that pension plans got “too much” tax relief and that we need to start taxing this disgusting foreign wealth which the wealthy pension fund holders have squirreled away overseas. . A further wrinkle is the argument that  sure the pension fund industry has been taking too much in fee income anyhow so this will (how?) incentivise them to buck up.  This revolves to : we are doing this for your own good.  Quiet…

Much of this is tosh. There is no doubt that over the years pension funds in Ireland have been given very generous, some might say over generous, tax treatment. But there is already in place (writ in the stone of the IMF Memorandum of Agreement , section on fiscal consolidation ) that these provisions will be scaled back. In any case one can think of lots of areas that got overly generous tax treatment that are not being so targeted. Racehorses anyone?

There is also no doubt that for the majority of people who hold private pension funds they do not have a pot of gold. The average amount of money invested in pension funds is somewhere in the region of €154,000.   This represents the savings of some 500,000 persons, money that they were encouraged to put aside in order to ensure that the state would not be liable for the entirety of the burden of supporting them in their old age.  But here is the rub : the most wealthy have not been availing of the pension funds which will be hit. They instead have been availing of special creatures called Approved Retirement Plans, and these billions will NOT be hit. One can only wonder why, but perhaps not where lawyers can hear. In any case, there are arguments for a wealth tax , and at one stage even Donald Trump was arguing in favour of one. However, a wealth tax would tax all forms of wealth, while this taxes one small form mainly held by the middle classes

As to the argument on fees, this has superficial attraction. Its certain that like most other things in Ireland over the last while the costs of managing ones retirement fund soared. And to be fair the government has agreed to investigate this. However, the government itself has, as is often the case, been a cause of this , so it is alleged, via their fees structure for Personal Retirement Savings Accounts. In any case we have a long way to go before people “shop around” for pension fund management, and this levy is being laid not on the profits of management of the assets but on the actual level of the assets.

Finally we have the argument about overseas. One of the very few undoubted things we know about finance is that, for most investors, it makes sense to be somewhat diversified. In the case of IRish pension funds one of the main problems they have faced over the years is their relative lack of diversificaton. As of the latest Mercer Asset Allocation Survey in 2010 Irish funds held 20% of their holdings in Irish equities and 34% in Irish government bonds.  There is if anything too little overseas diversification evident there, not too much.

As Talleyrand stated about the murder of a prominent member of the French royal family, the decision to begin to expropriate private savings, no matter for what reason, was worse than a crime, it was a blunder.   Their is a long and inglorious history of governments using what has become known as “financial repression” to enable them to close, surreptitiously, the gap between government spending and government revenue.  The academic and research literature on financial repression mostly lives in the area of development, and for the most part was, we thought, an interesting if somewhat historical curiosity.

We should have known of course that this time is never different. And indeed the author of that eponymous and magnificent book, Carmen Reinhardt, has recently produced an extremely interesting research paper on the issue of financial repression.  Financial repression in general refers to situations where the government and the financial system become very much more closely entwined.  The objective of this close intertwining is that the government can reduce its debt not only through prudent fiscal housekeeping but also through in some way directing or expropriating private savings, replacing other forms of investment with government debt.

This intertwining of course has been going on, a macro level in Ireland, ever since the disastrous events of the first bank guarantee. On a more operational level a number of different strands of financial repression can be identified. Perhaps the most common and indeed historically the most effective way in which financial repression occurs is through the government inducing or permitting negative real interest rates, via a combination of artificially low nominal interest rates combined with a slow but steady dose of inflation, inducing or permitting negative real interest rates. We should be aware that the ECB have an explicit anti-inflation mandate and this therefore is likely to play only a small part if any in any repression. Another form of financial repression is through capital controls, forcing investors to invest monies domestically, again not possible (or perhaps it is, if you listen to this clip from Junker )  within the Eurozone context, but a necessary precursor if anybody was to consider leaving the Eurozone.   A third form of financial repression is where the government directs private saving towards its own use. This is usually done via the government directing large pools of private savings, such as bank deposits pension funds, to invest all or a large part of the investment in government debt. The 0.6% pension levy is, in my opinion, a move towards that kind of approach. It forces the private sector investor to underpin the cutting of a tax rate, which would otherwise have had to be met by reduced expenditure elsewhere or by borrowing.

We should also notice that respected analysts suggest financial repression as an explicit means.  The director of the Centre for European Policy Studies has recently suggested that the Irish government should direct the pension and life investment community to invest all of their overseas bond holdings into government bonds. One wonders why he didnt suggest they convert their forein equity holdings as well and be done with it…This would be a direct and explicit form of financial repression. It also be flying in the face of 60 years of financial wisdom, that investors should diversify. Irish pension and life insurance investors are already very “long” Ireland as i have noted above. Forcing them, through their pension funds, to have an even longer position in Ireland would make no sense.  Nonetheless savers and advisors should be aware of this kind of discussion and would be wise to make such musings part of their decisions. Deposits have been flowing out of irish banks for years now and it would be a worrisome development if people were to fear that they have to contemplate similar flight for their remaining assets

While it is an exaggeration to say that the small levy is a smash and grab, it is in my view the first element of a new phase, one that hopefully will not continue. It is essential that the government make it extremely plain that they will not go down the road of recent countries. In Bolivia the government has nationalized pension funds, following the same path as Argentina. In Hungary the state has directed that the in effect mandatory payments into the private pension funds be directed instead to state funds, and a partial version of the same has taken place in PolandBulgaria planned to move in a similar direction but union pressure put paid to that plan. A Peruvian presidential candidate has placed nationalizing private pension funds as part of his campaign, although this plan changes reasonably rapidly depending on the strength of perceived opposition to it.

These are all desperate measures, and ones that we need to see the government here ruling out. Of course, the converse of this is that the state needs to get its finances in order, sharpish. This will require very sharp reductions in state expenditure, moving as much as possible to close totally the funding gap over two to three years.  Doing that will require that all bear the brunt of sacrifice, and in an environment where judges and the top layer civil servants avoided the cuts in pay that others took state leadership will require that not only will these burdens be shared but will be seen to be shared.