Financial repression is coming to ‘fix’ Britain’s broken economy

The Government, whether it is Tory or Labour, is likely to reach for a little-know tool called ‘financial repression’ to fix our broken economy in the next five years, according to Edmund Greaves, editor of Mouthy Money

Yesterday I watched a remarkable exchange on ITV’s Good Morning Britain. Martin Lewis, the doyen of personal finance in the UK, took a Labour politician to task over how the party plans to pay for the things it intends to do.

Jonathan Ashworth, the shadow paymaster general, was left thoroughly skewered by the veteran money journalist. He didn’t have a convincing answer when Lewis said:

“You can increase debt, which you’ve said you won’t do. You can print money, which would be inflationary. You put up taxes, which you’ve said you won’t do. Or you could cut spending, which you’ve said you won’t do, which means if you can’t do any of those, we’re living in fairytale land.

 “You are hoping to be in the next Government. We need to know from you which of those four options will you use to fill the black hole, because we know there is one there.”

This exchange struck me. There is much being left unsaid in this General Election campaign which Lewis, and many others, are starting to needle at. What do our politicians actually plan on doing?

In particular, as Lewis points out, our politicians are actively discounting the most obvious ways in which they might actually fix our broken economy, without having any real answer otherwise.

Economic predicament

Our predicament is this. The State (the British Government in this case) took on enormous amounts of debt in order to get us through the crisis of the pandemic. It then did the same again when we had an energy crisis and the onset of the war in Ukraine, to subsidise household bills.

This has left the national debt bill painfully high and means more of the Government’s income is forced into paying this down, and paying the interest on that debt, instead of things we actually want such as nurses or potholes filling in.

This is compounded by higher interest rates, caused by runaway inflation, which was itself caused by the Government racking up all that debt, and exacerbated by the energy crisis.

In orthodox economics there are a few ways in which you can get us out of this predicament, which Lewis alluded to in his questioning of Ashworth.

First, you grow the economy. This is a good solution because effectively you grow the economic ‘pie’ which the Government can then take a larger slice of (in taxes) without actually having to leave households with less themselves. People feel better off and the Government has more money. Win win.

But growing the economy becomes hard when you have highly regulated industries, poor productivity, a general lack of innovation and a lack of investment in new ideas. It is a puzzle we have failed to solve.

Evidence of this poor productivity is particularly stark currently, as workers are getting big pay rises, but aren’t producing more with their time. This, economists warn, is a possible cause of fresh inflation.

Liz Truss and Kwasi Kwarteng tried this method with deregulation, tax cuts and other giveaways, but the bond market hated the idea and rejected it, and they were kicked out of office before they had the chance to really try any of it.

The second choice is to hike taxes. This is easiest in the practical sense that the Government has all the tools, and the power at its disposal to simply increase taxes.

Now, the Government has been doing this to an extent already, through freezing of tax thresholds – which is called fiscal drag. Fiscal drag works as a backdoor tax hike because while you don’t increase the nominal tax thresholds, you allow inflation and wage rises to tip more workers into higher bands, thus earning more money from that higher band.

The reason the Government does this is because bare-faced tax rises are unpalatable, and generally make voters very unhappy. Indeed, they’re so unpalatable that no one wants to admit they’ll do it, despite the woeful situation.

Thirdly, you can cut costs. This is what the Government opted to do in 2010 in the ‘Coalition’ years when austerity was the name of the game. This is arguably now a radioactively toxic idea in political terms. Because of this, it’s very unlikely to happen in an open or obvious way.

If we look at what is actually happening now, it is ultimately a mixture of the three. The Government is paying as much lip service as it can to growth, which isn’t very forthcoming, while quietly increasing the tax burden, and trimming as much as it can from Government services without striking too much ire.

The problem with this is it is all half-baked. Growth is pathetic, taxes are at post-war highs and everything the Government touches feels as if it is crumbling. From the NHS to roads, schools to defence, it all feels very broken. So what do you do?

Read more from Edmund Greaves on Mouthy Money

Financial repression

There is a fourth option that no one really talks about, but I think is potentially what will happen once the dust settles on this election. That is something called financial repression.

Financial repression is a devious way of “fixing” a broken economy in our exact position. There are significant similarities with how our economy looks today, compared with how it looked after World War Two. Financial repression is what they did.

Firstly, you force investors to hold UK-based assets. You do this by limiting what capital (i.e. money) that can go abroad, so investors have to buy assets here. And when I say investors, I mean anyone with a pension pot, or any other kind of investment – a much bigger pool of people than you might imagine.

Then, you allow inflation to run higher than it should be over an extended period of time somewhere in the region of 4%.

By doing this, you don’t decrease the nominal amount of debt that the Government owes, but you do devalue it in inflationary terms, while increasing your tax take. This is because as inflation runs higher, people ask for bigger wage rises, which leads to more tax income and making the relative pile of debt look smaller.

So who loses in this situation? Anyone who is forced to hold local investments such as bonds or equities, which are priced in the local currency (pounds) and as such perform badly relative to higher inflation.

This notionally means anyone with a pension, but in practice it makes older people who have accrued larger investment pots over their working lives more susceptible, particularly as they will be more exposed to bonds which are the worst-affected asset in this scenario.

Now, is this a fantasy theory I’ve just concocted? No, it is already happening.

The current Government has said it is looking to force pension funds to hold more UK-based assets and Government debt. It has introduced new gimmicks such as the UK ISA to encourage investors to put more cash into local assets.

It has cut taxes (National Insurance) at a time when it isn’t really a good idea to do that, threatening to embed more inflation as a result. It already paid a lot of money to households to cover energy costs at a time when putting money into the economy was just going to cause more inflation.

There is one thing standing, theoretically, in the way of this situation – the Bank of England. The Bank has an inflation target of 2%. This means no matter what the Government does to try and stoke some inflation, the Bank will be there waiting to hike interest rates to combat this.

There are a few ways around this though.

The Bank of England is independent, and doesn’t take orders from the Government. But the Government does get to pick the Governor, so could put one in place that was more charitable to its aims.

The Government can also do some inflation stoking measures by the back door, beyond lowering some taxes. It can do this by bypassing the mainstream financial system and guaranteeing loans to businesses or even individuals that encourage spending which in turn stokes inflation.

It can also just make a bare-faced play to change the inflation target, something that is being openly discussed in policy circles.

Where next?

So where do we go from here? It’s good to look at history to see where we might be headed. Post-war financial repression carried on until the early 1970s, and largely did its job of making the war debt look smaller relative to the size of economy paying the bill for it. 

Once major capital controls were lifted by the Government, the movement of money abroad into better-performing assets by pension funds was stark, and fast, and helped to contribute to various crises in the 1970s which ultimately culminated in a radical Thatcher Government of the 1980s.

I do think that any Government with a mandate for the next five years, faced with a panoply of unpalatable decisions otherwise, is going to end up trying this option.

This is particularly because financial repression as a tool affects asset holders rather than workers and this is politically easier than the other choices (especially for certain political persuasions) because it is convoluted and sneaky, so easy to use to hoodwink voters.

The takeaway for anyone wondering how this will affect them is this:

• holding cash that doesn’t have inflation-beating interest rates will make you poorer
• holding UK-based assets, particularly bonds, will make you poorer
• not getting inflation matching or beating wage rises will make you poorer

How you beat these issues comes down to individual choices. I hope in writing this column it encourages you to ensure you’re well-prepared for what is coming.

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