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How Central Banks Are Bleeding the Middle Class Dry

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The Western welfare states know many ways to get rid of their enormous sovereign debt — at great cost of their citizens. Once the debt burden becomes unbearable, the government simply reforms the currency. Then, the government debt will be “adjusted” with the private wealth of the citizens. This is when the citizens will notice that their government's sovereign debt is their own debt.

But the government does not always need to make use of these large torture devices. More subtle ways, such as financial repression, are possible.

What Is Financial Repression? 

"Financial repression" describes a set of tools with which the government can intervene in the market and keep its refinancing cost (the interest on its debt) artificially low. As a consequence, savers and investors are suffering from negative real interest rates because the nominal interest rates are below the inflation rate. The mathematical difference between the savers' nominal interest rates and the inflation rate is the loss of wealth, the rate at which savers and investors are forced to contribute to the debt financing of their governments.

Under normal circumstances, increasing amounts of government debt would cause a rise in interest rates. But due to the mandated artificially low interest rates, the government merely needs a small nominal growth in order to slowly get rid of its debt – at the cost of savers and investors. Using financial repression, wealth is being redistributed in a covert manner — away from the savers and investors and towards the government.

The negative real interest rates are caused by, among other things, the politically mandated low interest rate policies of the central banks since the sovereign debt crisis, and the actions to save the euro. At the same time, investors' money flows from the crisis countries to those states which are (still) considered to be safe, which causes their interest rates on money to decline further.

The often-made claim that low interest rates are revitalizing growth and the business cycle has been proven to be wrong in reality.

Savers and Investors Are Losing this Battle

As of now, savers and investors all over the world are losing more than a hundred billion euros per year because inflation rates exceed the interest rates in many countries. 23 countries are now suffering from negative real interest rates. Even German savers alone are losing roughly 14 billion euros a year by using money market accounts, giro accounts, and savings accounts. This is shown in calculations by the Frankfurt Dekabank and the Institut der Deutschen Wirtschaft (IW).

In the reverse case, when the citizen owes (tax) money to the government, the currently low interest rates are not playing any role. The bond-issuing state is still demanding 6 percent annually — and at a considerably low risk, because, unlike private lenders, the government can foreclose the property of the debtor at a moment's notice.

The Middle Class Is Suffering

Financial repression — also called a “savings account tax to overcome crises,” is currently hitting the middle class much harder than the truly wealthy because the pensions of the middle class (life insurance, savings plans) in particular are suffering. Funded pension insurance systems become unattractive because savers are no longer finding investments which provide substantial rates of return. The problem which already exists with the pay-as-you-go pensions today can no longer be solved by private pension plans. Interest rates and compounded interest rates are so low that they don't contribute as much to capital accumulation as, for example, it was envisioned when the ”Riester pension” was introduced in Germany. In that case, even the government subsidies to ”Riester pensions” are not useful. Thus, a massive provision gap exists now.

Pension Plans Hard Hit 

If the period of low interest rates will continue for long, some insurance companies will start having liquidity problems because they (are obliged to) hold more than 60 percent of their investments in fixed income papers. This means that bonuses derived from profit distribution get lower. Roughly 40 million households in Germany would be affected by a decline in credit vouchers. Clients must continue expecting lower degrees of profit participation and low yields that keep getting lower. In Germany, the difference between the yield generated by life insurance companies and the guaranteed interest rate is, on average, at merely 0.4 percent. This begs the question: How many life insurance companies have sufficient financial buffers to survive this period of a low net interest rate on their capital investments? The life insurance industry is not the only one which suffers; the pension funds are affected as well. The risk capital of life insurance companies, which is necessary to overcome fluctuations in revenue, has shrunk by up to 60 percent in recent years.

Thus, the insurance companies and their clients suffer from a capital market situation which is governed by “political interests”. The interest rates are kept artificially low because, otherwise, countries within the European Currency Union would start to no longer be able to bear the interest payments on their huge sovereign debt and would thus have to declare their bankruptcy. Insofar, these non-market low interest rates have a goal in mind: governmental delay of bankruptcy.

Negative Interest Rate Policy and a Ban on Cash

Meanwhile, the European Central Bank (ECB) demands interest rate payments from the banks which deposit their money at the ECB. The markets expect that, soon, the commercial banks will also start demanding interest rates from their clients (private persons and corporations) on their deposits, i.e. that negative interest rates are introduced.

To prevent bank clients from avoiding these measures by withdrawing their money and storing it in their homes, the government is planning measures to restrict the usage of cash – and even ban cash entirely – at the same time. Thus, as a first step, using cash is prohibited in transactions which are greater than 4,000 euros. Officially, the cash-restricting policies are being justified by the alleged fight against black market criminality and the fight against terrorism financing. However, the true reasons are obvious.

Future Outlook: Recession

From an economic perspective, the artificially low interest rates lead to a misallocation of money towards investments which would not be profitable under normal market circumstances, the result being a creeping more severe recession in the future. On top of that: Interest rates which are lower than the gross domestic product (GDP) growth cannot be sustainable for long. Eventually, in spite of financial repression measures, one can expect a “property haircut” to happen eventually. According to the fiscal monitoring report of the IMF of October 2013, a recommended German “property haircut” of 11 percent was calculated. The international consulting agency Boston Consulting Group even expects a necessary “property haircut” of 25 percent. Because the sovereign debt has drastically increased since then, experts are already expecting a “debt haircut” of at least 35 percent. But even with these measures in place, Germany, relatively speaking the most stable nation in the European Currency Union, would only reach the debt level of the beginning of the 1990s.

Slowly but surely, the enormous sovereign debt is suffocating the European welfare states. They will only be able to eliminate their debt at the cost of their citizens.

Rodion Giniyatullin is an auditor in Russia and teaches at the Ural State University of Economics (USUE) in Ekaterinburg, Russia. Vincent Steinberg is an economist who regularly translates articles for the Ludwig von Mises Institut Deutschland. He is currently a student at Frankfurt School of Finance and Management.


Rodion Giniyatullin

Rodion Giniyatullin is an auditor in Russia and teaches at the Ural State University of Economics (USUE) in Ekaterinburg, Russia.

Vincent Steinberg

Vincent Steinberg is an economist who regularly translates articles for the Ludwig von Mises Institut Deutschland. He is currently a student at Frankfurt School of Finance and Management.

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