Debt and Inflation During a Period of Financial Repression

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The large accumulation of public debt which took place as a consequence of the recent financial crisis, poses the question of how governments are going to reduce their debts. In this dissertation I look at prior episodes where most advanced economies were highly indebted to understand the possible courses of action that may be available to governments in the future.

Chapter 1, written with Carmen M. Reinhart, documents the role played by financial repression and inflation in reducing government debt after the end of World War II. This mechanism represents a more subtle and gradual form of debt restructuring. Evidence on the evolution and distribution of several measures of real interest rates show that during the period 1945-1980 interest rates were markedly more negative than what they were both in the period before World War II and after 1980. When looking at the real interest rate on the portfolio of domestic debt, real interest rates were negative half of the time for the 12 countries in the sample. A negative real interest rate on the portfolio of domestic debt represents a saving on interest payments for the government. In this case, savings on interest payments averaged 2 to 3 percent of GDP. The chapter also documents the series of defaults, restructurings and conversions that took place after the end World War I and the Great Depression.

Chapter 2 builds on the results of the first chapter. It provides a conceptual framework to understand the different ways through which inflation can affect the value of government debt, and also how to think of financial repression as a restructuring mechanism. Several econometric exercises are performed to disentangle the relative contribution of financial repression and unanticipated inflation. The results point to financial repression combined with inflation (i.e., a nonmarket interest rate combined with inflation) as a relatively more important factor explaining the debt reduction in the post-World War II period. Finally, the question of how investors were affected during this period is explored. It is shown that the equity premium almost doubled during this period. This result suggests that the presence of financial repression, during the period 1945-1980, could help explain to some extent the equity premium puzzle.