Overview

In response to the deficit limit circus and the credit downgrade of the US government, the Federal Reserve pledged to repress investment and savings yields across the United States, and thereby victimize investors, for at least the next two years (even if the press release wasn't quite phrased that way). The Fed's actions are a textbook case of "Financial Repression", a historically popular strategy employed by governments attempting to avoid defaults on massive debts, which entails forcing interest rates below the rate of inflation, thereby effectively paying down debts through a gradual confiscation of the true (after-inflation) net worth of savers and investors.

The highest levels of the US government were so dysfunctional that they were incapable of agreeing to any specifics on how to keep the national debt from doubling to over 200% of GDP over the next decade. Instead, they made (effectively) non-binding promises that "super-committees" and future politicians would do as instructed, which would mean showing the courage that current politicians lack, and finding a way to drop the debt level projected for ten years out to a mere 190% or so of (current) GDP.

Obviously, this is a profoundly inflationary event when it comes to the value of the US dollar over time.

In the Theater of the Absurd that characterizes all too much of the investment markets these days, this unprecedented promise of two full years of investor abuse and repression that would keep citizens from getting fair returns on their savings, was greeted with an over 400 point surge in the Dow Jones Industrial Average. The shearing of the sheep is proceeding with an impressive lack of subtlety - and the potential rewards from acting nothing like a sheep have rarely been greater.

Financial Repression & Shearing The Sheep

"Financial Repression" may sound like a phrase coined by a radical, anti-government fringe group. In fact, however, it is the academic term used to describe the highly successful strategy used by Western governments to pay down their World War II debts. As covered in my recent article "Financial Repression: A Sheep Shearing Instruction Manual" (linked below), the last time government debt levels in the Western world were this high (as a percentage of GDP) was in the immediate aftermath of World War II when all those war bonds needed to be paid down. As shown in the graph below, the debts of the Western developed nations were indeed mostly paid down (relative to the size of the economy) over a period of approximately 35 years, through the governments' using a very deliberate strategy of "Financial Repression".

The essence of Financial Repression is a government using an assortment of methods (as described in the article linked above) to artificially hold down interest rates, creating a collection of carrots and sticks that together collectively ensure that an average saver never gets a fair rate of return. Through regulation and intervention, the government creates an environment of ongoing inflation, but "rigs the game" so that investors receive returns that are substantially less than the rate of inflation. Because the investors can't keep up with inflation, the value of their savings drops each year, even as the inflation-adjustedvalue of the government's debts also falls each year.

With enough time, this is a highly effective method of paying down government debts.

The phrase "Financial Repression" re-emerged into prominence when the International Monetary Fund circulated a paper on the subject earlier this year. However, the policies of Financial Repression were already being deployed long before the recent resurgence of interest in the term itself, as covered in another article of mine from earlier this year, titled "Cheating Investors As Official Government Policy".

From a conventional perspective, for the great majority of savers whose economic awareness is limited to short tidbits from the mainstream media, it may seem a bit puzzling as to why interest rates are low, when the prices for so many necessities are rising. However, there is no mystery and there is no coincidence, rather this is effectively a matter of government policy. And it is a policythat has moved to a dramatic new stage with the recent Fed announcement.

An Extraordinarily Inflationary Event

As concretely demonstrated by the (quite belated) downgrade by Standard & Poor's Corporation of the once impeccable credit rating of the US federal government, the United States is in a serious financial and economic mess. Government borrowing as a percentage of GDP has now passed 100% when Social Security and other government trust fund bond holdings are included, which is a level not seen since the end of World War II. Unfortunately, and unlike the post-World War II situation, it looks like the extraordinary annual deficits are not ending, but only just getting started. US government deficits in excess of $1.5 trillion per year are seeming to stretch out into the indefinite future. If we continue on our current path, then the US government will be twice as much in debt by the end of 2021 than it is right now, even before accounting for the expected increasing costs of future entitlements. We have a catastrophic situation that is getting worse by the day.

This was the time when the federal government needed to pull together, set partisanship aside, and make the hard choices that are necessary to try to solve this terrible problem that is destroying jobs, threatening the national standard of living, and even placing national security in jeopardy.

Instead what we got was a three ring circus between the President, the House of Representatives, and the Senate. What all of them had in common was that none of them had an actual plan for truly solving this, at least not a plan to which they were willing to openly commit as we come closer to the 2012 presidential elections.

The end result of the brinksmanship that came within a day of potentially triggering an entirely unnecessary government default, was effectively - nothing. There was no deal on specifics. The new "super-committee" notwithstanding, the bottom line of the so-called deficit reduction package is that a group of politicians who lack the willpower to solve this problem, agreed to bind themselves, and others in the future, to solve this problem in some as yet unknown manner. With the "binding" consisting of effectively a big knot they tied around themselves, that can be untied at will for any reason. There is no ability to force wisdom, political courage or virtue onto legislators next year, let alone 5 or 10 years from now, because Congress can repeal laws about congressional behavior just as easily as it can pass them in the first place.

Because the US government controls the value of its own currency and has the ability to create money at will (as amply demonstrated by the Federal Reserve in recent years), I don't believe that an actual default of the US government is at all likely, unless there is another political screw-up on an even more epic scale. Instead the US government will likely pay its debts in the time-honored way, which is to create inflation, and thereby reduce the value of the dollar, which makes the repayment of debt more easy over time. So when we look at the "solution" to the US government deficit problem that is really no solution at all, it's hard to interpret the results as being anything other than causing rising rates of inflation.

Creating inflation is the necessary fuel for Financial Repression, otherwise there is no destruction of the value of the debt. Low interest rates over time are the other essential ingredient, and the Federal Reserve has just made an unprecedented pledge to maintain historically low interest rates for two full years. Truly, if one was writing an economics textbook and crafting an example of how Financial Repression works, it would be difficult to come up with a more clear-cut example.

Victimization Versus Wealth Maximization

So we have a textbook case of the government openly acting to repress yields and effectively confiscate the wealth of savers, against the backdrop of a government deficit limit fiasco and credit downgrade that are some of the biggest inflationary events of our lifetimes. Yet the response of the markets to this pledged confiscation was enthusiastic, with the Dow rising more than 400 points in a single day (before plunging even more the next day as the European situation continued to deteriorate).

How could that be? Is the market made up of masochists?

It is worth keeping in mind that the equity markets are no longer primarily where small investors directly invest their money, but rather they are the playground of investment banks, large institutional investors and money managers. For many institutional investors, the Federal Reserve did not lower their investment returns because these investors don't make their money buying treasury bills. Instead, what the Federal Reserve action did was to promise to lock in and extend a historically low cost of funds for banks and other institutional investors.

So for any given investment held by an institutional investor over the next couple of years (if the Fed remains in firm control of interest rates, which is quite uncertain), the spread between their return from the investment and their cost of funds just grew wider. This is a deliberate, government-induced redistribution of wealth, with the institutional investor potentially making more, because the individual saver and depositor gets paid less.

The essence of what just happened is that the United States central bank - which is owned by the banks it purportedly regulates - changed the rules yet again, in a very open and explicit manner, that will increase bank profits even while cheating ordinary individual investors.

From a sheep's perspective this is rather outrageous, but it's really just more of the same. Most of the "sheep" unfortunately will never know the difference. They don't understand enough about economics and finance to know what's going on, they just know that their wealth once again seems to be strangely failing to multiply in the manner that has been promised to them over the last 20 or 30 years.

Keep in mind - the effectiveness of Financial Repression in "shearing the sheep" without most of them ever realizing they are being deliberately sheared is no mere theory, and neither is the willingness of governments to do this to their own citizens. My article on Financial Repression (previously linked) contains a link to a lengthy IMF-published paper on how this strategy was "successfully" deployed on a global basis between 1946 and 1980, and it is worth reading both my analysis and the source paper.

So we can either accept being sheared by the system as part of a very deliberate strategy of Financial Repression, or we can look Chairman Bernanke directly in the eye and say: "Thank you very much!"

We do this by taking advantage of what is being offered to us and acting in a manner that is much closer to how the institutions act, but has very little in common with how conventional "sheep" / personal finance investment education works. If we can fundamentally change our perspective so that we see the overwhelming personal opportunities that are opened up by this overt Financial Repression, then this environment of systemic cheating of the people of the nation is something that can be reversed on a personal level. So that the more outrageous the government actions, the more our own net worth grows.

The key is education, and of a sort that is quite different from even the usual contrarian personal finance, let alone conventional personal finance.