What is 'financial repression' – and should countries embrace it as debt climbs?

In 1940, a year before the US joined World War II, public debt stood at $50.7 billion. In 1941, the ratio of public debt to GDP was 42%. In December that year, the US joined the war. By 1945, public debt had jumped fivefold to $260 billion as the Fiscal Service of the Treasury borrowed to fund the war effort.

While debt levels remained around the same level, the post-war era was one of growth - and the public debt-to-GDP ratio fell from 106% in 1946 to 23% in 1974, according to an IMF working paper.

It wasn’t just growth that enabled this remarkable feat, something else was at play.

Interest rates were held down in what a 2024 study by the German central bank, the Deutsche Bundesbank, called an “unconventional policy for reducing debt-to-GDP”.

Known as ‘financial repression’, the policy entails measures that enable a government to place its debt with financial institutions at “artificially low interest rates”.

And it wasn’t just the US that used this method to bring down the debt burden post-war. Across the developed world, the debt-to-GDP ratio went from 100% in 1945 to 20% by 1970, according to the BBC.

Countries can manage debt through various strategies, including fiscal consolidation (policies to cut spending or increase taxes to reduce budget deficits), debt restructuring (renegotiating repayment terms), debt-for-environment swaps (forgiving debt in exchange for environmental commitments), and international debt relief programmes (such as the HIPC Initiative) to support economic growth and sustainability.

But with the global economy under considerable strain, governments are left with few fiscal options to bring down the debt-to-GDP ratio, making financial repression an attractive prospect.

In October 2024, the IMF estimated global public debt at more than $100 trillion, or around 93% of global GDP, with the potential to reach 100% of GDP by 2030 – back up to 1945 levels. This means governments are spending more on interest to service the debt, undermining efforts to boost growth.

The World Economic Forum’s Chief Economists Outlook in January said: “Governments will face mounting pressures to address a ‘fiscal policy trilemma’ of dealing with the costs related to security, population ageing, and climate change, without either jeopardizing debt sustainability or leading to political pushback against rising taxes.”

US debt stands at $36.2 trillion, a figure that the vast majority of chief economists surveyed by the Forum believe will rise under the Trump administration.

Bridgewater Associates founder Ray Dalio has warned the US, UK and other countries with climbing debt deficits about the “debt death spiral” – when the debtor needs to “borrow money in order to pay debt service, and it accelerates”.

Meanwhile, the debt burden is having a huge impact on development, with more than 50 developing countries spending more than 10% of total revenues on debt servicing costs and an estimated 3.3 billion people living in countries that spend more on debt interest than on education or health.

Financial repression is essentially a set of policies designed to manage a country’s fiscal obligations by keeping interest rates artificially low. But while potentially effective in the short term, the approach comes with significant long-term risks and economic implications.

It typically results in savers earning returns below the rate of inflation, effectively eroding the real value of their savings over time.

The concept was first introduced by Stanford economists Edward Shaw and Ronald McKinnon in 1973 to describe growth-inhibiting policies in emerging markets but has since been applied more broadly, particularly following the 2008 financial crisis.

In their 2015 IMF Working Paper, The Liquidation of Government Debt, economists Carmen Reinhart and Maria Belen Sbrancia explain the features of financial repression include:

1. Interest rate caps or ceilings

2. Government control of domestic banks and financial institutions

3. High reserve requirements for banks

4. Creation of a captive market for government debt

5. Restrictions on capital movement across borders

These measures allow governments to borrow at lower interest rates and potentially reduce the real value of their debt over time, especially when combined with inflation.

In the short term, financial repression offers several benefits:

Debt reduction: By keeping interest rates low and allowing inflation to erode the real value of debt, governments can reduce their debt burden over time without resorting to outright default.

Lower borrowing costs: Both governments and companies can access cheaper loans, potentially stimulating economic activity and investment.

Economic stability: In times of crisis, these policies can help stabilize the financial system and prevent market panic by ensuring a steady flow of credit to the economy.

The approach also has significant drawbacks:

Negative impact on savers: Savers may see the real value of their savings erode due to returns below the inflation rate. This can lead to reduced consumer spending and increased economic inequality.

Market distortion: By interfering with market forces, financial repression can lead to inefficient allocation of capital and reduced economic growth. It may discourage productive investment and innovation, as artificially low interest rates fail to accurately signal the true cost of capital.

Wealth redistribution: Financial repression effectively transfers wealth from savers to borrowers, including the government.

Long-term economic consequences: While financial repression may provide short-term relief, it can lead to long-term economic distortions and reduced productivity growth.

Central banks' ultra-low interest rate policies and large-scale asset purchases in recent years have led some economists to argue that a form of financial repression is already underway in many advanced economies.

Implementing such policies in today's interconnected global economy may be more challenging and potentially disruptive than in the past, however. The free flow of capital across borders and the increased sophistication of financial markets make it more difficult for governments to maintain a captive domestic market for their debt.

As governments grapple with rising debt levels, the debate over the use of financial repression is likely to intensify. Policymakers will need to carefully weigh the potential benefits against the risks and consider alternative strategies for managing public debt.