They say that nothing is certain except for death and taxes. As Americans, we're subject to a lengthy list of federal, state, and local taxes on everything from our income to our property. As if this wasn't enough, there's another "hidden" tax that fewer people know about. It's a direct result of government policies implemented over the past four years -- and it's shortchanging your savings.
What the heck is it?
It's called financial repression -- an ugly phrase that describes government policies used to channel funds to places they wouldn't be if the market were deregulated. Carmen Reinhart, one of the leading authorities on the topic, elaborates further: "Policies include directed lending to the government by captive domestic audiences (such as pension funds or domestic banks), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks, either explicitly through public ownership of some of the banks or through heavy 'moral suasion.'"
The most common way it's used is by holding interest rates artificially low, as the Fed has done since late 2008, with the benchmark rate near zero. In many cases, interest rates are held below the rate of inflation, which means that real, or inflation-adjusted, borrowing costs end up being negative.
Given the record-low yield on 10-year U.S. Treasuries, which slid to 1.62% on Wednesday, investors can likely expect negative real returns from bonds. Even Warren Buffett is wary of bond investments. In this year's Berkshire Hathaway (NYSE: BRK-B ) letter to shareholders, he writes:
Most of these currency-based investments are thought of as 'safe.' In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.
How it taxes savers and benefits borrowers
Negative real interest rates serve as a tax by transferring wealth from those who have saved money, such as investors and creditors, to those who have borrowed money, namely the government. In particular, they hurt savers who depend on income from interest-bearing assets. Due to extremely low interest rates, the interest income that households earn from their savings has fallen by some 25% since the recession began.
On the other hand, the low-interest-rate environment is a boon for companies like Annaly Capital Management (NYSE: NLY ) and Chimera Investments (NYSE: CIM ) . Both companies are arbitrage plays, with the unique ability to borrow money at lower short-term rates and reinvest it at higher long-term ones. And because the Fed has promised to keep rates extremely low until at least 2014, if not much longer, the interest-rate risk these companies typically face is significantly lowered.
The less-understood motive behind low rates
While we're constantly fed the rationale that interest rates are held low to promote economic recovery, it's actually got a lot to do with reducing this massive debt we've built up. When a government is heavily indebted, keeping interest rates artificially low can help it liquidate, or pay off, its debt faster. Low rates reduce borrowing costs and make it cheaper to service a given stock of debt.
Think of financial repression as a sneakier, more under-the-radar way of dealing with high debt loads. The alternatives, such as austerity or outright default, would be grimmer and more conspicuous. You don't have to look any further than Greece and other European countries to see the kind of public outcry austerity can lead to.
How we ended up here
When we emerged from the global financial crisis, the U.S. and other developed world governments found themselves with debt the likes of which hadn't been seen since World War II. After racking up all these liabilities, the next challenge they faced was to find somebody to buy this stuff.
So to whom did they turn? The Federal Reserve and other central banks around the world -- the only ones who stepped up to the plate.
Ever since, the Fed and foreign central banks, most notably the People's Bank of China, have become bigger players than ever in the market for U.S. debt. For years now, they've steadily been increasing their share of government Treasury holdings, as well as agency Treasuries -- those issued by entities like Fannie Mae and Freddie Mac. In fact, the Fed -- not China -- is currently the biggest holder of U.S. debt.
Implications for investors
All this central bank interference leads to two alarming questions. How safe is the U.S., and other developed-world-government, debt really? And where would interest rates be without all the meddling?
We've always looked at the yield on long-term U.S. Treasury bonds as the best proxy for the risk-free rate. But what happens when the risk-free rate is no longer risk-free? Today, it would appear we're buying return-free risk, not risk-free return.
While bonds might still be a good option depending on your circumstances and appetite for risk, you might do even better investing in high-quality, dividend-paying companies that you can hold for the long term. Stalwarts like Johnson & Johnson (NYSE: JNJ ) and Procter & Gamble (NYSE: PG ) have consistently raised their dividends every year for several decades. And they yield twice as much as Treasuries, with dividend yields of 3.9% and 3.6%, respectively.
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