Fiscal vulnerability and financial repression in France since 1950

To be presented at Strasbourg Conference, September 13-14, 2012

Macroeconomic and financial vulnerability indicators in advanced economies

by

Marcel Aloy, Aix-Marseille Université (AMSE) and GREQAM

Gilles Dufrénot, Aix-Marseille-Université (AMSE), Banque de France & CEPII

Anne Péguin-Feissolle Aix-Marseille Université (AMSE) and GREQAM (CNRS)

Abstract

This paper contributes to the recent empirical literature on financial repression and the

vulnerability of public finance through the examination of the French case since the end of

World War II. Using a simple econometric analysis we obtain several interesting results. Over

the years of financial repression, governments were able to obtain primary balances

consistently above sustainable levels. This suggests that fiscal adjustment needed to lower the

debt ratio have been smaller than during the years of full liberalization of credit markets.

Secondly, the negative interest-rates were the consequence of low nominal rates, the latter

being correlated with different indicators of financial repression. These indicators also played

a major role in accounting for the growth of real GDP. Given these results, we conduct a

counterfactual analysis to see whether the vulnerability of public finances would have been

different, if, since the late 1980s, governments had continued to carry out the same financial

repression policies? We answer affirmatively showing that the cost of debt service would

have been reduced, that the contribution of growth to the variation of the debt ratio would

have been more important than it actually was, and that the repressive policies would have

eased the adjustments of the primary balance.

JEL classification : G28, H63, N20

Keywords : Financial repression, Fiscal vulnerability, France, historical economics

1

Fiscal vulnerability and financial repression in France since 1950

Marcel Aloy, Aix-Marseille Université (AMSE) and GREQAM

Gilles Dufrénot, Aix-Marseille-Université (AMSE), Banque de France & CEPII

Anne Péguin-Feissolle Aix-Marseille Université (AMSE) and GREQAM (CNRS)

1.- Introduction

Could new financial repression policies help the French governments to deal with the fiscal

vulnerability induced by the high debt ratio this country has experienced since more than a

decade now? This is a hotly debated issue. When the resources needed for growth and public

finances become scarce (because governments face stronger constraints in international

markets and have to rely on resources stemming from domestic credit markets), what is the

best way of allocating efficiently these rare resources in the economy? Can financial markets

working alone do the job, or do we need institutional rules to increase the selection

capabilities? Are the effects of the contributions of debt service, growth and primary balance

to the variation of the debt ratio conditioned by the nature of financial policies implemented

by government: liberalization or regulation?

The answers to these questions are not unambiguous, if we refer to the theoretical literature

dealing with the effect of financial repression on the determinants of the debt ratio.

It is common wisdom that a higher growth helps reducing fiscal vulnerability. From a

theoretical point of view, models of the causal link between repressed finance and growth

were proposed during the 1990s within the context of endogenous growth theory. Their

conclusions are mixed. While some of them conclude that financial repression policies leads

to lower growth rate, others shows that it can be optimal to repress the financial sector in

order to foster growth1. These models attempted to give a formal basis to an already existing

theoretical apparatus on financial repression and growth. The negative impact of financial

repression had its foundation in the neoclassical tradition. In their pioneering papers

McKinnon (1973) and Shaw (1973) explain that strict regulation of interest-rate, high reserve

1 See, among others, Greenwood and Jovanovic (1991), Levine (1991), De Gregorio (1991), Greenwald and

Stiglitz (2003), Roubini and Sala-i-Martin (1995).

2

requirements and a compulsory regulation of credit allocation reduces the amount of saving

needed for financial intermediation and result in a misallocation of capital in productive

sectors. The reason is that, when government deficits pre-empts lending resources of the

deposit banks, private saving and investment are stifled. The negative impact also works

through financial distortions that reduce the rate of innovation (King and Levine, 1993). Other

authors also point to the costs induced by financial repression: rent-seeking behaviors, erosion

of the tax base, capital flight, etc (see for instance, Dooley and Mathieson, 1987). Regulated

interest-rates prevent the credit markets from achieving their equilibrium, credit controls

result in a reduction of financial flows. On the other side, criticisms have been leveled against

the neoclassical view by the institutional approach to financial economists. Those who

demonstrate the effect of a positive causality of financial repression on growth are based on

the fact that the existence of market failures and credit rationing motivates a potential role for

governments in the allocation of credit (see for instance, Stiglitz and Weiss, 1981, Stiglitz,

1993).

The budgetary impact of financial repression has also been analyzed. Government revenue

from such a policy includes the reduction of interest expenses stemming from the tax inflation

or the nominal interest-rate ceiling, the increase in the size of implicit tax base through the

high cash reserve requirements, the gains accruing to the government from seigniorage. The

main conclusion from the theoretical arguments is that some governments may choose to

resort to this type of implicit taxation while other may not, depending on several factors like

the efficiency of tax systems, tax evasion, the degree of financial development, asymmetric

information (see, among others, Bacchetta and Caminal, 1992, Bhattacharya and Haslag,

2001, Cuikerman et al., 1992, Di Giorgio, 1999, Espinosa and Yip, 1996, Haslag and Young,

1998).

In spite of the ambiguous findings of the theoretical models, the idea that a financial

repression policy could be a way to solve the sovereign debt crisis resurfaces today. It is

implemented by the central bankers themselves, for instance through the adoption of the

recent quantitative easing policies or through the declaration of former governors like

Greenspan confessing that there was a flaw in his prior belief that self-interest would prevent

the type of financial crisis we recently faced and arguing that tighter capital and liquidity

controls appears uncontroversial (see Taylor, 2011). Moreover, in a number of cases, the

negative causality between financial repression and economic growth obtained in the

theoretical models is contradicted by the historical observation, especially in the industrialized

3

countries. Indeed, in some countries, a strict control of the financial system promoted

impetuous growth. For instance, this was the case of Japan during the Meiji era between 1868

and 1912 (Konno, 2003), of most Asian tigers from the years 1960s onwards and of some

European countries after WWII.

This motivates the re-emergence of empirical studies dealing with the public finance

aspects of financial repression. For instance, some recent papers attempt to quantify the

amount of debt wiped out since the post World War II in the industrialized countries due to

the so-called liquidation effect, i.e. saving to the governments from having a negative interest-

rate (see Magud et al., 2011, Reinhart and Sbrancia, 2011). Additional studies are needed to

examine the impact of financial repression on the other determinant of the debt ratio so that

we understand how repression today could contribute to rapid debt reduction.

This paper seeks to contribute to the recent empirical literature on financial repression and

the vulnerability of public finance through the examination of the French case since the end of

World War II. Previous papers examined how the real interest-rate, the primary balance and

the growth rate contributed to the variations of the debt ratio in this country. The main

conclusion is that the three variables accounted for the reduction of the debt ratio up until the

mid 1980s. however, since 1990 fiscal rectitude and growth rebounds do not help in stopping

the debt ratio that is climbing at rapid rate (see Dufrénot and Triki (2012a, 2012b). Can the

specific kind of the domestic financial and monetary policies explain these differences?

Indeed, from the end of World War II till the mid 1980s, the financial architecture was

characterized by financial repression with government debt accounting for a significant share

of the domestic banks’ asset holdings, high reserve requirements, captive credit markets and

ceilings on nominal interest-rates. During these years the inflation rate was high, thereby

implying negative interest-rates. In the wake of the liberalization policies undertaken all over

the world from the mid 1980s, the restrictions and regulations in the credit and financial

markets were progressively lifted and financial liberalization was completed in the 1990s. An

interesting question is for instance whether the fiscal adjustments undertaken to reduce the

debt levels before the mid 1980s were facilitated by the capacity of the governments to have

an implicit taxation of the banking system? Could the healthy growth of the thirty glories be

explained by the negative interest-rates and by the fact that public firms and the governments

could recur selectively to the domestic credit?

As part of the answer to the above question, Monnet (2011) estimates the impact of credit

control and selectivity on the investment and the output growth rate of 49 sectors between

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1949 and 1974. He documents a positive correlation between the marginal productivity of

capital and investment credit, a positive correlation between medium to long-term credit and

the most capital intensive sectors, a positive impact of credit investment on the growth of

production within each sector. The results of his quantitative evidence are along the line of

previous qualitative studies showing the strong relationship between the industrial policy and

the financial repression policy in France during the postwar years (Hall, 1986, Hayward,

1986, Zysman, 1983, Loriaux, 1991). These studies are interesting because they show that,

contrary to a widespread idea according to which financial repression impedes growth, it

served as a tool of growth-enhancing during the period from 1950 to 1975.

Our paper goes a step further in an attempt to answer the preceding questions. We first

consider the historical experience of financial repression policies in France from 1950 to the

mid-1980s, examining the effects on the determinants of the public debt ratio. By using a

simple econometric analysis we obtain several interesting results. Over the years of financial

repression, governments were able to obtain primary balances consistently above sustainable

levels. This suggests that fiscal adjustment needed to lower the debt ratio have been smaller

than during the years of full liberalization of credit markets. Secondly, the negative interest-

rates were the consequence of low nominal rates, the latter being correlated with different

indicators of financial repression. These indicators also played a major role in accounting for

the growth of real GDP. Given these results, it is then interesting to conduct a counterfactual

analysis: would the vulnerability of public finances have been different, if, since the late

1980s, governments had continued to carry out the same financial repression policies? We

answer affirmatively showing that the cost of debt service would have been reduced, that the

contribution of growth to the variation of the debt ratio would have been more important than

it actually was, and that the repressive policies would have eased the adjustments of the

primary balance.

The remainder of the paper is structured as follows. Section 2 presents an overview of the

salient features of the institutional framework of financial repression policies in France

between 1950 and the end 1980s. The comparative behavior of the real interest-rate in

contexts of financial repression and liberalized financial markets is brought in Section 3.

Section 4 looks at the impact of financial repression on fiscal vulnerability through the effects

on the main determinants of the debt ratio. Finally Section 5 concludes.

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2.- The institutional framework of financial repression in France between 1950 and the

end 1980s

The concept of financial repression was coined in the seminal papers by Shaw and

McKinnon (1973). It refers to situations where the financial system is regulated such that

prices and quantities in credit, money and asset markets do not reflect market equilibrium

conditions. Financially repressed policies take several forms: legal ceilings on nominal

interest-rates, high reserve requirements, creation of captive credit markets with governments

pre-empting the resources of the deposit bank, seigniorage via the monetary financing of

public deficits. Whichever are the policies adopted, financial repression is usually

accompanied by capital account restrictions and exchange rate controls. Further, interest-rate

savings are obtained through an inflation policy. Given nominal interest-rate caps, high

inflation rates have the following incidence: real rates are very low (negative) and below the

growth rate of the real GDP, thereby facilitating episodes of huge drops of the debt ratio.

Like in other industrialized countries, financial repression policies in France have been

used as a method of resolution of public debt surges from the post-war years till the end

1980s. We briefly portray the main features of the financial architecture in this country at that

time for a more in-depth analysis, we refer the reader to Quenouelle-Corre (2005) and Monnet

(2011).

Though financial repression was a widespread practice in the industrialized countries after

the instauration of the Bretton Woods system and the breakdown of fixed exchange rates, this

policy was already implemented in France before the Second World War. The regulatory

framework of the 1950s inherited from both the post-WWI and the interwar years. In order to

consolidate the huge amount of debt inherited from WWI, governments relied primarily on

the banking system. From the 1920s onwards, the selling of public debt to investors was

based on a network of commercial banks that the government legally erected as “Agents”.

The banks included the Crédit Lyonnais, the Société Générale, the Crédit Industriel et

Commercial. 23 institutions were involved. At that time, the commercial banks designated to

take a very active part in the creation of captive markets for public debt were highly involved

because, in turn, they received high commissions from governments. The amount of public

debt sales and the interest rates were defined during meetings between the Ministry of

Finance and commercial banks. This was completed during the interwar years by the active

role of the “Caisse des Dépôts et Consignations” that bought short-term public debt in the

monetary market and exchanged them at the Treasury against long-term securities. The Great

6

Depression of 1930 promoted the role of the central bank in the financing of budget deficits:

rediscount of Treasury bills held by banks at the Banque de France, seigniorage through the

central bank’s advances to governments, implementation of open market policy. During the

1940s the so-called “Treasury circuit” was set up. It consisted of a set binding mechanisms

allowing the government to direct domestic savings to himself: banks’ portfolios were mainly

composed of treasury bills, regulations promoted payment by check and bank deposits,

Treasury deposits and postal check accounts developed, the issuance of private bonds and

equities beyond a certain limit were subject to authorization, the public treasury was fed by

the “correspondants du Trésor”. All these took place within a context of authoritarian setting

of the volume and of the timing of issuance of private bonds and equities in the financial.

The end of WWII and the willingness to liquidate part of the accumulated war debt gave

birth to financial repression policies inherited from the pre-war years. The rules of credit

allocation and credit policy orientations were defined and supervised by the “Conseil National

du Crédit” a supervision agency created in 1945. Public financial institutions were directly

involved in the distribution of resources to the productive sectors and credits were monitored

across sectors according to a policy of credit selection. The priority was the long-term

financing of public firms and much effort was devoted to reduce the cost of public borrowing.

In this view, the power of the Treasury, of the Caisse des Dépôts and of the Banque de France

was reinforced to control of nominal rates in the bond and monetary markets.

The interest-rate policy relied on the following triptych: the control money market rates by

the Bank of France, the control of public bond yields through the interventions of the Caisse

des Dépôts in the bond market and a regulation of the deposit rate. This helped maintaining

the nominal rates at very low levels and allowed the government to benefit from negative real

rates. For purpose of illustration, Table 2.1 traces out the main yields of saving between 1969

and 1980. We see that the regulated deposit rates were sometimes twice as low as the market

rates, Treasury bonds and other public bonds had a higher yield than deposits in banks and

that there was a strong spread between the interest of medium- to long-run savings and the

short-term interest rate. Interest rates appeared to be negative over the whole period because

they were stabilized in spite of the acceleration of the inflation rate. Credit loan rate were also

maintained at low levels through a system of subsidized credits in order to support medium-

term and long-term investment. An interesting feature is that the fixation of the conditions and

of the level of lending rate was the outcome of discussions within the Conseil National du

Crédit between different economic actors. Indeed, the CNC council was composed by

7

representatives of the Banque de France, of high level civil servants of the main ministries

and of private and public commercial banks. As illustrated in Table 2.2, there were huge

differences between the non-subsidized and subsidized real interest rates, the latter being

importantly negative. From the viewpoint of the lenders, repressed finance consisted in

creating legally specific types of loans in order to reduce the borrowing costs and boost the

investment in some selected sectors. The subsidies stems from a fund called the “Fonds de

Développement Économique et Social”.

Another practice was the management of a queue of borrowers that contributed to create

captive credit markets in which public firms had an advantage over the private companies.

The mechanism was the following. A company or institution wishing to issue bonds above a

given amount preliminary needs the authorization of the minister of finances. At the

beginning 1950s, the threshold was 250000 Francs. Then, governments established legally an

order in the queue of borrowers. The first institutions able to sell bonds in the capital market

were the Treasury and the financial institutions and enterprises under its control: Postal and

Telecommunication administration (PTT), the national railway enterprise (SNCF), the gas and

electricity company (EDF), etc. Then, in second place, big companies were served (in

different sectors such as automobile, aeronautic, etc). In last place, private companies could

sell their bonds. Given the context of scarce domestic resources and the capital account

control, a consequence of this system was credit rationing with an eviction of private

companies which were unable to collect the whole amount of debt they needed for their

business.

In addition to these measures the former system of Treasury circuit was re-activated and

seigniorage was further used as a mean of financing public expenses. The Banque de France

plays a central role in rediscounting medium-term loans through a system of ex-ante selection

of the sectors needing credits (see Monnet, 2011). Further, restrictions and extensive controls

of capital account and exchange rate were maintained up until 1986-1988.

3.- Financial repression and the real interest-rate: some empirical observations

We now attempt to quantify some of the dimension of financial repression in France and

its consequences on the cost of service on public debt. Since the core variables reflecting

financial repression are the interest-rates and inflation, some key features on these variables

are first shown.

8

Table 2.1. Nominal and real interest-rates on saving

Saving banks Medium-term deposits and certificates of deposits

Treasury bill

(5 years)

Home saving plans

Public bonds Equities

Regulated rates Non-regulated

rates

Nominal Real Nominal Real Nominal Real Nominal Real Nominal Real Nominal Real Nominal Real

1969 4.00 1.40 4.50 1.90 8.85 6.25 7.50 4.90 8.0 5.4 8.63 6.03 3.95 1.35

1970 4.25 -1.55 4.50 -1.30 8.15 2.35 8.25 2.45 8.0 2.2 8.26 2.46 4.47 -1.33

1971 4.25 -1.25 4.50 -1.00 7.15 1.65 7.87 2.37 8.0 2.5 8.28 2.78 5.28 -0.22

1972 4.25 -1.95 4.50 -1.70 7.65 1.45 7.50 1.30 7.0 0.8 8.78 2.08 4.55 -1.65

1973 4.25 -3.15 4.50 -2.90 10.95 3.55 7.50 0.10 7.0 -0.4 9.65 2.25 5.40 -2.00

1974 6.50 -7.20 6.75 -6.95 12.95 -0.75 9.02 -4.68 8.0 -5.7 11.21 -2.49 7.82 -5.88

1975 7.50 -4.20 7.00 -4.70 9.35 -2.35 9.25 -2.45 9.0 -2.7 10.18 -1.52 6.17 -5.53

1976 6.50 -3.10 6.50 -3.10 10.15 0.55 10.50 0.90 9.0 -0.6 11.04 1.44 6.96 -2.64

1977 6.50 -2.90 5.50 -3.90 8.80 -0.60 9.75 0.35 8.0 -1.4 11.07 1.67 7.68 -1.72

1978 6.50 -2.60 5.50 -3.60 8.30 -0.80 9.50 0.40 8.0 -1.1 9.94 0.84 5.84 -3.26

1979 6.50 -4.20 5.50 -5.20 11.0 0.30 9.50 -1.20 8.0 -2.7 12.59 1.89 5.79 -4.91

1980 7.50 -5.80 6.50 -6.80 10.75 -2.55 10.50 -2.80 8.0 -5.3 14.31 1.10 6.69 -6.61

Source: Bulletin Trimestriel de la Banque de France and INSEE

9

Table 2.2. Real cost of credit, subsidized and non-subsidized loans

1969 1972 1977 1979

Non-subsidized loans

Commercial discount 4.65 3.8 3.4 4.4

Overdraft advances 5.85 5.0 4.1 5.0

Personal loans 7.05 6.55 8.48 6.85

Base rate 2.0 0.8 -0.1 0.8

Medium-term credits 4.55 3.2 2.25 3.25

Housing credits (buyer) 6.30 4.8 5.6 5.2

Subsidized loans

Loans to young artisans -0.95 -0.95 -3.4 4.7 to -3.2

Loans to artisans 0.55 0.55 -1.4 -1.2

Export credits - 0.70 -1.4 -2.7

Subsidized loans to agriculture sector -1.70 -1.70 -4.9 -4.7

Participation to the rebuild of firms -3.20 -3.20 -6.4 -7.7

Loans to public housing building -1.20 -2.5 -2.9 -

Loans associated to home saving plans -0.70 -1.2 -3.9 -5.2

Special loans of the real estate bank -0.70 0.8 -1.4 -

Source : Conseil National du Crédit et Bulletin Trimestriel de la Banque de France

The real cost of debt in relation to other interest-rates

Figure 1 shows the evolution of the effective nominal interest-rate on public debt

(measured by the cost of debt service as a ratio of the stock of debt in the previous year) along

with the inflation rate (headline and core inflation2). The interest-rate appears to be

characterized by a stepwise evolution. It first remains below or near 1% from 1950 to 1982,

than increases gradually to a ceiling of 1.8% until 1990 and jumps at higher levels with a peak

corresponding to the year 1998. The curve of core inflation is suggestive of a humped-shaped

dynamics with an increase up until 1979 followed by a gradual decrease until 1990 before a

plateau is observed from 1991 onwards. As a consequence, the real interest-rate on public

debt is negative before 1990 with the gap between the nominal rate and inflation being

particularly huge between 1965 and 1986 (see Figure 2).

2 The latter is measured by applying a HP filter to the series of headline inflation

10

Figure 1. Nominal interest-rate and inflation Figure 2. Real interest-rate

-4

0

4

8

12

16

20

24

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

50 55 60 65 70 75 80 85 90 95 00 05 10

Nominal explicit interest rate on debtHeadline inflationCore inflation

-16

-12

-8

-4

0

4

60 65 70 75 80 85 90 95 00 05 10

Nominal interest rate minus headline inflationNominal interest rate minus core inflation

Figure 3. Interest-rate on public debt and lending rate Figure 4. Lending rate (nominal and real

0

4

8

12

16

0

1

2

3

4

50 55 60 65 70 75 80 85 90 95 00 05 10

Nominal interest rate on public debtLending rate

-16

-12

-8

-4

0

4

8

12

16

50 55 60 65 70 75 80 85 90 95 00 05 10

Lending rate (nominal)Lending rate minus inflation

11

12

Are these evolutions related to the policies undertaken by governments during the era of

financial repression? As shown in Figure 3, the nominal interest-rate seems to evolve in

parallel with the lending rate until 1983 with a gap between the two rates shrinking between

1972 and 1983. And then, from 1984 onwards a divergent evolution is observed. The lending

rate is quite stable until 1968 as the result of explicit caps on interest-rates. Then, it increases

between 1970 and 1980, thereby reflecting the governments’ effort to channel to themselves

the credits by discouraging the demand for credits by the private sector and increasing their

weights in the credit market in a context of control of capital flows and a low financial depth.

As is seen in Figure 3, the increase in the lending rate (or other nominal rates) allows the

governments to benefit from a cost of debt service on public debt between 1970 and 1980

lower than the average cost before 1970.

Further, Figure 4 shows that the nominal and real lending rate evolve jointly only after

1985. These observations reflect the fact that the nominal interest-rates were inhibited from

reacting to inflation before 19853. This comes from the interest-rate policies, described in the

preceding section, during the years of financial repression: administrative control and

regulations on credit markets allow the governments to keep the real interest-rates below the

level they would have achieved in a context of deregulated markets (notably between 1970

and 1983).

Implicit tax on financial intermediation

A financial repression policy results in an implicit tax on financial intermediation. This is

achieved in several ways. First, interest-rates on T-bills are considerably lower than the rates

on deposits, thereby implying that required holding of government bonds is equivalent to a

tax on the banking sector. Figure 5 illustrates this situation during the years of high financial

repression from 1960 to the mid 1990s. The nominal spread, defined as the difference

between the nominal lending rate and the nominal deposit rate was also high between 1978

and 1995, reflecting a high cost of financial intermediation. The lending rates reach fairly

high levels because the banking sector was forced to hold a high proportion of deposits in

statutory reserves and could not substitute foreign assets for public domestic assets. The

legislation in France during the 1960s, 1970s and 1980s was typical of an asymmetric control

of capital flows. Indeed, public enterprises were encouraged to borrow abroad, but credit to

3 We obtained similar conclusions by considering other interest-rates such as the deposit rate or the central bank

discount rate.

13

the private sector and foreign sector was rationed or prohibited. Figure 6 shows a positive

correlation between the cost of intermediation and the negativity of the interest-rate (the

higher the interest-rate spread, the more negative the real effective interest-rate on public

debt).

The role of financial repression variables in accounting for highly negative interest-rates

Looking at Figure 2, the real interest-rate on public debt can be regarded as evolving in

two “regimes”. These regimes correspond respectively to times of exceptionally negative low

real rates (between 1970 and 1985) and times of “normal” levels of the real rate (moderately

negative - before 1970 and between 1985 and 1990 - or positive rate after 1990). To see

whether the times of exceptionally low real interest-rate could be attributable to the financial

repression policies, we propose a simple empirical model with financial repression variables

that distinguish between the two regimes.

We estimate a time-varying transition probability (TVTP) Markov-switching model

proposed initially by Filardo (1994). Technical details on the model are given in Appendix A.

Such a model allows a relationship between the two regimes and some indicators of financial

repression. Different variables can potentially serve as indicators for financial repression.

Such variables capture elements of inflation “surprise”, the degree of banking intermediation,

captive borrowing markets and stock market depth. The variables we propose to capture these

features are the following.

Inflation “surprise” is measured as the difference between headline inflation and a ten-year

moving average of this variable. The reason is that governments may search to reduce their

debt level through unexpected inflation. Dufrénot and Triki (2012) show that, historically, the

contribution of inflation in explaining times of decreasing debt ratio was important when

inflation was unanticipated. The degree of banking intermediation is measured by the level

the M2-to-GDP ratio. We expect this variable to be negatively correlated with the real

interest-rate in times of financial repression since this ratio tends to be higher in market

economies. A variable measuring captive borrowing markets is here the ratio of commercial’s

banks and/or central bank’s claims on government relative to total public debt. A high ratio is

illustrative of a situation of financial repression. Finally, captive credit market are successful

in terms of channeling the available saving to the public sector if financial entities no or low

access to other assets such as equities. Therefore, the stock market capitalization as share of

14

GDP is an indicator of financial constraint put on the investors. The initial data are collected

from the International Financial Statistics of the IMF for the different indicators. The

endogenous variable is the ex-post real effective interest-rate on public debt. The series is

taken from Dufrénot and Triki (2012a).

Tables 3.2 till 3.4 report the results of the estimated TVTP model. The model is able to

differentiate between very low or normal real interest-rate regimes. The regime of low

interest-rate is identified by a negative -and very often statistically significant – intercept,

while the intercept is either statistically positive or near zero in the second regime. For

instance, when the central bank’s claims on government is the indicator of financial

repression, the estimated mean of the real interest-rate is -2.13% in times of low interest-rate

(regime 1), while it is 0.19% in the second regime corresponding to times of moderately

negative or positive real interest-rates (see Table 3.2). An interesting feature of the regressions

is that the dynamics of the real interest-rate appears to be more volatile in the regime of low

interest-rate (for instance, in the case of the central bank’s claims on governments, the

volatility equals 4.82 against 0.74 in the other regime). Since we saw that the nominal rate

was quite stable during the years of negative real rates, this result would suggest that the

source of volatility is headline inflation. When the cost of debt service is diluted through price

changes this may come from transitory shocks in inflation. This does not mean that investors

were reacting to noise rather than to new signals in the prices (in repressed markets, investors

are confronted to fixed nominal rates and there are no Fisher effects). The result simply

suggests that there is an overlap between the regime of low real interest-rates and years of

high variability in inflation. Up until the mid 1980’s the surge in the inflation rate was due to

several shocks: the Algerian war, the end 1960’s social crisis, the oil price shocks and the so-

called “stop and go” policies.

The model also captures the transition from one regime to another. Indeed, at least one of

the coefficients of the transition function is statistically significant, thereby indicating that the

variables of financial repression considered are successful in predicting changes in the

regimes of real interest-rates.

15

Table 3.1. TVTP model Financial repression variable : surprised inflation

Table 3.2. TVTP model Financial repression variable : Claims on gvt. (Cl. Bank)

________________________________________________ Param std-errors t-statalpha1 -0.8584 0.6378 -1.3460 alpha2 0.7244 0.1392 5.2042 beta1 0.9074 0.0916 9.9022 beta2 0.0751 0.0318 2.3622 sigma1 2.3696 0.2705 8.7600 sigma2 0.5876 0.0937 6.2711 a1 1.8279 0.3715 4.9204 a2 -1.3972 0.4172 -3.3490 b1 0.6661 0.2135 3.1193 b2 -0.6700 0.2517 -2.6619 ________________________________________________

________________________________________________ Param std-errors t-statalpha1 0.4566 0.2380 1.9188 alpha2 -5.2121 1.3392 -3.8919 beta1 0.7381 0.0612 12.0562 beta2 0.7243 0.3138 2.3085 sigma1 0.7952 0.2966 2.6810 sigma2 4.8273 1.1908 4.0538 a1 1.5866 0.5016 3.1630 a2 -0.5849 0.3627 -1.6127 b1 -0.1347 0.0390 -3.4517 b2 0.0379 0.0322 1.1785 ________________________________________________

Table 3.3. TVTP model Financial repression variable : Claims on gvt. (total)

Table 3.4. TVTP model Financial repression variable : M2/GDP

________________________________________________ Param std-errors t-statalpha1 -3.9076 1.5061 -2.5946 alpha2 0.3172 0.1413 2.2444 beta1 0.5909 0.1428 4.1376 beta2 0.7109 0.0361 19.7089 sigma1 4.0481 0.7023 5.7643 sigma2 0.6313 0.1048 6.0239 a1 1.2002 1.0222 1.1741 a2 -3.8714 1.3696 -2.8266 b1 -0.0071 0.0163 -0.4356 b2 0.0559 0.0253 2.2098 _______________________________________________

________________________________________________ Param std-errors t-statalpha1 0.6180 0.1538 4.0172 alpha2 -0.6578 0.5190 -1.2674 beta1 0.0614 0.0294 2.0894 beta2 0.9024 0.0774 11.6540 sigma1 0.5139 0.1034 4.9717 sigma2 2.1411 0.2411 8.8822 a1 -6.0016 5.3577 -1.1202 a2 2.5584 2.2196 1.1526 b1 0.1677 0.1450 1.1565 b2 -0.0931 0.0539 -1.7283 ________________________________________________

16

Figure 5. Nominal interest-rate spread Figure 6. Real rate on public debt (y-axis) and nominal spread (x-axis)

0

2

4

6

8

10

12

14

16

1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

(Nominal spread :lending rate minus deposit rate, )

-11

-10

-9

-8

-7

-6

-5

-4

-3

0 1 2 3 4 5 6 7

Figure 7. Posterior probability of low real interest-rate (inflation) Figure 8. Claims on government

0

10

20

30

40

50

60

70

80

50 55 60 65 70 75 80 85 90 95 00 05 10

Commercial banks' claims on governementCentral bank's claims on government

17

An increase in unexpected inflation (inflation surprise) raises the probability that the real

interest-rate will continue to be strongly negative if this is already the case, but reduces the

probability that the real interest-rate continue to be positive, moderately negative or near zero

if this evolution is currently observed. Indeed, in Table 3.1 we see that the coefficient b1 is

positive and statistically significant while b2 is statistically negative. Therefore surprised

inflation is successful in signaling the occurrence of very low interest-rate whichever their

current level. Figure 7 shows the estimated posterior probability of the low interest-rate

regime. We see that this regime is identified as corresponding to the years from 1960 to the

end 1980s which as we know were characterized by financial repression.

b1 and b2 estimated for the central bank’s claim ratio also carry the expected signs (see

Table 3.2). However, this variable is informative only about the transition from a situation of

“normal” to low real interest-rates (as b1 is significant while b2 is not). This means that if we

consider the real interest-rate dynamics over the period from 1950 to 2010, the central bank’s

claim on government was a leading indicator in signaling the occurrence of moving from

moderate to low interest-rates. In other words, we can say that a higher weight of the

government in the credit market was a factor of decreasing real interest-rate. However, there

was no correlation between the end of captive credit markets and the times of interest-rate

increases. The graph of the posterior probability of the regime of low interest-rate corresponds

to the years from 1950 to the end 1980s, but is not reported here to save place.

However, the choice of this variable may raise some concerns since it does only partially

capture the weight of governments in the credit market due to captive policies. Let us consider

not only the central bank’s claims, but also the commercial bank’s claims on governments as

share of GDP. A high ratio can also reflect the oligopolistic structure of the banking sector.

From the years 1970’s onwards the share of public debt hold by the commercial banks

become higher than that of the Banque de France (with a stronger role for the Caisse des

Dépôts et Consignations). Figure 8 shows that, between 1970 and 1982 (a period of

resurgence of strong financial repression after timid liberalization reforms undertaken during

the 1960s), the share of public debt hold by the former increases while the share of the latter

decreases. During these years, the Treasury set the amount of bonds, the schedule of

emissions in consultation with banks and the setting of loan rates (on the T-Bills, bonds with

long maturities and other rates) was the result of negotiations with the ministry of finance, the

Banque de France and the financial institutions which were the main holders of public debt.

In Figure 3, we observe that during these years the nominal lending and effective rate on

18

public debt increase. As a consequence, an increase in the total claims on central governments

does not necessarily help predicting low real interest-rate (which is reflected by the small and

non-significant coefficient b1 in Table 3.3). Conversely, a positive correlation may exist as

shown by the positive sign carried by b2.

Table 3.4 presents the results when the variation of M2-to-GDP ratio is used as the

indicator of financial repression. The graph of the posterior probability of a low real interest-

rate (Figure 9) suggests that this regime was observed up until the mid 1980s and also during

the end 1990s and the 2000s. From 1950 to 1986, credit transactions were intermediated

mainly by the banking sector and this important level of banking intermediation is known to

have taken place within a financial repression policy. This distorted the interest-rates paid by

the governments due to the required bank holdings of government bonds at controlled and low

interest-rates. Therefore, a-priori, we could expect b1 to carry a negative sign and b2 to be a

positive sign, in the sense that a high intermediation ratio drives down the interest-rates and

vice-versa. Meanwhile, as seen from Table 3.4, b2 is significantly negative. A plausible

explanation might be the following. Financial repression tends to induce disintermediation

since this creates an incentive for the banks to reduce savings. This result could be shown

using a microeconomic model where banks have a reservation real interest-rate. The saving

decision is likely to vary inversely with the spread between this reservation rate and the loan

interest-rate imposed by governments. In times of financial repression the spread tends to

widen, thereby reducing loan decisions. Therefore, a decline in financial intermediation may

actually signal a stronger financial repression policy, while a higher level of the M2-to-GDP

ratio may reflect the end of the financial regulation. Figure 10 shows the evolution of this

ratio. We see that from 1973 to 1992 it declines hugely before rising up from 1993 onwards.

In summary, the point that leaps out from this section is that there are signs of financial

repression in France, at least until the end 1980s. How this happened is the important

question. Firstly, can we consider that the negative real interest-rates were the outcome of a

strategy of deliberate debt liquidation through inflation? We saw above that the component of

inflation that seems to play a role in explaining the real interest-rate is the noisy component

(variability of the inflation rate and unexpected inflation). Therefore, though the inflationary

context in which the financial repression took place should not be ignored, the choice of

inflation as the main instrument to reduce the cost of debt service is not uncontroversial.

19

The evidence collected from the empirical observations above suggests that it is the

maintenance of the nominal rate at low levels which explains the negativity of the real rate

peculiarly up until the end 1980s. For instance, to allow low negative interest-rate required

increased costs of banking intermediation and direct government bond purchases by the

central bank. Our empirical features also point some features on which there are not an agreed

upon about whether they should be interpreted as signs of financial repression. For instance,

the usual story according to which financial regulation are positively correlated with high

banking intermediation does not apply in our case. The logic might be reversed, as a stringer

repression can provoke a disintermediation (this is shown by the inverted signs of the

coefficients b1 and b2 when total claims and the M2-to-GDP ratio are retained in the

transition function).

4.- The effect of financial repression on the determinants of the debt ratio and impact on

fiscal vulnerability

4.1.- How much revenues lost from the end of repressed interest-rates?

Papers in the literature have attempted to calculate the so-called “liquidation effect”.

Reinhart and Sbrancia (2011) define it as the amount of government debt reduction wrought

by financial repression. This is an equivalent of an increase in government revenues due to a

financial repression tax. This tax can be defined in several ways. First, the revenues accruing

to government as the result of artificially low level of interest-rates can be measured by the

difference between a market-based real rate and domestic interest-rates times the stock of

domestic public debt (with the market rates reflecting the shadow price of funds). These

market rates can be the interest-rates in the world markets (like in Giovannini and de Melo,

1993, Easterly et al., 1995). A second approach is to consider that financial repression is the

result of nominal rate ceilings well below the prevailing inflation rate. This approach is

retained for instance by Reinhart and Sbrancia (2011) who consider savings in interest cost as

stemming from negative real interest-rate.

Unlike previous studies, this paper proposes, not only to calculate the amount of savings on

the cost of servicing debt during the years of financial repression, but also the amount that

governments would have obtained after the end of such policy, had they decided to pursue

such a policy up until now. Indeed, lowering the real interest-rate payment is not only a

historical issue, but also timely, in regard to the current debt crisis. The issue of captive

20

markets is back (see Magud et al. (2011). To perform our calculation, we propose a

methodology more cumbersome than simply considering the years of negative interest-rates.

But it provides us a more accurate estimate of the savings gained from the repressed interest-

rates and the revenues lost from the end of financial repression.

Choosing the years of real negative interest-rate as those of the “liquidation years” for

public debt raises several worries. The zero cutoff as the threshold for liquidation value is

arbitrary (see Taylor (2011) for an extended discussion). Secondly, our preference is to relate

the cutoff for the real interest-rate, not only to inflation, but also to the determinants of the

nominal interest-rates in times of repressed interest-rates and market-based interest-rates.

We proceed as follows. First, as the determinants of the real interest-rates over the years

from 1950 to 2010, we consider the following potential explanatory variables: the central

bank’s claims on government, surprised inflation, commercial banks’ reserve as share of total

debt, changes in the M2-to-GDP ratio, the German interest-rate (discount rate), the volatility

of the nominal exchange rate against the US dollar. All the data are taken from the IFS data

base.

The explanatory variables

As argued before, claims on governments by the central bank capture the captive

domestic credit markets.

The commercial banks’ reserves are determined by two elements. First, the statutory

reserves can be viewed as a way of taxing financial intermediation (this has been analyzed in

theoretical models among which Brock (1989) and Romer (1985)). Secondly, the extra-

reserves may be high in a repressed economy because the financial intermediaries cannot

diversify their loan portfolio. This facilitates the imposition of high reserve requirements.

We also consider the influence of the external side of the economy. The discount rate in

Germany is retained as a leading indicator of the other nominal interest-rates in this country.

In a context of binding controls on foreign and domestic securities and a situation where

governments searched to bar the foreign borrowers in the domestic market, the French bond

market was insulated for the European market. During the years of financial repression, we

thus expect the French real interest-rate not to be connected to the German. Conversely, the

end of repressed domestic rates marked a convergence in the European bond markets.

21

We introduce an indicator of the management of the exchange rate (through the volatility

of the nominal exchange rate), as the era of financial repression in France between 1950 and

1980 was also a period during which devaluation policies were one of the backbones of the

strategies to boost the economy. After the second World War II There were five devaluations.

The French Franc was devaluated by 29% in 1958, 11% in 1969 and three small cascades of

devaluations occurred between 1981 and 1983 between 2.5% and 5%. These have been

associated with a higher variance of the nominal exchange rate in comparison with what was

observed from the beginning 1990s onwards (see Figure 11). This higher volatility has been

channeled to the real interest-rate of public debt through both the inflation rate and the

nominal rate in an unexpected way (unexpected with regard to what we would a priori expect,

as devaluations are usually thought of as resulting in higher internal prices and thus reduced

real interest-rates). Figure 11 shows three peaks in the exchange rate volatility corresponding

to the years of the devaluations we have just mentioned. Astonishingly, it is seen that they

coincide with times when inflation slowdowns or drop. Therefore, it is likely that we would

find a positive relationship between the real interest-rate and the volatility of the exchange

rate. The explanations are the following. All the devaluations between 1950 and 1985 were

triggered in a context where governments attempted at the same time to reduce the inflation

rate. In 1958, Pinay launched a policy of “grand emprunt” (big borrowing) increasing the

interest-rate on public bonds to 3.5% and adopting measures to keep inflation under control

by squeezing the domestic demand and adoption regulation policies on retailed prices. In

1969, Valéry Giscard d’Estaing adopted a plan which aimed at reducing domestic demand

and substituting foreign demand for it, while also increasing the nominal rates on public debt.

Finally, while devaluating the currency in the 1980, the government retained a series of

measures that allowed them to cope with inflationary pressures (freeze of price and wage

increase, no indexation of salaries on inflation, decreases of expenditure in the public sectors,

quantitative credit control, etc.).

Endogenous variable and stepwise regressions

To the extent that we choose a zero cutoff for the real interest-rate in order to identify

times of liquidation, there exists a potential risk that the latter will be overestimated. We

accordingly choose to separate the observations of the real interest-rate according to the mean

of the series over the period under examination. The mean is -3.27%. Below this value, the

22

real interest-rates values can be defined as being “very low” and above this value they are

stated as “moderately low” or “positive”.

With the mean as a cutoff, the following years are identified as of years of low real

interest-rate and those of non-low rates:

years of moderate or positive real rates: 1953-1955, 1959-1961, 1964-1968, 1985-2011

years of low real rates: 1949-1952, 1956-1958, 1962-1963, 1969-1984.

The second group includes those years during which financial repression has been the most

intensive, from the beginning 1970s to the mid 1980s.

Then, for each group of observations we run a stepwise regression. This is a step-by-step

iterative regression that involves an automatic selection of the explanatory variables according

to the statistical significance of the estimated coefficients. We include all potential

independent variables in the model (contemporaneous and lagged) and eliminate those that

are not significant.

In addition to the independent variables mentioned before, we consider a constant term and

the lagged value of the real interest-rate. This allows us to see whether the financial repression

has been enduring. Indeed, as argued by Alesina et al. (1998), there are several reasons why

governments may search to delay or abort financial reforms in order to deregulate or liberalize

the financial and banking sectors. These motivations can be studies in political economy

models (governments are reluctant to painful fiscal adjustment because market-based

financial reforms are usually accompanied by changes in taxation and public spending, vested

interest may prevent any changes, etc.). Even with the end of financial repression, a

persistence of the real interest-rate can be observed linked with the behavior of investors in

the markets.

Table 4.1 and 4.2 contain our results. In both cases, surprised inflation exert a negative

effect on the real interest-rate (the cumulated sum of the contemporaneous and lagged

coefficients are negative). Also, in both cases we find evidence of a persistent dynamics of the

real interest-rates. Now, what does distinguish the two regressions?

For the observations below the mean, the model selects the following variables as key

determinants of the real interest-rates: the central bank’s claims on governments, the reserves

as share of total debt, changes in the M2-to-GDP ratio. It is noteworthy that the latter two

variables are not selected for the observations of the real interest-rate above the mean. Instead,

23

for this regression, we find that the German nominal discount rate is a significant explanatory

factor, thereby indicating a higher integration of the French market with foreign markets when

interest-rates are market-based. The signs of some coefficients are consistent with our

observations in Section 3. In time of repressed interest-rates, the behavior of the banking

sector can lead to a situation whereby the high degree of banking intermediation is compatible

with higher interest-rates (so the cumulated sum of the coefficients of changes in the M2-to-

GDP ratio is positive in Table 4.2). A higher volatility of the nominal exchange rate does not

produce lower real interest-rates (the coefficient carries a positive sign).

From these regressions, we are able to see how the real interest-rate would compare with

the actual interest-rate, had the governments continue to repress the interest-rate and to use

inflation to wipe out their debt. In this respect, we compute the predicted values of the real

interest-rates, from 1950 to 2010, using the estimated model in Table 4.2. Figure 12 shows the

savings in interest-rate service on the debt as percentage of GDP. It is computed as the

difference between the historical interest-rate and the predicted real rate multiplied by the debt

ratio. This can be viewed as the revenues stemming from financial repression governments

would have afford, had they maintained regulated nominal rates. From 1985 onwards, such a

policy would have generated financing and the lost savings is even stronger when we consider

the years following 1999. The repression tax (saving in interest-rate as percentage of GDP)

would have been about 0.57% per year between 1985 and 1998 and by 1.14% on average per

year between 1999 and 2010. Similarly, France would have been better off, if we compare the

differential between the real GDP growth rate and the interest-rate. Using the historical data,

we find a difference of respectively 2.46% and 0.64% on average per-year for the periods

1985-1998 and 1999-2010. Using the predicted values of the model in Table 4.2, these

numbers turn to respectively 4.36% and 2.8%. The key point here is that these numbers

accumulated over the last ten years would mean a debt service reduction of around 30% over

a decade.

4.2- Positive growth in spite of a repressive financial policy

To investigate the causal relationship between the financial repression policies and the

growth rate of GDP in France, we adopt a macroeconomic perspective. We propose a simple

econometric investigation in which the growth rate of the real GDP is used as dependent

variable and regressed on three types of explanatory variables.

24

We first consider a set of indicators of financial repression: claims on central government

(central bank and depository bank) as share of total debt, reserve requirements as share of

total debt, the growth rate of the ratio M2/GDP and a dummy variable capturing the influence

of negative real interest-rate. The latter is computed by considering the difference between the

deposit rate and the inflation rate. If the difference is positive, then our variable takes the

value 0. If the difference is negative and lower than -5%, the variable takes the value 0.5.

Finally the variable takes the value 1 if the real interest-rate is higher than -5%. We do so

because we want to distinguish between moderately and strongly negative real interest-rates

Table 4.1 Regressions of the real interest-rate (real rate above the mean)

Coeff. t-ratio

Intercept -0.30 -1.28

Claims on government (-1) (central bank) -0.12 -2.92

Surprised inflation -1.03 -14.09

Surprised inflation (-1) 0.73 14.37

German interest-rate 0.14 3.47

Real interest-rate (-1) 0.72 18.50

Adjusted R²

Table 4.2 Regressions of the real interest-rate (real rate under the mean)

Coeff. t-ratio

Intercept -3.09 -3.91

Claims on government (central bank) 0.16 3.10

Reserve requirements (-1) -0.14 -4.72

FX volatility 4.78 7.72

Surprised inflation -0.89 -15.64

Surprised inflation (-1) 0.62 6.50

Variation of M2/PIB 0.31 4.65

Variation of M2/PIB (-1) -0.26 -4.08

Real interest-rate (-1) 0.85 18.88

Adjusted R² 0.97 0.98

25

Figure 9. Posterior probability of low real interest-rate (M2/PIB) Figure 10. M2-to-GDP ratio

32

36

40

44

48

52

56

60

64

68

72

1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Figure 11.- FX volatility and inflation Figure 12. Loss in tax repression

0

4

8

12

16

20

24

28

-4

0

4

8

12

16

20

24

50 55 60 65 70 75 80 85 90 95 00 05 10

FX Volatily INFLATION

-4

-3

-2

-1

0

1

2

3

60 65 70 75 80 85 90 95 00 05 10

Savings in interest rate service on the debt as % GDP

26

27

The second set of independent variables captures the role of the degree of financial and

trade openness. Likewise in Section 4.1, we consider the volatility of the nominal exchange

rate vis-à-vis the US dollar and the German nominal interest-rate.

The third set of explanatory variables consists of the following determinants: the growth

rate of production of industry, the growth rate of wages rates taken as a proxy of the growth

rate of labor productivity and the growth rate of population as a proxy for the demographic

factors. These variables are taken from the OECD and IFS databases over the period from

1950 to 2011.

We consider the following equations:

¿ (1)

gindt=α 2+∑i=0

1

β6 i primt−i❑+∑j=0

1

β7 j REPRt− j+∑k=0

1

β8 k inflt−k+ε t2 (2)

g is the growth rate of the real GDP, gind is the growth rate of industrial production of,

gwages is the growth rate of wage rates, REPR is a vector of financial repression variables,

OPEN is the vector of trade openness and the volatility of the nominal exchange rate, prim is

the primary fiscal balance as share of GDP, infl is the inflation rate and n is the population

growth rate.

The second equation is helpful in taking into account the fact that the financial repression

policy up until the end 1980s took place within the context of a planned economy in which

selective and directed credit, as well as heavy interest-rates, served as a tool for industrial

policy. Selective credit operations aimed at fostering the industrial basis of the economy.

Therefore, during the thirty glories a great part of the investment was directed toward

industrial sectors and the growth rate of total industry was strongly correlated with that of the

investment rate. We therefore consider that the growth rate of the industrial sector is

endogenous, at least with respect to the financial repression variables. We also consider that,

irrespective of the nature of financial policy, governments have played a major role in

fostering global investment through public expenditure. The role of public consumption and

investment is reflected in the primary balance. Equation (2) is estimated first, by GLS using a

Newey-West correction for the variance-covariance matrix of coefficients, and then the

predicted values of the dependent variable are substituted for gind in equation (1). We do

stepwise regressions an eventually select those variables whose coefficients are statistically

significant in the regressions.

28

Since our aim is to see whether financial repression makes a difference in fostering growth,

we consider estimations of the above equations over two sub-periods: 1950-1985 and 1986-

2010.

As a starting point, the results of the regression corresponding to Equation (2) show that

while the indicators of financial repression affect the growth rate of total industry during the

years of financial repression, their coefficient are no longer significant during the second sub-

period after 1986. During the years 1950-1986, lower negative real interest-rates appear to

significantly foster industrial growth while higher statutory reserves and financial

intermediation are positively related to the growth rate of output in the industrial sector. Then,

from the regressions in Table 4.4 we see that the variables of financial repression do not

appear to be significant, once they are already used as instruments in Equations (2) and the

fitted values reported in Equation (1). This is in accordance with the fact that financial

repression has been used to achieve long-run industrial output growth and this was in turn

reflected in the global growth rate. During the years of financial liberalization (after 1986),

the real growth rate is influenced by both the financial and trade openness (the coefficients of

these variables are statistically significant in the second regression, ie over the years 1986-

2011). The outcome of the regressions in Table 4.4 is that repressive policies between 1950

and 1985 in France had a positive effect on growth due to their fostering effect on the

industrial production.

It is interesting to wonder about the implications of these results for public finances. What

would the contribution of growth to the variation of the debt ratio have been, had the

governments maintained the repressive policies? By proceeding in a similar way as in Section

4.1, we first compute the fitted values of regression (1) obtained for the years 1950-1985

using the historical data of the exogenous variables for the period from 1986 to 2010. In order

to consider realistic hypothesis, we assume that if such policies had continued to be activated

after 1985, the inflation rate would have been higher than its actual level. We assume an

arbitrary level of 4%. Further, in order to take into account the structural transformation of the

economy (the greater part of services in accounting for the economic growth), we consider

only half of the impact of the industrial growth rate on the global growth rate. We consider a

coefficient of 0.18 instead of 0.37 as reported in Table 4.4. The computation of the

contribution of growth is done as usual by using the government’s budget constraint in which

the ratio of debt is expressed in terms of the primary balance ratio, the real growth rate and the

real interest-rate. For the latter, we consider the simulated series used in Section 4.1 to

29

compute the saving in interest-rate that governments would have obtained under the

assumption of financial repression.

Table 4.3 Regressions of the growth rate of industrial production

1950-1985 1986-2010

Coeff. t-ratio Coeff. t-ratio

Growth rate of industrial production (-1) -0.2 -1.79 -

Primary balance ratio 3.87 7.11 2.89 7.29

Primary balance ratio (-1) -2.95 -6.46 -1.87 -2.48

Inflation -0.53 -5.79 -0.41 -1.54

Real interest-rate (-1) (dummy variable) -6.56 -5.20 -

Claims on governments -0.03 -2.03 -

Reserve requirements 0.30 2.89 -

M2/PIB 0.33 6.45 -

Intercept - - 7.34 5.39

Adjusted R² 0.76 0.71

Table 4.4. Regression of the growth equation

1950-1985 1986-2010

Coeff. t-ratio Coeff. t-ratio

Population growth 0.77 2.32 - -

Growth rate of wages 0.12 2.71 - -

Growth rate of wages (-1) -0.17 -3.10 0.39 2.71

Growth rate of industrial production (fitted) 0.37 7.22 0.39 10.20

FX volatility -2.80 -1.93 -

German rate (-1) - -0.62 -4.10

Trade openness - -0.14 -2.74

Intercept 3.21 4.26 10.57 3.38

Adjusted R² 0.73 0.75

Figures 13 and 14 suggest that the consequences on the reduction of debt ratio might be

important under repressive policies. Figure 13 is consistent with the hypothesis that if

financial repression had continued after 1985, the consequences on growth would have not

30

been harmful. The regressions indeed show a positive gap between the historical growth rate

and the growth rate simulated after 1986. A direct consequence is that the contribution of

growth to the reduction of public debt might have been more important (Figure 14).

4.3- Implications for debt sustainability and fiscal adjustment

Over the period of financial repression, from 1950 to the end 1980s, the French primary

balance has evolved above its levels considered as sustainable. In figure 15, the sustainable

level is deduced from the government budget constraint using the usual definition of the

primary balance ratio for which the debt ratio remains constant over time. Comparing the

primary balance and the sustainable balance based on historical data, the graph suggests that

budgetary imbalances have been limited and fiscal adjustment easier in comparison to what

happened from the beginning 1990s onwards. There is an indication on the graph that the

positive gap was facilitated by the context of financial repression. Indeed, we draw a second

curve of sustainable primary balance using the results of the regressions in Sections 4.1 and

4.2. We see that, at least up until the mid nineties this curve is very near the historical curve

corresponding to the historical sustainable level. The years after 1990 are characterized by

episodes of over-borrowing (1991-1996 and 2000-2004). Using the simulated series for the

interest-rates and the growth rate under a regime of financial repression to construct another

series of sustainable primary balance under financial repression, we see that the fiscal

adjustment that governments actually needed to make debt burden bearable is sharper than the

adjustment that would have been needed, had the policy of financial repression been pursued.

From 1997 onwards, the spread between the actual primary deficit ratio and the sustainable

level is systematically positive under repressed finance, thereby suggesting the elimination of

overhang and over-borrowing problems. The explanation of the huge gap observed in the

graph is explained by the fact that, under financial repression, debt would have been more

comfortably serviced (in section 4.1 we found a repression tax between 0.57% and 1.14% per

year on average) and the contribution of the growth rate of the debt ratio more important. It is

noteworthy that this outcome could have happened in spite of the swings of the primary

balance from surpluses to deficits. When the tax revenue is not stable, it seems interesting to

resort to implicit taxation through financial repression.

31

Figure 13.- Growth rate under repressive policies Figure 14. Contribution of growth to the debt ratio

-4

-2

0

2

4

6

8

10

50 55 60 65 70 75 80 85 90 95 00 05 10

GROWTH (actual)GROWTH (financial repression)

-4

-3

-2

-1

0

1

2

50 55 60 65 70 75 80 85 90 95 00 05 10

Growth contribution (actual)Growth contribution (financial repression)

Figure 15.- Comparing primary balance to its sustainable level

-5

-4

-3

-2

-1

0

1

2

3

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Primary balance ratioSustainable primary balance (historical data)sustainable primary balance (financial repression)

32

An alternative approach to examining the issue of fiscal adjustment under financial

repression is to consider fiscal policy reaction functions. Usually, it is argued that fiscal

reaction functions ensure fiscal sustainability if the primary balance reacts to the debt level.

Specifically, it is expected that surpluses increase when debt rises. A standard approach to

study such a relationship is to make a regression of the primary balance as share of GDP on

the debt ratio and the output-gap. Then, one concludes in favor of sustainability if the

coefficient of debt has a positive and statistically significant sign. We expand the standard

fiscal rule by adding indicators of financial repression to the debt ratio and the output-gap as

explanatory variables. With the inclusion of these variables the finding of a significant

coefficient of the debt ratio is no longer a no-longer a necessary condition for sustainability.

The reason is simply that financial repression becomes an alternative mean of financing

excess expenditure to the financing through a higher indebtedness (inflation tax coming from

money creation, tax on financial intermediation through reserve requirements, reduction of the

cost of borrowing by driving nominal interest-rate below market rate and by rationing the

availability of credit to the private sector, etc.

Table 4.5 displays the estimations of several augmented fiscal reaction functions. For the

period from 1950 to 1986, we show the regressions for which the added financial repression

variables are statistically significant4. For the period of financial repression, we estimate four

equations. Regression 1 is the estimation of the standard equation, while Regressions 2 till 4

contains a variable of financial repression. For purpose of comparison, we also estimate a

fiscal reaction function for the years of post financial repression (1986-2010). The striking

feature of the estimation is that the fiscal reaction to accumulating debts disappears when an

indicator of financial regression enter the list of explanatory variables significantly. Indeed,

while the debt ratio coefficient carries a significant and positive sign in Regression 1, it

becomes non-significant in Regressions 2 till 4. This should be contrasted with the sharper

reaction found for the years 1986-2010. For this period, none of the financial repression

variables appeared to be significant. Instead, we find that changes in the fiscal balance are

influenced by the German interest-rate and the inflation rate. This suggests that, as repressed

policies were progressively abandoned, reliable primary surpluses that could repay the debt

eventually were conditioned by the financial conditions imposed on the international markets

and by the anti-inflationary monetary policy. Conversely, in times of financial repression, the

willingness to create primary deficits (for instance through increases in expenses) was 4 The output-gap is computed by applying an Hp filter to the real GDP and the estimations are done by GLs in

order to obtain spherical residuals.

33

facilitated by lower real interest-rate and seigniorage. Indeed, in Regressions 2 and 4 the

coefficients of the real interest-rate and of the ratio M2/PIB carry respectively a positive and

negative sign.

Table 4.5. Estimation of augmented fiscal reaction functions

1950-1985 1986-2010

Regression 1

Regression 2

Regression 3

Regression 4

Regression 5

Coeff.(t-ratio)

Coeff(tratio)

Coeff.(t-ratio)

Coeff.(t-ratio)

Coeff.(t-ratio)

Primary balance ratio (-1)

0.44(3.95)

0.42(3.63)

0.51(1.02)

-0.06(-0.32)

0.68(6.51)

Debt ratio (-1) 0.02(2.36)

0.04(1.57)

0.04(0.78)

-0.07(-1.43)

0.06(2.81)

Output-gap 0.04(4.75)

0.05(5.34)

0.04(4.64)

0.06(8.41)

0.02(3.27)

Output-gap (-1) -0.04(-3.66)

-0.03(-3.34)

-0.03(-1.32)

-0.03(-1.97)

-0.05(-6.67)

Claims on governments

- 0.01(1.75)

- - -

Real interest-rate (-1) (dummy variable)

- - 0.41(1.78)

- -

M2/PIB (-1) - - - -0.13(-3.49)

German interest-rate - - - - 0.32(2.19)

Inflation rate - - - - 0.67(3.18)

Adjusted R² 0.60 0.62 0.56 0.55 0.78

5.- Conclusion

This paper offers an illustration of the fact that issues on the use of financial repression as a

mean of dealing with the French debt overhang may re-emerge. The simple exercise done

here is not normative in the sense that we do not conclude from our regressions that one

should come back to financial repression measures as adopted by French governments from

1950 to the end 1980s. We simply illustrates a situation in which, if current governments had

decided to embark on policies with consequences similar to those of past financial repression

34

policies, then this could have help to reduce budgetary pressures by lowering the cost of debt

service, boosting the growth rate, a combination that would have allowed to reduce fiscal

vulnerability. Because, government seem confronted today to a limited room for maneuver in

adjusting fiscal taxes and spending in order to stop the surge in public debt, the adjustment of

nominal interest-rates on the domestic component of public debt may be the locus of future

financing policies of fiscal deficits.

Our simple econometric exercises suggest that France has not necessarily been in a much

better shape during the post financial repression years, than between 1950 and the end 1980,

if we judge by the influence of the determinants of the debt ratio on fiscal vulnerability. From

our regressions on fiscal reaction functions, it can be argued that governments need not

reacting to rising debt burdens because the crucial factor that made borrowing sustainable was

the financial repression policy.

This paper can be extended in the following way. Our counterfactual analysis could be

criticized in regard to the fact that, in order to deal with the current debt overhang,

governments are likely not to adopt the type of financial repression policies which were in

vogue at the creation of the Bretton woods system. So, the equations used to simulate the

effects of such policies for the period from 186 to 2011 might have been unstable across time.

Though, this argument is correct, the conclusions above can be viewed as providing

qualitative trends, in the sense that we rely on equations that mimic a financial repression

environment. To give further likelihood to the exercise, one solution would be to consider

new indicators of financial repression more in line with the current policies. In their paper,

Reinhart and Sbrancia (2011) provide examples of such policies, be they prudential regulation

policies, processes to create captive credit markets or central bank interventions on debt

markets to reduce the interest-rate.

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38

Appendix A. Time-Varying Transition Probability Markov-Switching Model

This appendix briefly presents the TVPMS model used in Section 3.1 to see which

financial repression indicators are good predictors of the evolution of the evolution of the real

interest-rate. This model was originally proposed by Filardo (1994).

Consider an endogenous variable y t (t = 1, …, T). The time varying probability Markov-

switching model is defined as follows

y t={α1+β1 y t−1+σ1 εt ,with a probability p1 j ( zt )α2+β2 y t−1+σ2 εt ,with a probability p2 j ( zt )

, (A1)

where ε t∽i . i . N (0,1 ) and [ εt

ηt]∼N (0 , Σ ) , Σ=[1 ρρ 1] and cov (ε t , ηt ± h )=0 , ∀h ≠0.

α 1 , α 2 , β1 , β2 , σ1 , σ2 are scalars. y t is assumed to “visit” two regimes. For instance, in our

case, one regime may correspond to negative real interest-rate and the other to positive real

rates. Since the regime are unobserved ex-ante, we consider a hidden state variable st that

takes two values: 1 if the observed regime is 1 and 2 if it is regime 2. For purpose of

simplicity, we assume that st is a first-order Markov chain with transition probabilities:

P {st ∕ st−1 }=P {st /st−1 , z t }, (A2)

where z t is a vector of predetermined “transition” variables that govern the transition from

one regime to the other (indicators of financial repression).

Assuming a Probit specification for the occurrence of z t on st, we write:

st={1 , if ηt<a1 (s t−1 )+b1 ( st−1 ) z t

2, if η t ≥ a2 ( st−1 )+b2 (s t−1 ) zt, (A3)

where ηt∼ i .i . N (0,1). We thus define the transition probabilities as follows:

{ P {s t=1/st−1= j , zt }=p1 j ( z t )=Φ (a1 ( st−1 )+b1 (s t−1 ) z t )P {st=2 /s t−1= j , z t }=p2 j ( zt )=¿1−Φ (a2 ( s t−1 )+b2 ( st−1) z t )

, (A4)

where Φ is the standard Normal cumulative distribution function.

This model is estimated via the maximum likelihood (henceforth ML) method with relative

minor modifications to the nonlinear iterative filter by Hamilton (1989). We define the

following vectors:Ωt=(Y t−1' , Z t

' )’ the vector of observations of yx and z up to time t-1 and t

39

respectively, ξ t=( y t , y t−1 , …, y1 )’ the vector of observations of the endogenous variable, and

θ=(α 1 , α 2 , β1 ,σ 1 , a1 , b1 , β2 , σ2 , a2 ,b2 , ρ )’ the vector of parameters.

The conditional likelihood function of the observed data ξ t is defined as

L (θ )=∏t=1

T

f ( y t /Ωt , ξ t−1 ;θ ) (A5)

where

f ( y t /Ωt , ξ t−1 ;θ )=∑

i∑

jf ( y t /st=i , s t−1= j , Ωt , ξt−1;θ )

× P (s t=i , st −1= j /Ωt , ξ t−1 ;θ ) .(A6)

The weighting probability in (A6) is computed recursively by applying Bayes’ rule:

P (st=i , st−1= j /Ωt , ξ t−1 ;θ )=Pij(z t) P ( s t−1= j /Ωt , ξ t−1 ;θ )¿ P (st=i /st−1= j , zt ) P (st−1= j /Ωt , ξ t−1 ;θ )

¿ Pij ( z t ) P (st−1= j /Ωt , ξ t−1 ;θ )(A7)

We also have

P ( st=i /Ωt+1 , ξ t ;θ )=P ( s t=i /Ωt , ξt ;θ )

¿ 1f ( y t /Ωt , ξt−1;θ )

∑j

f ( y t /s t=i , st−1= j , Ωt , ξ t−1;θ )

× P ( st=i , st−1= j /Ωt , ξt−1;θ )

(A8)

To complete the recursion defined by Equations (A6) and (8A), we need the regime-

dependent conditional density functions:

f ( y t /s t=1 , st−1= j ,Ωt , ξ t−1 ;θ )=ϕ ( y t−α 1−β1 y t−1

σ1 )Φ ( a j+zt' b j−ρ ( ( y t−α1−β1 y t−1 ) /σ1 )

√1−ρ2 )σ1 P1 j ( zt )

(A9a)

f ( y t /s t=2 , st−1= j , Ωt , ξ t−1 ;θ )=ϕ( yt−α 2−β2 y t−1

σ2)Φ (−(a j+z t

' b j )+ρ (( y t−α2−β2 y t−1 )/σ2 )√1−ρ2 )

σ2 P2 j ( z t )

,

(A9b)

Where f is the standard normal probability distribution.

The parameters of Equations (A1) and (A4) are thus jointly estimated with ML methods

for mixtures of Gaussian distributions. The ML estimator has the advantage of computational

40

ease. If ρ=0

, then the state variable is exogenous. Conversely, ρ≠0

corresponds to the

endogenous switching case. A test of the null hypothesis that the state variable is exogenous

can thus be derived by testing the null hypothesis 0 (see Kim et al. (2008)).

The influence of zt on P1j and P2j provides information about the way in which the

transition variables influence the probability of being in either regime or another. For

instance, suppose that regime 1 is the regime of negative real rates. A positive (resp. negative

value) of b1 (resp. b2) implies that the transition variable rises the probability of being in the

regime of negative interest-rates at time t and decreases the probability of being in the regime

of positive real interest-rate, regardless of the economy’s state at time t

41