Rising U.S. Government Debt Leads to Soaring Long-Term Treasury Yields… Will Financial Repression Policies Reappear?

Investments by big tech companies are heavily dependent on the decisions of capital providers, who can halt investment activities when interest rates rise. Lee Eun-taek, Department Head at KB Securities, pointed out that rising interest rates are the biggest threat to capital providers, leading to an increase in CDS premiums.

Recently, the possibility of slowing demand for AI frontier models has been raised, and there are claims that this phenomenon is indeed proving true. Lee Eun-taek believes there have been issues with the demand for frontier models, and he analyzed that this could lead companies to adopt price reduction strategies to secure market share. Such price competition could affect the entire AI-related industry.

Although the recent surge in 30-year Treasury bond yields is due to a combination of factors, the primary cause, according to Lee Eun-taek, is market skepticism about government debt. He stated that a clear correlation exists between long-term Treasury yields and the government debt-to-GDP ratio, noting that other developed countries besides the U.S. also face serious debt problems. Such an increase in debt raises concerns about national creditworthiness, pushing up interest rates.

The sheer size of government debt is not the only problem; rather, when interest rates rise in a situation with high debt, it can have a fatal impact on the national economy. Lee Eun-taek warned that when interest rates increase with high debt, the government's interest expenses surge, creating a circular reference structure that further increases debt and deteriorates national finances. Even a reserve currency country like the U.S. is not immune to the risks of this circular reference, which can threaten the sustainability of the national economy. Therefore, he emphasized the need for careful management of debt size and vigilant response to interest rate fluctuations.

While some express concern about the severity of current government debt, historically, there have been periods with even higher debt-to-GDP ratios. Lee Eun-taek referred to the period immediately after World War II, when the U.S. debt ratio was much higher than it is today, yet the U.S. did not lose its hegemony and instead entered an economic golden age. At that time, the U.S. overcame the crisis through successful policies like debt restructuring, suggesting the possibility of resolving current debt issues as well.

Many people believe that government bond yields are determined by market supply and demand, but historical examples show that this is not always the case. Lee Eun-taek cited the period from the 1930s to the 1940s when U.S. Treasury yields were fixed at around 1% regardless of inflation. This demonstrates that the government could artificially control interest rates, indicating that historical facts exist that differ from market conventional wisdom.

The policy of governments artificially fixing interest rates at a low level, regardless of inflation or economic growth, is called 'financial repression.' Lee Eun-taek explained that financial repression involves the government forcing interest rates, such as to 1%, regardless of CPI increases or economic growth rates. This signifies a powerful tool for governments to directly control interest rate levels beyond market logic.

While financial repression can cause inflation, reducing the real value of government debt, whether this is an intentional government policy is debated. Lee Eun-taek argued that inflation could be detrimental to maintaining power, so a government cannot continuously pursue such a malicious policy of intentionally causing inflation to harm its citizens. He explained that inflation should rather be seen as an unavoidable side effect that occurred as the government lowered interest rates to reduce interest expenses. In other words, debt management was the primary objective, and inflation was a collateral outcome in that process.

Questions are being raised about whether the financial repression policies that were successfully implemented in the past would be equally effective in the current global market environment. Kim Young-rong, Department Head at Shinhan Asset Management, expressed skepticism about whether financial repression could lead to a virtuous cycle as it did in the past, considering the current absolute money supply, the status and influence of the dollar and bonds, and the interconnectedness of foreign exchange markets with other countries. Although past financial repression had many side effects, new investment opportunities were also created in the process of resolving them, necessitating a careful analysis of the current situation.

In the past, governments employed various coercive measures to suppress rising long-term Treasury yields. Lee Eun-taek explained that the Federal Reserve supplied liquidity to the market through bond purchases focused on short-term instruments and asset expansion. Furthermore, the government eased regulations to encourage banks to actively purchase long-term Treasury bonds, and even imposed legal obligations that required companies to include a certain percentage of long-term Treasury bonds in their assets to be recognized as sound. These measures were accompanied by policies that forcibly lowered deposit rates to preserve bank profitability.

One of the main reasons for the success of past financial repression policies was the lack of suitable investment alternatives. However, with the financial market now digitalized and online trading active, the effectiveness of capital controls is questioned. Lee Eun-taek pointed out that in modern society, where online trading is commonplace, preventing capital outflow in the same way as in the past may be practically impossible. The emergence of digital assets like cryptocurrencies also makes capital control more difficult, leading to the analysis that comprehensive capital control like in the past is unrealistic.

It has been argued that the biggest cause of the government deficit is not congressional tax cuts but rather the interest payment costs of the Federal Reserve. Lee Eun-taek emphasized that the interest paid by the Fed imposes a greater burden on government finances than tax cut policies. Indeed, interest expenses, which have grown larger than defense spending, are pointed out as a risk factor threatening U.S. hegemony. He cited Ray Dalio's 'Big Cycle' theory, warning that such an increase in interest expenses could harm the nation's fiscal health in the long run.

The independence of the Federal Reserve is not a fixed concept; there have been periods when it was maintained and periods when it was not, depending on the circumstances. Lee Eun-taek assessed that the current era is simply one where the Fed's independence is difficult to uphold. An environment similar to when President Donald Trump strongly demanded interest rate cuts from the Fed could re-emerge, suggesting that external pressure might influence the Fed's policy decisions. Therefore, investors should focus on the actual policy outcomes, i.e., the cooperation between the Fed and the government, rather than the justification of the policies.

In an era of inflation, certain economic agents and businesses gain a relatively advantageous position. Lee Eun-taek identified three parties that benefit from inflation: first, debtors who borrowed at fixed rates; second, investors in real assets; and third, companies with pricing power. Companies with pricing power, in particular, can pass on rising cost burdens to consumers, making it easier to maintain profitability in an inflationary environment. Therefore, value investing in such companies can be key to survival and profit strategy in times of high inflation.

In an inflationary environment, certain economic actors suffer significant disadvantages. Lee Eun-taek identified cash and deposit holders as the first disadvantaged group during inflation. This is because deposit rates are only 1-2%, leading to negative real interest rates and a continuous decline in the purchasing power of cash. The second group is wage earners, as their wages often fail to keep pace with inflation, risking a decrease in real income. The third group is bond investors, as inflation erodes the real value of bonds and increases upward pressure on interest rates, negatively impacting bond prices. These economic actors are exposed to asset value depreciation and reduced purchasing power due to inflation.

Governments primarily resolve debt issues in three ways: first, fiscal austerity; second, default; and third, financial repression (inducing inflation). Lee Eun-taek pointed out that historically, most governments rarely resolve debt problems through fiscal austerity. While there are rare cases like South Korea, which adopted extreme austerity during the IMF foreign exchange crisis to resolve debt, this caused severe hardship and misery across society. Therefore, historically, most governments have opted for financial repression, i.e., inducing inflation to reduce the real value of debt, rather than austerity. While this weakens the real purchasing power of citizens, it has been seen by governments as a way to alleviate the debt burden without resorting to the extreme option of direct default. Considering these historical patterns, Lee predicted that the current U.S. debt problem is also likely to be resolved through financial repression.