Financial repression

Financial Repression is a mechanism by which governments buy foreign bonds in an effort to sterilize currency. The degree to which this process occurs is directly proportional to the liberality of said political economy.

The effects of financial repression are to hold down interest rates as an offset to the value of currency. This, in turn, leads to a more competitive trade regime in said country due to the relative value of [cheap] money.

Hume's Price specie flow mechanism would otherwise cause money to appreciate as trade balances of said countries became increasingly positive. However, the financial repression maneuver works to artificially stem the rising tide of natural price fluctuations in the international money market such that a disequilibrium occurs between a government's cost of capital and it's returns on foreign exchange reserves.

The buildup of pressure occurring from this differential (reflected in interest rates) causes the financially repressive economy to experience decreasing marginal returns on its foreign assets. Consequently, continuing this process (of holding foreign monies to depress the price of one's currency) is an unsustainable one.

Inflation results as a consequence of financial repression such that the underlying value of currency is distorted. Hence, the price of risk on instruments connected with said currency is distorted. This causes investors to undercompensate for return on investment (ROI) and to overextend themselves in search of greater profits as perfectly competitive markets inevitably shrink economic profits to zero. The search for greater profits leads to excessive risk taking (on thin margins) and will invariably lead to some sort of implosion (e.g., LTCM in 1998 or the 2007 subprime mortgage financial crisis).


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