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taking stock

When the world's leading central bankers reached into their medical bags this month to treat chronically underperforming economies, they really had only one possible elixir – more quantitative easing designed to pump additional fuel into troubled financial systems and keep interest rates at historic lows.

But the massive injection of capital by the Federal Reserve and the Bank of Japan, as well as the European Central Bank's pledge to buy up sovereign bonds of troubled euro-zone members, has precious little to do with growth. If monetary stimulus were the answer, the Japanese economy would surely not still be stuck in neutral after years of unprecedented pump-priming. What the central banks are about, some economists and financial historians have concluded, is financial repression – a concerted effort to keep real interest rates below the level of inflation for long periods in order to reduce mountains of public debt and keep the costs of funding it under control.

"Faced with a private and public domestic debt overhang of historic proportions, policy makers will be preoccupied with debt reduction, debt management and, in general, efforts to keep debt-servicing costs manageable," acclaimed U.S. economist Carmen Reinhart wrote in a Bloomberg commentary in March. "In this setting, financial repression in its many guises (with its dual aims of keeping interest rates low and creating or maintaining captive domestic audiences) will probably find renewed favour and will likely be with us for a long time."

Kevin Mellyn couldn't agree more. Once governments dig themselves into enormous debt holes, they have two basic paths out of the mess, short of defaults. One is high inflation, which wipes out the creditors. The other, more palatable route is financial repression, in which "you slowly confiscate their wealth" by keeping yields at negative levels for years on end, says Mr. Mellyn, author of Broken Markets, which delves into the causes and consequences of the Great Meltdown of 2008 and what is likely to emerge when the dust eventually settles. (Hint: The glory days of finance ain't coming back.) Mainly because repression, which amounts to an undeclared tax on bondholders and savers, has worked in the past – notably when Britain and the U.S. were wrestling with huge war debts – "we're going back to that world with a vengeance."

One potential consequence of sustained financial repression is asset bubbles, as investors seek something better than negative returns on their money. "Without full-bore financial repression, would you have the equity markets at the levels they're at in the U.S.? I doubt it," says Mr. Mellyn, whose academic interest is financial history, but who also has had a long career as an international banker and consultant to the likes of the Saudi and Kenyan central banks. Because interest rates are kept artificially low, equities get reflated by investors seeking higher returns. Of course, the Fed's big hope is that real estate, a key engine of U.S. growth, also draws some of this hot money. "The whole debt sausage machine only works because there is a genuine hunger for high-yielding assets."

In Broken Markets, Mr. Mellyn sketches a 12-scene plot summary for financial crises and their outcomes, with the latest drama now playing out on the cusp of scenes 10 and 11. In scene 10, economic recovery and meaningful gains in employment "remain elusive," and markets "swing wildly from hope to fear on political or corporate earnings news." Scene 11 brings an "unanticipated shock" that the system has no remaining tools to fend off. The financial system collapses again and has to be rebooted from scratch.

"I can picture us revisiting the second leg of the 2008 panic by 2014 or 2015 with something much bigger and much worse and with no ammunition," he says matter-of-factly.

Mr. Mellyn, who thinks of himself as a classical liberal in the 19th century British tradition, is sharply critical of what he regards as Washington's rush to over-regulate the banking sector in the wake of the 2008 collapse and the near-death of the global financial system. But he also takes a strip off Republicans who advocate a hands-off approach to regulation and a new era of austerity to repair public finances. "Since banks and the financial markets more broadly are the only institutions that can blow up the whole economy overnight, there has always been a public interest in limiting the trouble they can cause," he writes in Broken Markets. And real austerity, with genuine deep spending cuts – which the Republicans aren't proposing in any case – has always unleashed a major economic contraction and significant pain for a large swath of the population, as any Spaniard will attest.

The final scene of his movie is actually rather hopeful, because markets will not stay broken for long. Banks in his "post-finance" universe will revert to their former role as utilities accounting for a considerably smaller portion of economic activity. The biggest institutions will be broken up, because they will be worth more in pieces, and other non-bank financial players like an eBay or Apple with strong brand equity will make digital inroads into some core retail functions such as payments.

"But the natural requirement for the allocation of capital, the movement of deposit money and management of risk is [still] out there. The growth models are just not going to be big corporate bureaucracies."