I have been doing some reading on what most of you would consider a boring topic- the history of interest rates. James Grant calls this book by Edward Chancellor “A masterpiece of history, analysis—and properly understated outrage.” It is called “The Price of Time.”
What fascinated me was “understated outrage” being applied to interest rates and I assumed it would chronicle the long fight against usury and the religious and secular outrage over people with means applying a charge based on time for the use of their wealth.
The first seventy-five pages of this excellent book are just that, but then a new idea emerges which changes the religious and ethical restraints: “Once the idea took hold that time not only had value but was an individual’s possession, clerical injunctions against usury lost much of their force. If a merchant gained from a loan, why shouldn’t the lender share in those profits?” This ushered in trade and commerce based on the time value of money. But money itself then had value because the medium of exchange was gold or silver or something scarce and valuable itself.
Money Morphed Into Something Without Intrinsic Value
The next revolution in the history of interest rates was economic theory from a Scottish economist, John Law, who changed the paradigm by suggesting money was not valuable itself but rather served as a medium of exchange. This concept underpins every aspect of central banks and modern monetarist theories all of which advocate a medium of exchange untethered to anything of value.
As you move through financial history Mr. Chancellor documents the world’s boom and bust cycles and points to the unfailing correlation between low interest rates and speculation. He suggests a natural rate of interest exceeding 2% is necessary for savers. Otherwise, their money begins to lose purchasing power to even modest inflation and they reach for returns. Savers become speculators and asset bubbles are created, nurtured, and then burst with resulting pain and suffering.
Another Bubble After The Big Recession
Imagine the enormity of the worldwide bubble after a sustained period of interest rates below 2% in the United States and negative rates in Europe. That is exactly what happened in the decade following the Big Recession in 2008. First central banks replaced commercial banks as arbiters and suppliers of credit by setting the interest rates on savings and loans at unusually low levels. Next, they replaced commercial banks by providing gargantuan liquidity for all asset classes (including student loans, mortgages, stocks, bonds and money market instruments) under the concept of “quanititive easing”. It should not surprise us that zero cost for plentiful debt encouraged every person, corporation and country to load up on debt. The speculation ended up in stock buy backs, low-rate mortgages, zombie corporations, meme stocks, SPACs, cryptocurrencies, art escalations and non-fungible tokens. Almost any asset class that could receive an inflow went up. In 2020 more money was raised by US public offerings than in any previous year, including the “dot com” frenzy. Mr. Chancellor credits Warren Buffet with this simple explanation:
“Warren Buffet agreed that ultra-high valuations were supported by ultra-low interest rates. ‘Interest rates, said the Sage of Omaha, basically are to the value of assets what gravity is to matter’. Once this gravitational force was removed, Dogecoins, NFT’s, meme stocks and other speculative assets were free to float into the stratosphere.”
Seth Klarman, manager of the value oriented Baupost Group, painted the picture this way in a year end letter to clients:
“The idea of persistent low rates has wormed its way into everything: investor thinking, market forecasts, inflation expectations, valuation models, leverage ratios, debt ratings, affordability metrics and corporate behavior”.
Mr. Chancellor concludes his book by bringing us up to 2022. He sees an economy conditioned to rely on a central authority for functioning markets and a low cost of debt. Austerity measures like removing quantitative easing and raising interest rates may lessen inflation but slow down economic growth. As the world’s largest, multi trillion-dollar debtor on the verge of owning a “zombie” balance sheet a 4-5% inflation rate is quite appealing. He reminds us that as long as a central bank can impose an interest rate and print money, the normal functioning of interest as a charge for the time use of money is suspended:
“The source of the problem is that, whereas capital is limited, the medium by which savings are transferred- namely money-can be created without limit by central banks (fiat money) and commercial banks (fountain pen money). As a result, interest rates on money loans becomes detached from savings.”
I encourage all our readers to explore this excellent financial guide for uncertain times. It helped me make sense of the last 14 years and helped me understand how this experiment with interest rates and money may unfold over the next decade.
The above commentary is for informational purposes only. Not intended as legal or investment advice or a recommendation of any particular security or strategy. Information prepared from third-party sources is believed to be reliable though its accuracy is not guaranteed. Opinions expressed in this commentary reflect subjective judgments based on conditions at the time of writing and are subject to change without notice.
