July 5, 2023 | Podcast
The Cost of Money

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The idea of lending with interest can be traced back thousands of years. But despite the pivotal role interest rates play in our economic structures, they continue to be misunderstood. In this episode of The Active Share, Hugo sits down with Edward Chancellor, journalist, financial historian, and author of The Price of Time, for a conversation that challenges everything we thought we knew about the cost of money.

Comments are edited excerpts from our podcast, which you can listen to in full below.


Interest rates have been with us for thousands of years. Why did you decide to write about them now?

Edward Chancellor: During the period of the ultra-low (even zero) interest rates that followed the global financial crisis, we saw high valuations return to the U.S. stock market. We saw an increase in international carry trades, a deterioration in credit standards, and several other curious effects of outflow interest rates.

By the middle of the last decade, these outflow interest rates were not just having a strange impact on the markets. They were also having a curious effect on the economy and society at large.

This seemed to me a good subject to write about. When I embark on a book, it’s because I’m trying to write about questions I haven’t found the answers to yet.

The price of money is still not well understood. How can that be?

Edward: Interest is a complicated phenomenon. But investors incorporate interest into their activities and leave it at that.

I think what happened is that the economics profession lost sight of what interest is and does. One of the reasons I started to write The Price of Time was because central banks around the world were saying, “the threat of deflation is not very far away, and therefore, we’ll take interest rates to zero and engage in monetary experiments like quantitative easing to try and move the inflation rate higher.”

The central banks’ view of interest was reduced to a lever to control inflation. If inflation’s too high central banks increase interest rates and when it’s too low they decrease rates. That was their role, as they saw it. And they didn’t think more deeply about the role of interest.

The aim of The Price of Time was to ask, “what are other functions of interest?”

Economics in the post-war period became very technical, very model driven, and based on abstract metaphors. But this doesn’t describe the world well at all.

Nearly a quarter century ago, we had the dotcom bust. Economists at the time didn’t understand speculative bubbles and thought they didn’t exist. Then we had the credit boom, leading to the global financial crisis, but economists didn’t really understand credit. Then we moved into the era of zero rates and negative rates. It’s a problem of modern economics; it’s become so abstract and divorced from the real world.

The central banks’ view of interest was reduced to a lever to control inflation.

I write from the perspective of a person who’s trained as a historian and has read the history of economic thought. I found that most of the great economists in the past thought deeply about interest, but these perspectives have become neglected.

What are the first recorded instances of interest?

Edward: In ancient Mesopotamia and the Near East, there are records of lending at interest, as well as words for interest that relate to livestock. For instance, in Babylonia, the word for interest is “mash,” which means lamb, suggesting early farmers were lending out their livestock and crops and demanding some increment back.

Then, in the age of the first cities, a real-estate market develops. There are loans for buying houses, commercial activities, and farming that all charge interest. Lending at interest was performing quite similar functions as it does today.

But even in a predominantly agrarian economy, high rates of interest can be painful, particularly compounding interest. The ancient Hebrew word for interest is a serpent’s bite, or “neshekh,” and in the Bible, there are restrictions against charging interest. You also find restrictions against lending at interest in the philosophy of Aristotle and in ancient Greek political practices.

We can argue that interest exists to perform several economic and financial roles. But it also has a psychological element—human beings are mortal. We demand a premium to receive something in the future, as opposed to have it in the present.

Why do we have lower interest rates today than in the past?

Edward: It’s quite difficult to know whether there is a long-term downward trend in interest rates. And when people argue this, they tend to use the nominal rate of interest after inflation—also known as the “real” interest rate.

Inflation is often unexpected, as we’ve seen recently, which is why I’m distrustful of using the real interest rate as a measure of whether interest rates are declining.

In The History of Interest Rates, Sidney Homer and Richard Sylla argue that the course of interest rates over a civilization is u-shaped. As a civilization is established, interest rates are high because there are relatively high levels of risk and low levels of savings. And then over the course of time, interest rates decline and plateau. But as a civilization ages, risk increases and demand for capital, relative to savings, rises. Thus, interest rates rise.

We can argue that interest exists to perform several economic and financial roles. But it also has a psychological element—human beings are mortal.

The levels we’ve experienced in recent years are not the levels we would have experienced if the interest rate had been freely discovered in the market. But over the course of the 20th and 21st centuries, we’ve moved from a gold-backed currency to a fiat currency. We have seen both the highest interest rates in history and the lowest interest rates in history. The fact that the price of time went negative for the first time in five millennia is such an extraordinary event that it was worthy of deep examination.

It’s not information that brings interest rates down. When financial institutions were created, it led to greater efficiency in the financial market, which helped bring about lower interest rates.

Do low interest rates cause low economic growth or does low economic growth cause low interest rates?

Edward: The conventional central bank view is that low productivity is the rationale for lower interest rates, and productivity rises due to factors in the real world. I look at things the other way round.

One of the functions of interest is the allocation of capital, and interest is the hurdle rate for investment. It’s embedded in the payback period that we demand from investment. And the other important capitalist function is what Austrian economist Joseph Schumpeter calls the process of creative destruction, which is when resources are taken from low-return activities and reallocated to higher return investments.

After the global financial crisis, central banks brought interest rates down to very low levels, and there were relatively few bankruptcies and business liquidations in the United States.

But we then saw the phenomenon of so-called zombie companies. These were businesses that were unprofitable but stayed in business because the cost of borrowing was low. Their presence contributed to low productivity growth. Central banks, having seen that productivity growth fell, lowered interest rates even more. We were caught in a downward spiral.

But rising investment has usually led to improving productivity, and that just hasn’t happened.

Edward: If you have sectors in which unproductive companies that would normally fail are still in operation, there’s less incentive to borrow and invest and start a business in that sector.

But when interest rates are low and the corporate cost of borrowing is below a company’s return on capital, there’s an incentive to borrow and replace your equity with debt. Activities in which money is borrowed by corporations but not used for productive purposes became popular, which wasn’t the intention of central banks.

Do you think that low interest rates lead to monopolies?

Edward: Jonathan Tepper, a friend of mine and author of The Myth of Capitalism, which is about the growth of monopolies in the United States, came across a piece of research that cartels are likelier to form during times of low interest rates and more likely to break up when interest rates are high.

The growth of monopolies has been accelerated by the low cost of financing and by regulatory authorities being lax about imposing antitrust regulation. Central banks were keeping interest rates low because they wanted more inflation, while antitrust regulators allowed the creation of monopolies on the grounds that there would be cost savings that would bring down the prices charged to customers.

Is there a connection between low interest rates and the potential for meaningful changes in political systems?

Edward: Historically, the view has been that high interest rates lead to inequality. This is true when you look at the ancient world, where people who charged high interest ended up in debt bondage or slavery.

While high interest rates can create inequality, low interest rates can also create inequality. For example, if low interest increases the value of the market, asset management fees, along with fees on share repurchases, leveraged buybacks, and private equity transactions, will increase, regardless of what they’ve done. Low interest rates have the potential to feed the growth of the financial sector.

The fact that the price of time went negative for the first time in five millennia is such an extraordinary event that it was worthy of deep examination.

Homeowners and retirees may also benefit from falling interest rates. However, their benefit is offset by the cost born by the so-called have-nots, or the younger generation who’ve yet to acquire assets or save for retirement. Younger generations may find it harder to buy houses. This is particularly true in the United Kingdom, where housing prices have been elevated for a long time. High prices make it harder to get on the housing ladder and to save for retirement. It’s unsurprising that a young person without any assets would feel that the system is working against them.

In terms of bonds, as interest rates come down, the long-term returns of bonds will decline, and your return on investment will fall over time. This also holds true for the stock market. A stock market at a higher level of valuation will deliver a lower return in the future.

It’s nice if you already own assets to see housing, bond, and stock prices rising. But those are gains that have been brought to the future at the expense of those who are going to make investments in the future.

Let’s say you’ve become the head of a central bank. How would you approach implementing an interest-rate policy?

Edward: It’s difficult to determine what the rate of interest should actually be.

Taking a step back, central banks have largely operated with a certain mandate—getting to an inflation target of around 2%. And because inflation was largely in abeyance the last decade, and deflationary pressures were being felt, there was a rationale for cutting interest rates to historically low levels.

Overall, I think a narrow inflation target is the wrong mandate to give a central bank. These institutions should look at what’s happening in the economy and in the financial sector when they’re setting interest rates, rather than focusing only on the inflation target.

Further, there’s confusion over the question of deflation. There are two types of deflation. One comes from productivity improvement. The second type is debt deflation. We saw debt deflation occur in the early 1930s and after the global financial crisis, when banks constrained their lending after heavy losses and individuals started saving rather than spending their money.

I think a narrow inflation target is the wrong mandate to give a central bank.

Debt deflation has the potential to create a downward spiral in prices, and it arises from a position of over-indebtedness. The low interest rates in recent years led to increased indebtedness. By targeting this narrow inflation target, central banks built up the conditions of debt deflation.

We may potentially be on the cusp of another period of debt deflation. The U.S. regional banking crisis is a result of banks building up interest-rate exposure on their balance sheets at a time when interest rates are low. And these kinds of credit shocks that the United States is experiencing have historically been followed by periods of deflation.

Do you think central banks are going to stop focusing so narrowly on a level of inflation and think more broadly?

Edward: I think things will move slowly in the future. In The Price of Time, I suggest there is a possibility that a central bank digital currency could be almost equivalent to a digital gold standard.

The cost of borrowing and lending would then be determined by the market rather than by a committee of central bankers, getting closer to what is called the natural rate of interest. The market rate of interest would then reflect the demand for and supply of loanable funds.

If we went down that route, it could be a solution to the problem of asking fallible economists to set an interest rate—that universal price entered into every calculation. Because how could individuals with limited knowledge and limited understanding ever determine the correct price?

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