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The Cost of Money

Hugo Scott-Gall: Today I have with me, Edward Chancellor. Edward is a financial historian, author, journalist, and investment strategist. His most recent book, The Price of Time: The Real Story of Interest was long-listed for the FT Business Book of the Year 2022. It was also listed by Amazon as a top business book of 2022 and won the 2023 high book prize from the Manhattan Institute.

His prior book, Devil Take the Hindmost: A History of Financial Speculation has been translated into many languages and was a New York Times Book of the Year. He also wrote Crunch Time for Credit and Capital Returns: Investing through the Capital Cycle. After studying history at Cambridge and Oxford Universities, he worked for Lazard Brothers and until 2014, he was a senior member of the Asset Allocation Team at GMO. He is currently a columnist for Reuters Breaking Views and has contributed at the Wallstreet Journal, the Financial Times, Money Week and the New York Review of Books. Edward, lovely to have you on the show, great to see you. Thanks for coming on.

Edward Chancellor: Thank you for having me.

Hugo Scott-Gall: So, let’s talk about interest rates. So, you could argue why the need to write a book about interest rates, they’ve been here as you say for thousands of years. So, why do you need to write a book? What else is there to know, what is misunderstood?

Edward Chancellor: Well, I embarked upon this project in the middle of the last decade.

That was six or seven years into the period of the ultra-low, zero interest rates that followed the Global Financial Crisis. And at a time when in Europe, interest rates were negative and they were about to turn negative in Japan too, the following year. I was, as you mentioned, working for the asset allocation team at GMO in Boston until 2013, I think. And as you probably know, from fund managers and asset allocators, had all sorts of problems in the wake of the Global Financial Crisis, with these very low interest rates. We saw pretty high valuations immediately return to the U.S. stock market. We saw an increase in international carry trades, a deterioration in credit standards.

And a number of other curious effects of the outflow interest rates. So, people on the investment side, on the buy side observed. And by the middle of the last decade, I came to the view that these outflow interest rates were not just having strange impact on the investment markets, the asset markets. But also, having quite curious effects on the economy and society at large. So, I thought, I looked round to see if anyone had written any good books on interest, where I could read up about it. I didn’t find that anyone had written anything on the subject for decades. The last book that I came across was written in the 1960s. It’s a dry, academic toner. Almost unreadable.

So, there we were, these interest rates at zero. The question of interest being a subject that hadn’t been examined, as far as I could see by any other writers on finance in recent decades. And so, it seemed to me a good opportunity to write. When I embark on a book, it’s really because I’m trying to write about a subject that I can’t pull another book off the shelf and find that it answers the questions I’m looking for.

Hugo Scott-Gall: So, it still seems very strange to me—and I’m sure I’m not alone in this—that something so central to everyday life, to human existence, the way the world functions, the allocation of capital, savings, etcetera. The price of money is still not well understood. And so, I guess my question to you is, how can that be? Interest rates have been around for a very long time, we’re going to come onto history in a minute.

But how is it that as you say, researching this book, the last thing you found to really read was an arcane, very dry book from 30, 40 years ago which is almost unreadable and just to be clear to everyone listening, Edward’s book is eminently readable. But how can that be? Something so important is still not fully understood.

Edward Chancellor: Well I mean, first of all I’d say that interest is a very complicated phenomenon. So, to question whether something, whether one can fully understand interest is a moot point. But why was it neglected? Well, first of all I think, from the perspective of practitioners, investors, they just go about their business. The bond investors, the equity investors, investors in real estate. So, they incorporate interest into their activities and leave it at that, so to speak.

I think what happened is that the economics profession lost sight of what interest is and what interest does. One of the reasons I started to write the book was because, the central bankers around the world were saying, the threat of deflation is not very far away. Therefore, we’ll take interest rates to zero and engage in other monetary experiments, quantitative easing and so on, to try and move the inflation rate a bit higher.

And as far as I could see, the central bankers’ view of interest was reduced to a lever to control inflation. If inflation’s too high, as we’re seeing at the moment, central banks pick up interest rates and when it’s too low, they bring them down. So, that was their role, as they saw it. And they didn’t think more deeply about the role of interest.

And so, really the aim of the book was to say, well what’re all these things that the contemporary economists and monetary policy makers, and central bankers are ignoring? What are these other functions of interest? And once, in the course of writing the book, I came to the conclusion there are probably six or seven, possibly eight functions of interest.

Of which the role of interest in controlling inflation is probably one of the least important. And as for why this is a neglect of the economics profession, I would say that economics in the post-war period has become very technical, very model driven. Arguably based on metaphors of physics, equilibrium and how the number of assumptions that are highly abstract and unrealistic.

And really describe the world as we know it, particularly for those of us who’ve worked in the investment world. They don’t really describe that world at all well. So, and if you think of it Hugo, you’ve got the dot com bust coming up almost quarter of a century ago. And the economists didn’t really understand speculative bubbles.

They thought they didn’t really exist. And then we had the credit boom, going up to the Global Financial Crisis. And the economists didn’t really understand credit. And then we got into the era of zero rates and negative rates. And I’d say they were still not really understanding the world. So, it’s to my mind, really a problem of modern economics that it’s become so abstract and divorced from the real world.

I write from the perspective of a person who’s trained as a historian. But is also deep in economic history and has read the history of economic thought. And what was interesting in the course of the research, is that I found that most of the great economists in the past had actually thought quite deeply about interest. I could cite for instance Irving Fischer, the great American economist at Yale University, probably the greatest American economist of the 20th Century.

He wrote a marvelous book called, The Theory of Interest which I would recommend people read. And then the other economists, say Frederick Hayek, of the Austrian school also wrote at length in interest. And then if you go back earlier, there were all these comments and thoughts about why interest arose and what it did and that seemed to be neglected.

But I say it’s a wide-spread neglect of modern economics. Unfortunate, but true I’m afraid.

Hugo Scott-Gall: So, let’s use your training as a historian, just to tell I guess, the story of interest and how it began. So, one of the things, one of the many things I learned from reading your book was that the Hebrew word for interest is translated as snakebite, or the bite of a serpent. So, can you talk a little bit, let’s do a little bit of history before we get onto your central hypothesis, your contention that actually, there are many elements to the role of interest and many of the current challenges, instabilities, fragilities in a modern economy are to do with interest rates being too low, versus too high. So, let’s do a bit of history first. Where are the first recorded instances of interest and what can we infer from that, in terms of its role?

Edward Chancellor: Well, we have in the earliest records of civilization, in the ancient near east and Mesopotamia, we have records of lending at interest. And in the ancient languages, we have words for interest that relate to livestock or the offspring of livestock. For instance, in Babylonia, the word for interest is mash, which means a kid goat or a lamb. And what this suggests is that right at the dawn of history, the early farmers were lending out their livestock and crops and grain and demanding some increment back, in terms of interest. And once we looked at what was happening in ancient Mesopotamia, you get this age of the first cities, you get real estate market. You get loans for buying houses, that charge interest.

You get loans for commercial activities, loans for farming, all charging interest. So, if you look back five millennia ago, you find that lending at interest was performing quite similar functions as it does today. However, you mentioned also that the ancient Hebrew word for interest is a serpent’s bite, nahash. And what this points to, is that in a predominantly agrarian economy, that high rates of interest can be very painful, particularly the compounding of interest over time. And so, in the ancient world, and you find this in the Bible, prescriptions against charging interest. You find it in the philosophy of Aristotle.

And you find it in Greek, ancient Greek political practices. There are restrictions against lending at interest. There are denunciations of interest, even though interest is a common phenomenon. It seems to be, as I argue in the book, interest we can argue exists to perform a number of economic and financial roles. But it also has a psychological element that human beings are mortal. They are, I think Fischer said impatient. And therefore, they will demand a premium to receive something in the future, as opposed to have it in the present. So, there seems to be a psychological need for interest, aside from the various economic and financial functions that it performs.

Hugo Scott-Gall: In the long run, are observed interest rates really a function of information to assess risk, which you could say is the risk of not getting your money back or the risk of not being paid interest on your principal that you’ve lent. And to reward time, which is the opportunity cost of giving your money to someone else. So, surely it isn’t surprising that interest rates are lower today because information is more freely available.

And so, we have lower rates today because there are more ways to assess risk. And therefore, there’s a better pricing mechanism. And so, if you look back to why were interest rates higher in the 15th, 16th, 17th Centuries, part of that much be the asymmetries of information, the lack of information. Is that a fair comment?

Edward Chancellor: To some extent.

It’s quite difficult to know whether there is a long-term trend in interest rates, whether they’re trending downwards. I mean, people make the argument that long-term interest rates trending downwards, but they tend to use real interest rates. In other words, nominal rate of interest after inflation.

As you know, inflation is often unexpected, as we see over the last year and a half. And so, the fact is, I’m slightly distrustful of using the real interest rate as a measure of whether interest rate is declining. As for, if you look at, Dutch interest rates were very low in 17th and 18th Century. Northern Italian interest rates declined quite sharply in the 15th Century. You’ve probably seen the great history of interest rates by Sidney Homer and Richard Sylla.

And they argue that civilizations, that the course of interest rates over a civilization is U-shaped. That the interest rates start high, as a civilization is established, and you could say that’s because there are relatively high levels of risk. Probably low levels of savings. And then over the course of time, they come down and they plateau. And then as civilization breaks down and risk increases and perhaps demands for capital rise relative to savings. Then interest rates rise. So, I wouldn’t read too much into the very low interest rates of recent years as part of a long-term secular decline in rates. We’ll get on to later, my argument that anyhow, that the interest rates have been manipulated downwards, artificially.

So, the levels we’ve experienced in recent years are not the levels they would have been, had the interest rate been freely discovered in the market. But what one can say is that over the course of the 20th Century, and into the 21st Century. Which is largely the period in which we’ve moved from gold-backed currency to a fiat currency. We have seen both the highest interest rates in history and the lowest interest rates in history.

In particular, the lowest interest rates over the last decade, where they turn negative for the first time in five millennia. I think you asked me earlier why I wrote the book. I think the fact that the price of time, as I called it, had gone negative for the first time in five millennia is in itself such an extraordinary event that it was worthy of deep examination. So, in a nutshell, I would say it’s probably not information as such that brings interest rates down.

I think that when financial institutions created, such as banks that gather savings together and lend out money, that leads to a greater efficiency in the financial market or what we call financial deepening. And I think financial deepening in itself brings about lower interest rates.

So obviously, if we’re all hiding our savings under our bed, which is actually what wealthy merchants did in the 17th Century, in England. Some of them would just have a case of gold under the bed. Well, if you’re just hoarding your money then say things are harder to come by and then interest rates would be higher. So, it’s the development I say of banking that brought lower rates. But there is, having said that, not a pronounced secular decline in interest over the last few hundred years.

Richard Sylla, the co-author of the history of interest rates thinks that a nominal bond yield of six percent is more or less the norm over the long period. So, what has been abnormal is the extraordinarily low rates that, since the turn of the century getting extremely low, after the Global Financial Crisis.

Hugo Scott-Gall: Okay, so I think we’re really getting into the meat of it now. I was going to ask you about the role of interest rates in revolutions, be they political or economic and the rise and fall of empires and I think that’s a whole seam of history that we could sully. But let’s get on to the main event really, which is your contention that interest rates going negative the last decade, a decade and a half of very low interest rates, even though of course interest rates are higher today as we speak. But I guess the key question I think that I took from your book, that I still don’t know the answer to myself which is it, low interest rates cause low economic growth or low economic growth leads to low interest rates?

Edward Chancellor: It’s a chicken and egg problem. The conventional central banker view is that low productivity is the rationale for lower interest rates. And that low productivity rises due to some factors in the real world. You could say, education or the fitness of the workforce or the age of the workforce. Or the state of technology, any number of reasons might explain low productivity. And the conclusion, or the inference that a central banker makes when they see low productivity, is that interest rates should decline. In fact, they argue that the decline in interest rates in recent years has been a function of the low productivity. I look at things the other way round.

I say that one of the functions of interest is the allocation of capital. And interest as you know 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 that after, in the boom-and-bust period, we have what the 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 or businesses. And the way I see it is after the Global Financial Crisis, we brought interest rates down, central banks brought interest rates down to very low levels.

And what one saw was that surprisingly, in the aftermath of the so called, Great Recession, there were relatively few bankruptcies and business liquidations in the United States. And also, in Britain. And I think that was a function, a result of interest being extremely low and companies being able to have access to the credit markets and borrow at very low rates.

And then we saw the phenomenon appear of the so-called zombie companies. And the zombie companies were businesses that were unprofitable but stayed in business. And I think they stayed in business because the cost of borrowing was very low. And research suggests that the zombie companies, that sectors with a large number of zombie companies saw less investment, fewer new entrants into those sectors.

And importantly, lower productivity growth. So, if you see, you put that together, the absence of creative destruction and the presence of zombies contributes to this low productivity growth, then the central bank, having seen that the productivity growth has fallen, then lower interest rates even more. And we were caught in I think a downward spiral on that front.

Hugo Scott-Gall: But low interest rates, you would’ve thought, I can borrow more cheapy therefore, I can invest more so I’ll borrow money and invest it at a higher rate of return than the cost of borrowing the money. And therefore, you’ll see rising investments. And with rising investment usually comes improving productivity. That just hasn’t happened.

Edward Chancellor: Well I mean, as I mentioned Hugo if you have sectors in which the unproductive companies that would normally fail are still in operation, then there’s less incentive to borrow and invest and start a business in that sector. But the other thing that we haven’t mentioned is that when interest rates are very low, when the cost of borrowing, corporate cost of borrowing is below a company’s return on capital, there is in our modern financialized economy, an incentive to borrow and replace your equity with debt. And that’s what we saw, we’ve really seen this process of debt financed, leveraged share re-purchases or buy backs.

We’ve seen a long period of leveraged buy outs. And we’ve also seen a lot of merger activity of debt financed mergers.

And so, these are all activities in which money is borrowed by corporations, but is not used for productive purposes, but really for purposes of financial engineering. And that wasn’t the intention of the central bankers, but it was as we all know, those of us who observe the financial world, is what happened.

Hugo Scott-Gall: But do you think that low interest rates lead to monopolies, dominance in industries and that actually, too many monopolies who are very comfortable, duopolies, oligopolies, leads to clearly less competition, lower investment and that, in itself weighs on economic growth?

Edward Chancellor: Yeah, I think so. And I cite a 19th Century, a late 19th Century economist called Author Hadley. Who was also president of Yale. He says, interest is the cost of corporate control. Which is an interesting comment. But of course, it makes sense. my first job was at Lazard’s, the investment bank. And if your clients are seeking to buy companies, then the low cost of borrowing is an incentive for takeover.

And then I also cite in the book, a fellow friend of mine called Jonathan Tepper, who wrote a book called The Myth of Capitalism, which was really about the growth of monopoly in the United States in recent years. And Tepper comes across a quite interesting piece of research, which shows that cartels are likelier to form during times of low interest rates. And they’re more likely to break up when interest rates are high.

And then, we’ve got the private equity companies that I mentioned earlier and at a lower level, as you’re probably aware, a lot of their activity involves what we call roll-ups of buying companies in a particular area and then merging them together and creating some pricing power. So, I think that the growth of monopoly, which the classical economist like Adam Smith thought was very bad for the wealth of nations. In recent years, that growth of monopoly has been accelerated to a large extent by the low cost of financing. And also, by the fact that the regulatory authorities have been quite lax in imposing antitrust regulation.

And what I think, I find this, something particularly ironic happens is that the central bankers were keeping interest rates low because they wanted more inflation, while the antitrust regulators were allowing these, the creation of monopolies and oligopolies on the grounds that oh, there would be cost savings that would bring down the prices charged to customers. So, you had two branches of government, if you will, acting across purposes.

Hugo Scott-Gall: We’re going through your charge sheet of what’s wrong with low interest rates and the unintended consequences of them. So, let’s talk a bit about the role of low interest rates and political cycles, inequality and therefore, the potential for quite meaningful changes in political systems. Is that too much of a stretch?

I mean, you wrote this but do you, on reflection, think that’s an overstatement that low interest rates can lead to not political revolutions, although I think you argued that they could, but they contribute to some societal problems. And the second part of the question is that if central banks always respond to a crisis by lowering interest rates, I think to use your phrase, it’s the banishment of pain.

That if there’s any pain, the system will cut rates. That does seep into psychology, it’s been called the Fed put. But maybe that has broader societal implications, that the central bank will always help you no matter what the problem is, and so you just cut interest rates. And that then affects behavior, changes behavior which almost gets you to the Minsky argument that too much stability makes the probability of instability go up.

Edward Chancellor: Well, let’s deal with the first part of the question, first. Which is, the impact of interest on distribution of income and wealth. Let’s call it that inequality.

And historically, as we mentioned earlier, the view of interest is that high interest has been unfair and unjust and led to inequality. And that’s certainly true when you look at the ancient world, where people who charge too high interest ended up in debt bondage or slavery. So, there’s certainly an argument, and this is the conventional view, as far as I can see of most economists who specialize in inequality. There’s certainly an argument that high interest rates can create inequality. But I suppose the novelty of my argument, is that very low interest rates, in a modern, financialized economy, one that we live in today, can also create inequality and can also be unjust. And this happens in a number of ways.

First of all, asset managers, investors. Our fees are a function of our assets under management. Now, if low interest put up the value of the market, then fund managers, fees and hedge fund managers’ fees increase, regardless of what they’ve done. I mentioned earlier that low interest rates feed an increase in investment bank activity. So, you get more investment banking fees.

And fees on share re-purchases, leverage buy backs, private equity and so forth. So, you can see that the low interest rates can feed the growth of the financial sector. And then we have the impact of the difference in outcomes for those who already have assets, houses and investments or have already retired and bought an annuity. And they benefit from falling interest rates and higher asset prices. But this is no free lunch because their benefit is offset by the cost bourn by the so-called have-nots. In other words, the younger generation who’ve yet to acquire assets to buy and to buy houses and to save for retirement. As you know, as interest rates come down, the long-term returns of the bonds necessarily decline.

So that your return on investment will fall over time. That also holds true for the stock market. A stock market at a higher level of valuation will deliver a lower return in future. So, it’s very nice if you already own assets to see house prices, bond prices and stock prices rising. But those gains are gains that so to speak have been brought to the future, at the expense of those who are going to make investments in the future.

So, I think the upshot of that is the younger generation find it harder to buy houses. That’s particularly true in the UK, where house prices have been very elevated for a long period of time. And they become resentful against the capitalist system. Because they’re as we were saying earlier, the low productivity is feeding through into low-income growth.

And the high asset prices, is making it harder to get on the housing ladder and hard to save for retirement. So, it’s not surprising that a person without any assets, a younger person would feel that the system was geared against them.

Hugo Scott-Gall: So, we’ve been through, I think, a pretty good summary of your arguments against low interest rates. And again, it’s worth remembering that certainly in the U.S. economy today, short term interest rates are not low. They’re high versus certainly a 15-year history. But what are your solutions?

What is it you prescribe? You have become head of the Fed or you’re Governor of the Bank of England or you’re head of the ECB, take your pick. What would you do? How would you do it differently? What is, you said earlier that interest rates have been manipulated. Manipulated from what? Where should they be? So, where do you think, you’re in charge, how are you setting them in reference to was and what are they? What is the natural interest rate?

Edward Chancellor: Well, I remember you were saying earlier that could one fully understand the question interest or whatever and I said, I’m not sure if anyone can. There is a complexity to interest in that it’s very difficult to discover what the rate of interest should be. We can more or less discover the price of most other goods and services. If a person gets the price wrong, if the producer gets the price wrong, they’ll go out of business.

The central bankers have operated with this mandate of getting to an inflation target, in most countries nowadays, around two percent. And it was because inflation was largely in abeyance the last decade and deflationary pressures were being felt that that was the rationale for taking interest rates down to these historically low levels.

I argue that a narrow inflation target is the wrong mandate to give a central bank. And we can see, the central banks have been following this narrow inflation target, keeping rates down low, printing all this money. And it’s been leaving aside the question, the problems we’ve been discussing. It’s also failed to control inflation. So, I think that the narrow inflation target, narrow I mean just focusing on achieving your two percent inflation target over a short period of time is mistaken. I think one should look at a broader number of measures. Interest for instance is the cost of leverage and the price of risk. So, when interest is very low, you would expect higher leverage and more risk taking.

Interest is the capitalization rate for the valuation of assets, houses and stocks and bonds and so forth. And so, when the interest rate is very low, you would expect bubbles to form. And what I think is that the monetary policy makers should have a much broader view, or overview of what’s happening in the economy and in the financial sector when they’re setting their interest rates. Rather than just focusing on the inflation target. And the other point, as you know that I make in the book is that there is a tremendous confusion over the question of deflation. Because there are in effect, there are actually two types of deflation. There is the good deflation that comes about from productivity improvement.

When the price of your computer declines, I don’t know if it’s declined anymore, but the price of computers used to decline every year quite regularly. Well, that was just because of productivity improvements. Improvements in semiconductors and so forth. And that type of deflation actually makes people better off. People like prices to fall.

And I think it was wrong, categorically wrong for the central bankers to act against the type of deflation, falling prices that made people better off. And there is another type of deflation, which we call the bad deflation, which is the debt deflation. And that debt deflation is when as we saw in the early 1930s and after the Global Financial Crisis, when banks have losses and constrain their lending and savers start saving and not spending their money.

Then you can have a downward spiral in prices. And this was pointed out also by Irving Fischer, the American economist. But he says in his famous paper, the Debt Deflation Theory of Great Depressions, that debt deflation arises from a position of over-indebtedness. Now, as you know, the low interest rates in recent years, both before the financial crisis and after the financial crisis led to a growth of indebtedness. So in fact, the central bankers by targeting this narrow inflation target were actually building up the conditions to debt deflation.

Which is really I mean, we may be on the cusp of another debt deflation now because the U.S. regional banking crisis is quite clearly induced a result of banks having built up interest rate exposure on their balance sheets, at a time when interest rates were very low. And these type of credit shocks or credit crunches that the U.S. is experiencing at the moment have historically, often in the past been followed by periods of deflation.

Hugo Scott-Gall: So, I suppose my final question is this, which is you’ve offered something of a solution, something of an alternate way to doing this. Do you think central banks are going to change and stop focusing so narrowly on a level of inflation and think more broadly?

Edward Chancellor: I think things will move, probably slowly in future. There is, as you know, this question of central bank digital currencies coming up. And in the very last line in my book, I suggest there is a possibility that a central bank digital currency could really be almost equivalent of a digital gold standard. And under those circumstances, if you had a central bank digital currency as really, your basic money.

Then the cost of borrowing and lending that money would be determined by the market, rather than by a committee of central bankers. And you’d get much closer to what people call, the natural rate of interest.

The market rate of interest would reflect the demand for and supply of loanable funds. And I think if we went down that route, that would probably be a solution, possibly to the problem of asking people, fallible economists to set an interest rate when the interest as I mention in the book, is the universal price. The price that enters into every calculation. How could a bunch of people, individuals with limited knowledges and limited understanding, including myself. How could they possibly get that price right?

Hugo Scott-Gall: I think that’s a great place to end, with a very, very difficult question, as we’ve discussed, and a question that has, I guess stood the test of time and now to resolve it. But it has been great to have you on. It has been great to have this discussion. I think we touched on many, many important things. So, all that remains for me to say is thank you for coming on. Much appreciated.

Edward Chancellor: My pleasure. Good to speak to you again.