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Merryn Somerset Webb: Hello, and welcome to the MoneyWeek magazine podcast. I am Merryn Somerset Webb, editor-in-chief of the magazine, and today, I have with me Edward Chancellor. I know many of you will know, he's been on our podcast before, he's a Breakingviews columnist and he is the author of The Price of Time: The Real Story of Interest. It is 7th July. Edward, is it today the book comes out in the UK?
Edward Chancellor: Yes, it is. Same day that Boris Johnson falls. It'll be a day remembered in history, at least for one event.
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Merryn: Well, we don't know that for sure yet, do we? We’ve just being told that he will probably resign later. By the time you listen to this podcast, everybody, all will be clear or maybe not clear, not very clear, a little clearer? I don't know. But let's stick with what we're certain about, which is a book coming out today. This book has been a long time in the writing.
We have discussed it on and off for quite a few years now. It’s taken a long time to write, as it should. It’s an important subject. But what makes it so important to you? What was the idea behind the book?
Edward: So, Merryn, I’ve been writing about contemporary financial events and writing financial history for 25 odd years now. And it seems to me that each period that we've been living through, there's one issue that is overwhelmingly important that you need to understand. So, in the 1990s, I wrote a history of financial speculation, and that was concurrent with the .com bubble. And then at turn of the century, and for those following years, I spent a great deal of time writing about credit.
And I wrote a report called Crunch Time for Credit, which came out in 2005 and it was saying hey, look at, look at this credit bubble, isn't it something to behold? Anyhow, so there, the credit bubble burst in 2008, and then we had this period of quantitative easing, central banks going out and buying masses of securities, printing money to buy bonds, and taking interest rates down to their lowest level in five millennia of history.
And in 2012, William White, who's the former chief economist of the Bank for International Settlements, which is the central bankers’ central bank, as they call it. Anyhow, Bill White wrote a paper, which said what are the unintended consequences of these very low interest rates? And I had a column in the FT at that time, and I wrote up Bill White’s paper.
And then the more I thought about it, the more I came to the realisation that you couldn't really understand either the world of finance or what was happening in the economy, unless you unravelled or unpicked the unintended consequences of these ultra-low rates. Which is something, after all, that you, yourself, have written about many times over the last decade or so. And that sent me back on a historical journey to the invention of interest in Mesopotamia in the third millennium BC.
Merryn: I love the idea of the invention of interest in that it’s one of those things that is so intrinsic to everything around us, one never thinks of it having been something that was actually invented. It’s just there.
Edward: Well, invent. We don't know the origins of interest, because interest can be observed in the earliest historical records. And it is suggested, and quite likely, that even in prehistorical periods, men were lending probably agricultural wares, so probably lending grains, or they may have been lending cattle and other livestock, and would probably be charging an interest for those loans.
I describe it in the book, if you look at all the etymological origins of interest in Greek, or in Latin, or in Assyrian, or in Egyptian, they all draw upon the productivity of livestock. And so, that suggests that interest was around. It’s much older than money itself, but interest is really one of the oldest institutions known to man.
Merryn: And as far as we know, throughout these millennia where we can trace the interest being charged, there's never been a time when, for example, real interest rates have been negative for significant periods of time.
Edward: Merryn, you have to be careful about real and nominal. So, nominal interest is the interest that you pay, the 10% interest, 5% interest. The real interest, what we call the real interest, is a rather abstract notion is you take that nominal interest and subtract whatever the trailing inflation rate is. And there have been periods, notably in every high inflation and hyperinflation, when real interest has been very severely negative.
I think the real interest rates in Weimar, Germany, must have been negative to the rate of 1000s of percentage points. But we haven't had, and the more I think about interest, I think that what we call real interest, which was a notion invented by the American economist, Irving Fisher at the turn of the 20th century, it's a rather artificial economist notion. What really matters is the nominal interest. How much you actually pay.
You borrow a certain amount of money, and how much is your percentage charge on that? Now, he nominal rates of interest go back to Mesopotamia, third millennium BC. They were at 20% per annum. And we have records of interest rates since that date, and you probably have, I hope you have on your shelf, Homer and Sylla’s History of Interest. Do you have that, Merryn?
Merryn: No, I don’t, actually. But I should. Of course, you’re right, I should.
Edward: Yes, you should. I'll send you one as a present to add to your library.
Merryn: To add to my collection.
Edward: So, Homer and Sylla, and Sidney Homer was the Head of Research at Salomon Brothers, a famous figure, they recorded the history of interest rates. And what we know is there was, more or less, a continuous history over five millennia, and the interest rates never touched zero or went below zero, except for a couple of quirky tax and regulatory reasons, very briefly in the US in the 1870s, and then again, very briefly in the 1930s in the US.
But those were, as I say, really to do with regulatory and tax reasons. It wasn't a general phenomenon. What we saw in the last decade is not only interest rates being held in the US and UK nominal policy rates, short-term rates down very close to zero for a prolonged period of time, but negative rates in Europe and Japan.
And one historian describes the invention of interest as the most important invention in finance, because it allows people to transact across time. And I say, well, these negative interest rate are such an extraordinary phenomenon, that perhaps they're the second most important, possibly the craziest, innovation in finance over that five millennia period.
Merryn: Interesting. So, let's go back to the distortions that this period of extremely low interest rates have caught the switcher. Because you’ve recently written a column on this, the time to rediscover the importance of interest, talking about what's gone wrong by not thinking about interest properly, as a result of not thinking about interest properly.
Edward: Well, what we're seeing this year is the puncturing of a really great asset price bubble that was evident in many parts of the world. And you and I have been writing about these things for the last couple of years, the SPAC phenomenon, special purpose acquisition companies, that were buying into completely untested technologies.
The cryptocurrencies, many of them extremely dodgy, and some of them just spoofs on other spoofs. And then the US Stock Market, as a whole, being at its second most elevated level on all the valuation bases outside the very peak of the .com bubble. So, there’s no doubt we've been through, and we're seeing what's being punctured this year, and it probably will continue, is the bursting of a great protective bubble.
And I point out that one of the functions of interest everyone should be familiar with is that it is what we call the capitalisation rate, the rate of which you place a value on capital, or the discount rate, the rate at which you discount future cashflows, in order to arrive at a present value. Now, again, what we saw over the last decade is the Central Bank brought short-term rates down. They dragged the long-term rates down.
And then with the long-term rates down, everything else looked relatively cheap, relative to those very low long-term rates. But by any other measure, any historical measure, they became extremely expensive. So, the central bankers created yet another massive asset price bubble, as a consequence of these extremely low rates, and they paid no attention to it. So, that's just one pretty obvious aspect of a function of interest.
Merryn: But given that, and you know this and I know this, why did central bankers not know this?
Edward: Well, in a way I didn't really want to spend my whole time bashing central bankers. I think the problem with modern economics is that it's lost a sense of the richness of interest, of the pervasiveness of interest. Funnily enough, I've been searching for some metaphors to describe what interest is, and it occurs to me now, which I didn't actually put in the book, is that interest is really a force like gravity, that holds everything in place.
And we may not like gravity, if you fall down the stairs and scuff your knee or something, but without gravity, nothing keeps its space. And central bankers just don't think deeply enough, or haven't thought deeply enough, about what interest is. They just assume that the interest is out there is given by the things in the real world, the productivity of machinery, the demographics and so on.
And they assume that the interest is out there, and there's nothing they can really do about it. And they think of themselves as just controlling a short-term interest rate lever to affect the rate of inflation or deflation. So, because they’ve feared deflation over the last decade, they thought okay, it was fine to keep interest rates very low.
Now, one of the consequences of that, and it's true that interest is one way of controlling inflation, but by keeping interest rates very low and printing a lot of money over the Coronavirus lockdown period, they have, indeed, unleashed the inflation that they were so eager to have.
Merryn: I like one of the quotes you put in, an 18th century economist calling interest the price of anxiety.
Edward: That's Ferdinando Galiani, he’s a great Italian enlightenment thinker of the 18th century, and Galiani said, and he was a man of the cloth, an abbé, but he was very dismissive of all the clerical writers on newsery [?] before himself. And Galiani says that the act of lending causes anxiety, and anything that causes you pain must be rewarded. I have written a chapter in the book on the price of interest is the price of anxiety.
Or, perhaps easier to understand, the price of risk, that every loan involves a risk. You're giving up your own capital, and there's a risk that you may not get it back, either because the lender defaults or because inflation comes along and makes the money that you've contracted the loan in to be worthless. So, you need some compensation for the risk.
And my argument, which will be familiar to you, again, from your observation of the financial world, is that that very low period of interest, which coincided with very low volatility in the financial market, and with very low levels of default, because it's quite difficult to get to default on a debt, if you're not actually paying any interest on it, that lowered the price of anxiety and encouraged people to take more risk.
And one of the reasons they took more risks, and this is another theme that you find in the both the historical and the contemporaneous sections of the book, is that when interest rates are very low, people will, as we say, chase, yield. They would take more risk in order to maintain their income. And that's something observed in the 19th century by the famous Victorian financial journalist and editor of The Economist, Walter Bagehot, who said, and repeated many times in his own writing, John Bull, your archetypal Englishman, John Bull can stand many things, but he cannot stand 2%.
And Bagehot goes on to say that faced with 2%, he will do irresponsible things. He will speculate and in tulip bulbs, or in canals, in railways, and so forth, or engage in speculative commercial ventures. And we've seen that in recent years, another function of interest, obviously, is the price of leverage, the cost of debt, So, with the price of anxiety low, everyone, not everyone, but a huge build-up of leverage in the financial system and a huge amount of yield chasing, or what we call carry trades, people borrowing in cheap currencies and lending in more expensive currencies.
And that builds up risk in the financial system. There was a very good Harvard economist, one of the few academic economists, who I think really genuinely understands finance, called Jeremy Stein, and Jeremy Stein was, briefly a governor of the Federal Reserve for 2012, 13, thereabouts. And Stein got to the Federal Reserve, saw all this risk-taking, the leverage buyout boom was returning, and leveraged loans were going out of the…
Do you remember the famous payment in kind loan, picked loans, and all this evidence back ten years ago that the financial players were taking on too much risk? And Stein said well, you can regulate as much as you want to try and prevent this behaviour, but only monetary policy, or what I would say interest rates, get into all the cracks.
So, you'll see that the interest permeates everything. If you have a very low, or an abnormally low, or too low rate of interest, not only does it get into all the cracks, but it actually pulls out the mortar and makes the building more fragile.
Merryn: Okay. So, today, the price of anxiety is definitely rising, has been for some time, and we're beginning to see the consequences. And you said earlier that you expect market volatility, at the very minimum, to continue. What are you expecting from here? What cracks are we going to see as the price of anxiety rises further?
Edward: Well, we're both friends with Russell Napier, aren't we?
Merryn: We are.
Edward: He lives in the same town as you. And Russell, as you know, has been banging the drum for last couple of years at least, on what he calls financial repression of interest rates being kept below the level of inflation for long periods of time, in order to pay for the debt, for the huge build-up of debt, to come down a bit. And I think Russell's probably right. Actually, I think we've been in a state of, so to speak, financial repression for a long time.
In the last decade, we had negative real interest rates, as you know. So, that is financial repression, but that was a financial repression period, which coincided with rising leverage. Governments getting massively more into debt, corporations engaging in financial engineering buybacks, leveraged takeovers, in order to boost their earnings and their share price. Now, I reckon that that period of financial repression, and increasing leverage, and asset price bubbles has come to an end.
And the new era we're in is one of continued financial repression, but one against a background of moderately high and of cyclical inflation. And if we go back to the 1970s, that's associated with the volatile stock markets, with the occasional financial crisis, such as Britain had experienced in the secondary banking crisis of 1975, but also, the derating of equities. So, the beginning of this year, the US Stock Market was on a Shiller PE, a cyclically adjusted price earnings ratio.
The share price divided by average tenure earnings. Now, the Shiller PE ratio at the beginning this year was 33 times. In 1966, the Shiller PE was about 24 times, at the outset of the great inflation. At the end of the great inflation, the Shiller PE had fallen to seven times. So, you'll see there's a massive derating of equities, so I think that's something, obviously, that process has started.
We can argue from various investment strategies [?], some people would say, well, in the financial repression, you actually want to own equities, because they're real assets. And others will say the volatility means that you want to buy more of them when they're at lower valuation. And we don't know the exact answer, and don’t want to be overconfident of the actual cause .
But I think that we've had this period where people didn't really need to say if they already had some financial assets and if they owned a house, because the asset price inflation did the saving for them. I think now, and that's another point I make about interest, that interest, as some 19th century economist said, is a reward for abstinence. And there's really been no reward for abstinence over the last decade, but there's really been no need for abstinence.
If you were well established and already owned equity, owned a portfolio of investments, and had a house. It was a different matter for the younger generation coming up, because they couldn't afford to get on the housing ladder. And they've found it very difficult to accumulate. They have found it very difficult to accumulate assets.
So, what I'm hoping is the silver lining, going forward, is that as asset prices go down, it really represents the shift in wealth from the older generation, who are asset rich, to the younger generation, who should find it easier to buy properties and to accumulate investment portfolios, which have better expected returns going forward.
Merryn: Of course, in the 1970s, house prices went berserk, didn’t they? They quadrupled over the decade. So, we don't want that to happen again. Now, going back to the idea that inflation from here will be reasonably high and cyclical. I agree with you, but why do you think it'll be like that, rather than oil prices are coming off already, there's a view among a certain part of the financial world that inflation is peak, that it's coming down, and it will settle at 3% or 4% and that’ll be that for the next decade or so.
Edward: Merryn, you remember earlier I said that I didn't think central bankers understood interest rates?
Edward: I've now actually come, and I hadn't really thought of this before, but I gave a speech last week on inflation, I’ve started doing a bit of bit of work on it, and listened to an ECB seminar on inflation, which, first of all, Charles Goodhart at the London School of Economics, the grand, old man of English monetary economics, he says that economists no longer have a general theory of inflation.
They reject monetarism and the monetary aggregates are so in distribute, they never cite them, and they don't really have any theory. They don't believe in the Keynesian and the Phillips Curve, whatever, natural rate of unemployment or trade-off between unemployment and inflation. They don't really believe anymore in the strange idea of inflation expectations determining inflation. So, I think that the fact that the central bankers don't understand inflation is problematic for controlling.
I think if you don't understand something, how can you, so to speak, control it? That's one point. The other thing is, I wrote a piece, I don't know, six weeks or so ago, which was on what I call the political economy of inflation. And the argument there is it's all very well to say that inflation has certain sorts of causes, like growth and money supply, but what lies behind the growth of money supply?
And I argue, and again, drawing on some of the economists in the 1970s, that really, the inflation is a symptom of the dislocation within a society, which has been building up for a long time. And to some extent, as I point out in this book, the dislocations in the study were caused by the very low interest rate policies and the inequities that they produce. Anyhow, there's no doubt about it, those dislocations are here.
There's a huge amount of debt, as I mentioned earlier, and really, until the pain of the inflation exceeds, in the public's mind, whatever benefits there are from keeping interest rates very low and letting inflation rip, then I think it will probably continue for a while, for several years. And then the other argument, again, Goodhart, and you may have written about it yourself, Goodhart think that demographics of declining population growth in China will actually lead to push up the cost of labour. And there is a globalisation impact inflation, too.
So, you've got political forces inducing inflation, you've got financial forces inducing inflation, and you've got, so to speak, forces in the real economy that will also induce inflation. And then go back to our topic today, interest rates. We've just come to the end of the of a 40 year bull market in government bonds that really started when Paul Volcker, as the Federal Reserve Chairman, raised interest rates to a very high level in the early 1980s, in order to kill off inflation.
And since that period, US Treasury yields have been coming down, almost uninterrupted, for a 40 year period. Now, what we know, historically, is that cycles in the bond market, whether they're bull markets or bear markets, tend to last for decades. So, if you've just come off a 40 year bull market, it would be very surprising, from a historical perspective, if that period of rising interest rates won’t continue for, really, frankly, for decades.
Merryn: I was going to say, on that happy note, cheery note, we should end. I just wondered, before we do, if you had any suggestions for MoneyWeek readers about how they should behave financially in a new era, which many of them will not have experienced before, of regular volatility in inflation, in interest rates, and in markets?
Edward: Well, I think it's much harder work. Galbraith wrote somewhere that financial genius is a short memory in a rising market. I think going forward, it's going to be hard work. Almost all assets have been falling this way, even your beloved gold has been going down recently. And so, I think it's going to be difficult. But I think one has to look out for pockets of value.
I was having lunch with Peter Tasker, the Japan Investment Strategist, a grand, old man, yesterday and he and I were listing the attractions of Japanese equities. Not least, is the currency very depressed at the moment, but Japanese equities are depressed. And Japan tends to move on a different… Japan is different, as they say.
I know that you've extolled Japanese equities in the past. I think they're probably quite a nice space to be loading up on small cap Japanese value at the moment. It seems to me to be extremely good value.
Merryn: Excellent Edward, thank you. I think on that happy note we really can end – we’ve really enjoyed talking to you, thank you so much for joining us today. And everybody, please go out and buy Edward’s book The Price of Time: The Real Story of Interest by Edward Chancellor, you will not regret it I think. I hope that we will talk to you again at some point relatively soon Edward.
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