LONDON: Inflation is back, and along with it a widespread obsession about the future direction of interest rates. This is hardly surprising. In the past, a dose of tight money has brought prices under control. However, interest’s role in ensuring price stability is just one of its many functions. Our neglect of those other functions explains why the financial markets are in such a jumpy state today.
James Grant, the founder of Grant’s Interest Rate Observer, calls interest the “universal price” because it performs so many roles. For a start, it constitutes the capitalisation or discount rate without which valuation is impossible. As every business student learns, a company’s present value is calculated by discounting future cash flows. “Anticipation is always at a discount”, said the Scotsman John Law in the early 18th century. The Austrian economist Ludwig von Mises observed that if humans did not value consumption in the present over the future then an apple in a hundred years’ time would be worth the same as an apple today: an evident absurdity.
We have witnessed much such absurdity in financial markets in recent years. After the global financial crisis of 2008 central bankers reduced short-term interest rates to zero, and even lower in Europe and Japan. Longer-term rates declined too. The collapse in discount rates justified a great inflation in asset prices. The valuations of companies whose cash flows lay in the distant future benefitted most. Easy money pushed up property prices in many cities around the world.
Ultralow interest rates had other distorting effects. Interest provides an incentive to save – what the 19th-century English economist, Nassau Senior, called a “reward for abstinence”. Conversely, the prolonged period of low rates has depressed household savings across the developed world. None of this seemed to matter while financial markets were soaring.
Interest also influences the allocation of capital. If the minimum rate of return demanded by investors is too high, worthwhile investments will be neglected. But if it’s too low, scarce capital will be squandered. This arrests the process of “creative destruction” that the economist Joseph Schumpeter considered an essential feature of capitalism.
Very low borrowing costs can help keep chronically unprofitable enterprises alive. So-called zombie companies were first observed in Japan in the late 1990s around the time when the country’s central bank reduced its policy rate to zero. When central bankers in the United States and Europe followed suit after 2008 the phenomenon became more widespread. OECD research suggests that these zombie firms are partly responsible for the weak growth in productivity over the past decade.
The 19th-century American economist Arthur Hadley said interest is the “price paid for the control of industry”. Over the last decade, cheap financing has fuelled a great concentration of U.S. industry, similar in many respects to the powerful “trusts” created by Wall Street in Hadley’s day. Companies with dominant market positions tend to invest less, contributing to the productivity slowdown. Once again, ultralow interest rates have played a part.
Interest is sometimes referred to as the “cost of leverage”. American companies have availed themselves of low-cost credit to spend trillions of dollars buying back shares. In the short run, this financial engineering boosted companies’ reported earnings per share and helped raise stock prices. But it has left the corporate sector more vulnerable to rising interest rates. Governments around the world have likewise availed themselves of easy money. Debt owed by the developed economies grew from 78% of GDP in 2009 to 115% at the start of this year, according to the Bank for International Settlements.
Emerging markets, meanwhile, have got much deeper into debt since the financial crisis. China leads the way. Total non-financial debt in the People’s Republic stood at 294% of GDP at the end of last year, up from 154% in early 2009, according to the BIS. At least China’s credit is mostly self-financed. Other emerging economies have borrowed heavily from abroad.
This points to another neglected function of interest, namely as the regulator of international capital flows. History shows that when interest rates at the core of the global financial system are depressed, credit flows to developing countries, where interest rates are higher. When capital flows go into reverse, highly indebted borrowers are forced to default.
Investors may now regret having lent to over-leveraged companies and governments. Over the past decade, however, they had little choice. The era of ultralow interest rates induced a desperate scramble for yield. Recent research suggests that when interest rates fall below a certain level, investors take more risk to maintain their income. Back in the 18th century, the Neapolitan economist Ferdinando Galiani described interest as the “price of anxiety”.
Now interest rates are rising and asset prices are coming down. People are waking up to the fact that they are less wealthy than they believed. Many will be forced to save more and even postpone their planned retirement. Corporate credit spreads are widening and cross-border “carry trades” are out of favour. The cost of servicing public debt is picking up. Several emerging markets have recently defaulted. Financial anxiety is soaring. All these problems can be traced back to ultralow interest rates of recent years.
All economic activity takes place over time. Some mechanism is necessary to ensure that savings and investment balance, to keep asset prices in line with fundamentals, to ration capital and discourage excessive risk-taking. That mechanism is interest. I call it the “price of time”. Its appearance in Mesopotamia in the third millennium BC is hailed as the greatest financial innovation of all time. We can argue about to what extent central bankers are responsible for the lowest rates in five millennia. But the negative consequences of ultralow rates are increasingly recognised. If capitalism is to thrive once again we must rediscover the nature and necessity of interest.