Posted by Edward Chancellor on July 11th, 2022

Inflation is back, and along with it a widespread obsession about the future direction of interest rates. 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 on the cusp of yet another crisis.

Interest has been called the “universal price” because it performs so many useful roles. For a start, it constitutes the capitalisation or discount rate without which valuation is impossible. If humans didn’t 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 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. The collapse in discount rates facilitated a variety of speculative bubbles from contemporary art to vintage cars. Easy money inflated property prices, making many cities around the world unaffordable.

Interest provides as an incentive to save – what the 19th century English economist, Nassau Senior, called a “reward for abstinence.” The prolonged recent period of low rates has depressed levels of 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 low, capital - an inherently scarce resource- will be squandered. Savings become trapped in inefficient so-called “zombie” companies. The process of “creative destruction”, an essential feature of capitalism, is arrested.

The 19th century American economist Arthur Hadley suggested that interest was the “price paid for the control of industry”. Over the last decade, cheap financing has fuelled a great wave of company takeovers. U.S. industry has become highly concentrated, 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 further to the shockingly weak economic growth of recent years.

Interest is sometimes referred to as the “cost of leverage.” American companies, in particular, have availed themselves of low-cost credit to spend trillions of dollars buying back their shares. In the short run, financial engineering helped raise share prices. But it has left the corporate sector vulnerable to rising interest rates.

Governments around the world have likewise availed themselves of easy money. Over the last decade or so both the UK and US governments have sported the largest peacetime deficits in history. Emerging markets, meanwhile, have got much deeper into debt since the financial crisis, with China leading the way. At least China’s debt is mostly self-financed. Other emerging economies have borrowed heavily from abroad.

Investors may now regret having lent to over-leveraged companies and governments. But over the past decade they had little choice. The era of ultralow interest rates induced a desperate scramble for income. Back in the eighteenth century, the Neapolitan economist Ferdinando Galiani described interest as the “price of anxiety.” When rates are too low people become complacent and take too much risk.

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 costs 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. Today, the negative consequences of ultralow rates are increasingly apparent. If capitalism is to thrive once again we must rediscover the nature and necessity of interest.

The Price of Time by Edward Chancellor is published by Penguin Books on July 7th, 2022.