It’s time to rediscover the importance of interest

3D printed percent symbols are seen in front of dollar bills in this illustration taken May 25, 2020. REUTERS/Dado Ruvic/Illustration

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LONDON, June 30 (Reuters Breakingviews) – Inflation is back, and with it a widespread obsession with the future direction of interest rates. This is hardly surprising. In the past, a dose of monetary tightening has brought prices under control. However, the role of interest in ensuring price stability is only one of its many functions. Our neglect of these other functions explains why the financial markets are in such a nervous state today.

James Grant, the founder of Grant’s Interest Rate Observer, calls interest the “universal price” because it fulfills many roles. To begin with, it constitutes the rate of capitalization or discount without which the evaluation is impossible. As every business student learns, the present value of a business is calculated by discounting future cash flows. “Anticipation is always at a discount”, said the Scotsman John Law at the beginning of the 18th century. Austrian economist Ludwig von Mises observed that if humans did not value consumption in the present rather than in the future, an apple in a hundred years would have the same value as an apple today: obvious nonsense.

We have witnessed such nonsense in the financial markets in recent years. After the 2008 global financial crisis, central bankers cut short-term interest rates to zero, and even lower in Europe and Japan. Longer-term rates also fell. The collapse of discount rates justified high asset price inflation. Valuations of companies with cash flows in the distant future benefited the most. Easy money has driven up real estate prices in many cities around the world.

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Extremely low interest rates have had other distorting effects. Interest encourages saving – what the 19th century English economist, Nassau Senior, called a “reward for abstinence”. Conversely, the prolonged period of low interest rates depressed household savings in the developed world. None of that seemed to matter as financial markets soared.

Interest also influences capital allocation. If the minimum rate of return demanded by investors is too high, worthwhile investments will be overlooked. But if it is too low, scarce capital will be wasted. This stops the process of “creative destruction” that the economist Joseph Schumpeter considered an essential characteristic of capitalism.

Very low borrowing costs can help keep chronically unprofitable businesses alive. So-called zombie firms were first observed in Japan in the late 1990s, around the time the country’s central bank cut its key rate to zero. When central bankers in the United States and Europe followed suit after 2008, the phenomenon became widespread. OECD research suggests that these zombie firms are partly responsible for the weak productivity growth over the past decade.

The 19th century American economist Arthur Hadley said that interest is the “price paid for the control of industry”. Over the past decade, cheap finance has fueled a great concentration of American industry, similar in many ways to the powerful “trusts” created by Wall Street in the Hadley era. Firms in a dominant position in the market tend to invest less, which contributes to the slowdown in productivity. Once again, ultra-low interest rates played a role.

Interest is sometimes referred to as the “cost of leverage”. American companies have taken advantage of low-cost credit to spend trillions of dollars to buy back stocks. In the short term, this financial engineering has boosted companies’ reported earnings per share and helped drive up stock prices. But that left the corporate sector more vulnerable to rising interest rates. Governments around the world have also taken advantage of the easy money. Debt owed by developed economies has fallen 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 taken on a lot of debt since the financial crisis. China is leading the way. The People’s Republic’s total non-financial debt stood at 294% of GDP at the end of last year, up from 154% at the start of 2009, according to the BIS. At least China’s credit is largely self-funded. Other emerging economies have borrowed heavily from abroad.

This highlights another neglected function of interest, namely as a regulator of international capital flows. History shows that when interest rates at the heart of the global financial system are depressed, credit flows to developing countries, where interest rates are higher. When capital flows reverse, heavily indebted borrowers are forced to default.

Investors may now regret lending to over-indebted corporations and governments. Over the past decade, however, they had little choice. The era of ultra-low interest rates has brought about a desperate rush for yield. Recent research suggests that when interest rates fall below a certain level, investors take on more risk to maintain income. In the 18th century, the Neapolitan economist Ferdinando Galiani described interest as the “price of anxiety”.

Today, interest rates are rising and asset prices are falling. People realize that they are less wealthy than they thought. Many will be forced to save more and even postpone their planned retirement. Corporate credit spreads are widening and cross-border carry trades are no longer popular. The cost of servicing the public debt is rising. Several emerging markets have recently defaulted. Financial anxiety is skyrocketing. All of these problems can be attributed to the ultra-low interest rates of recent years.

All economic activity takes place over time. A mechanism is needed to ensure the balance between savings and investment, to keep asset prices in line with fundamentals, to ration capital and discourage excessive risk taking. This 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 ask ourselves to what extent central bankers are responsible for the lowest rates for five millennia. But the negative consequences of ultra-low rates are increasingly recognised. If capitalism is to thrive again, we must rediscover the nature and necessity of interest.

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Edward Chancellor’s “The Price of Time: The Real Story of Interest” will be published by Penguin on July 7.

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Editing by Peter Thal Larsen and Streisand Neto

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