Edward Chancellor is a financial historian and journalist, as well as a former investment strategist. Currently a columnist for Reuters Breakingviews, he has contributed to many publications, including the Wall Street Journal, MoneyWeek, New York Review of Books, and Financial Times. Fortune has called him “one of the greatest financial historians alive.”
Below, Edward shares 5 key insights from his new book, The Price of Time: The Real Story of Interest. Listen to the audio version—read by Edward himself—in the Next Big Idea App.
1. Time is money.
The notion that time is valuable goes back to Ancient Greece and was expressed by the Roman stoic Seneca, who claimed that time is man’s most precious possession. By coincidence, Seneca was one of Rome’s most prominent lenders. Interest has many definitions but it is best seen as the price of time. What economists call time preference—our tendency to value present over future pleasures—appears to be an innate human characteristic. The famous Marshmallow Test, pioneered by Stanford psychologist Walter Mischel in the 1960s, shows that children need an inducement of an extra marshmallow in order to defer current consumption. Adults are not so different.
2. Capitalism cannot function without interest.
The invention of interest was the most important innovation in the history of finance as it allows people to transact across time by borrowing and lending, valuing assets, investing, putting a price on risk, and so forth. From the early modern period onwards, it has been recognized that interest is an indispensable, if misunderstood, feature of a market economy.
Putting a price on time—or rather, charging for the use of capital over a period of time—helps ensure that capital is put to the best possible use. A high rate of interest encourages investment in projects with faster payback periods. If interest is too high, no one will invest at all, but if interest is too low, money will be wasted on investments whose profits lie in the distant future.
“Putting a price on time—or rather, charging for the use of capital over a period of time—helps ensure that capital is put to the best possible use.”
The recent gold rush in California’s Silicon Valley with its billion-dollar “unicorns” was spurred not simply by the advent of new technologies, but by the fact that, as one tech insider said a few years ago, this was the “best time for any kind of business to raise money for all of history, like since the time of the ancient Egyptians.” As a more jaundiced commentator noted, “a little-known fact about unicorns is that they feed on interest rates. They like low, little rates—the tinier, the better.”
Ultralow interest rates have also kept inefficient companies on life support. The widespread existence of zombie companies discourages entrepreneurs, slows the economic process of creative destruction, and ultimately reduces economic growth.
3. Interest is necessary to place a value on assets.
The time value of money is the key input in the valuation process. The Scottish economist and business projector, John Law, wrote in the early 18th century, “anticipation is always at a discount.” Interest serves as the discount rate or capitalization rate by which future cash flows are transformed into a net present value or market price.
The Everything Bubble that we’ve witnessed in recent years (that saw the U.S. stock market pushed to the highest valuation in history, second to the Dotcom bubble) and a variety of bubbles ranging from cryptocurrencies to listed Special Purpose Acquisition Companies (SPACs), from contemporary art to vintage cars, can only be understood in the context of the lowest U.S. interest rates in history. As an earlier economist pointed out, without interest, an apple in a hundred years-time would be worth the same as an apple today—an obvious absurdity. Or as Warren Buffett points out, “interest is to valuation what gravity is to matter.” Buffett’s partner, Charlie Munger, described the recent market frenzy that appeared during the pandemic as, “the most dramatic thing that almost ever happened in the entire history of finance.” Munger wasn’t exaggerating.
“Interest serves as the discount rate or capitalization rate by which future cash flows are transformed into a net present value or market price.”
The era of ultralow interest rates has served to weaken economic growth in the United States and elsewhere and contributed to increasing financial fragility, creating the conditions for yet another financial crisis. This year’s volatility on Wall Street supports this view.
4. Interest is the price of risk.
As another 18th-century economist, the Italian Ferdinando Galiani, pointed out, lending inevitably involves risk. Interest, said Galiani, is the “price of anxiety,” the compensation that lenders receive for handing their money to a third party.
Modern research finds that when interest rates fall below a certain level, investors take on more risk in order to maintain their accustomed level of income. This insight was understood by the best-known financial writer of the Victorian era, Walter Bagehot, who argued that people wouldn’t stand for interest rates as low as 2 percent. He said, “they won’t bear a loss of income,” but instead would, “invest their careful savings in something impossible,” like a canal or railway speculation, absurd business ventures, or even tulip bubbles (as the Dutch burgomeisters did in the 1630s).
Our behavior hasn’t changed since then. The ultralow interest rates that appeared after the 2008 financial crisis created a desperate “search for yield”—what on Wall Street is known as “carry trading”—as savers eked out extra income by lending to leveraged buyouts and private equity firms, or to emerging markets which offered higher rates.
“Interest, said Galiani, is the ‘price of anxiety,’ the compensation that lenders receive for handing their money to a third party.”
Since interest is the price of leverage, low interest rates have been accompanied by rising corporate debt and increasing indebtedness across emerging markets, especially in China. Central bankers believe that more financial regulations can ensure financial stability, but clever financial operators will always find a way around these regulations in search of profit. Financial arbitrage has been around since Babylonian times.
5. Interest affects the distribution of income and wealth.
In pre-industrial societies, there has always been a sense that rich lenders charged excessive interest, exploiting the poor and the vulnerable, and even driving people into debt bondage and slavery. In an economy that isn’t growing, compound interest is impossible.
But in a modern capitalist economy, where loans are used for productive investment, interest isn’t always exploitative. In fact, lenders aren’t necessarily rich. Even relatively low-income households have savings in the form of cash deposits (they keep more of their wealth in cash than the rich). Such households deserve a positive return on their savings, and yet after 2008, they have lost hundreds of billions of dollars in interest income.
The chief beneficiaries of the era of ultralow rates have been society’s most privileged members, namely CEOs of large companies whose stock-based compensation was inflated by the soaring markets; Wall Street bankers who earned large fees and bonuses arranging leveraged buyouts and debt-financed takeovers; private equity barons whose names have dominated the lists of top earners in recent years. Main Street has been the biggest loser.
The French economist Thomas Piketty alleges that inequality increases when the rate of return exceeds growth. Piketty’s formula needs to be reversed for our modern financialized economy: when return < growth, as it has been in recent years, inequality rises.
To listen to the audio version read by author Edward Chancellor, download the Next Big Idea App today: