The Price of Time by Edward Chancellor

• The book is about the role of interest rates in a modern economy. It was inspired by a Bastiat-like conviction that ultra-low interest rates were contributing to many of our current woes, the collapse of productivity growth, unaffordable housing, rising inequality, loss of market competition, or financial fragility. It has also seemed to play some role in the resurgence of populism as Sumner's Forgotten Man started to lose patience.
• 'What is Seen and What Is Not Seen' by Bastiat. The entire difference between a bad and good Economist is apparent. A bad one relies on the visible effects, while the good one takes account of both the effect one can see and those one must foresee
• The bad economist pursues a small current benefit that is followed by a large disadvantage in the future, while the good economist pursues a large benefit in the future at the risk of suffering a small disadvantage in the near term.
• Henry Hazlitt (Economics in One Lesson) lamented the persistent tendency of men to see only the immediate effects of any given policy, or its effects on only a special group, and to neglect to inquire what the long-run effects of that policy will be not only on the special group but on all groups.
  • Hazlitt attacked the what he called the "fetish" of full employment
    • Schumpeter's idea of "creative destruction" must be allowed to operate unhindered, as it was important for the health of the economy that dying industries be allowed to die as it was for growing industries be allowed to grow
  • Hazlitt compared the price system in a competitive economy to an automatic regulator on a steam engine. Any attempt to prevent prices from falling would only keep inefficient producers in business
  • Supply and demand for capital are equalized by interest rates said Hazlitt
    • But an excessive fear of "excessive" interest rates induced governments to pursue cheap money policies.
      • Hazlitt said "easy money" creates economic distortions…. It tends to encourage highly speculative ventures that cannot continue except under the artificial conditions that have given birth to them.
    • William Graham Sumner described how A and B hatch a plan to help X, but ignore the impact on C. C is the "Forgotten Man"
• Proudhon's Deam is realized
• After the Lehman Brothers bankruptcy in September 2008, neoliberal economists implemented Proudhon's revolutionary scheme. Central bankers pushed interest rates to their lowest level in 5 millennia. In Europe and Japan, rates turned negative – an unprecedented development.
  • Central bankers congratulated themselves on restoring calm on Wall Street. The bogey of deflation was dismissed. Unemployment came down. These were all the "Seen" effects. The secondary consequences of zero interest rates went largely "Unseen"
    • Canadian economist William White published a short paper "Ultra Easy Monetary Policy and the Law of Unintended Consequences." White said that lower interest rates had encouraged households to spend more and save less. The downside of bringing forward consumption from the future was people must in fact save more for any goals, and, given the low interest rates, it would take much longer to accumulate a satisfactory nest egg.
      • Ultra-easy money was responsible for misallocation of capital. Creative destruction was thwarted.
      • Provided an incentive for investors to take undue risks
      • Insurance and pension providers were struggling to cope with this low interest rate regime
      • Due to the low costs of borrowing, governments were unconstrained to run up their national debts
    • In his analysis, easy money served only to postpone the day of reckoning. On Wall Street, they talked about "Kicking the Can"
      • White also suggested that policy makers might face trouble exiting from their ultra-low rates
  • Bastiat's claim that free credit would be a disaster for working people was not far off.
• It is believed that the earliest transactions were for credit rather than barter. We do know that the Mesopotamians charged interest rates on loans before they discovered how to put wheels on carts. Interest is older than coined money, which originated in the 8th century BC.
• The Mesopotamians invented what is known as "compound interest"
• They figured out a problem with interest, in that when debt compounds with interest, it is likely to become unpayable.
• Richard Price calculated in the late 18 century: A penny…. Put out to 5% compound interest at our Savior's birth, would, by this time (1773) have increased to more money than would be contained in 150 million globes, each equal to the earth, and all solid gold.
  • Debt crises were a regular feature of Mesopotamian history.
  • Rulers were known to have debt cancellations. Usually, every 50 years or so.
    • The bible in the Book of Leviticus discusses debt jubilees or clean slates in Ancient Israel
• How interest rates are determined remains one of the most perplexing problems in the field of economics.
• Some believe that the interest rate is derived from the returns on real assets – like the surplus yielded by farmland
• Others to the rate of population growth and changes in national income (GDP)
• Some maintain that it reflects society's collective impatience or time preference
• While others claim that it is influenced by monetary factors
• Some economists believe that interest rates were determined simply by custom
  • In summary, the ancient history provides no strong support for any particular view as to how interest rates formed. All the above played a role
  • Bohm-Bawerk declared that the cultural level of a nation is mirrored by its rate of interest. In the ancient world, interest rates charted the course of great civilizations. It followed a U-shaped curve over the centuries; declining as each civilization became established and prospered, and rising sharply during periods of decline and fall. Very low rates appear to have been the calm before the storm.
• There is no evidence of a barter to money myth. It is more likely that credit antedated money and that they earliest forms of credit bore interest
• Interest arose from some combination of need and greed. Interest existed at such an early stage of civilization because capital was in short supply
• In any society with private property, whether in Mesopotamia or later civilizations, the payments of interest are required to induce people to lend their resources. Without interest, they would have inevitably have hoarded their capital.
• To 21st century policymakers, interest is simply a lever used to control inflation and tweak economic output. Yet an acquaintance with the Babylonian origins of interest should give us pause for thought.
• Interest has always been with us because resources have always been scarce and must be rationed somehow.
  • Bohm-Bawerk says "interest is the soul of credit." Interest exists because loans are productive. Those in possession of capital need to be induced to lend, and because lending is risky business. Because production takes place over time and human beings are naturally impatient.
    • Bohm-Bawerk – Interest was "an organic necessity."
    • Irving Fisher – called interest too omnipresent a phenomenon to be eradicated
    • Joseph Schumpeter – interest permeates, as it were, the whole economic system
• In Fable of the Bees (Bernard Mandevile) exposed the paradox at the heart of the modern world, that private vices brought public benefits.
• Adam Smith incorporated this into his political economy.
  • In the Wealth of Nations, Smith described the individual as one who "by pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it."
    • "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest."
• A bird in the hand is worth two in the bush
• Turgot had the earliest known reference to society's "time preference" or our propensity to place a higher value on immediate pleasures
  • Walter Mischel (Psychologist) demonstrated this with the famous 'Marshmallow Test' on children and delayed gratification. The study showed that humans are impatient.
• Time preferences are infinitely varied
  • A hungry person puts a higher value on a meal today than in 6 months
  • Age plays a role too. Younger are more impatient and cash strapped (they want to borrow money and pay it back in the future). Older tend to have a lower time preference and be less inclined to borrow money
    • Irving Fisher – maintained that impatience (i.e., positive time preference) is a fundamental attribute of human nature
    • Von Mises – believed that time preference (and therefore interest) is a category inherent in every human action. He stated it would be impossible to abolish interest.
    • Murry Rothbard asserted that future satisfactions are always at a discount compared to present satisfactions.
      • If this statement is true, then the interest rate must also ALWAYS be positive and a negative rate is unnatural
    • John Rae (Scottish Economist) first noted a connection between investment and time preference. The formation of capital 'implies the sacrifice of some smaller present good, for the production of some greater future good.'
• Interest – the time value of money – lies at the heart of valuations
• John Law wrote that 'anticipation is always at a discount.' $100 paid now is of more value than $1,000 to be paid $10 a year for 100 years.
• Capital value and interest are inversely related
  • A high discount rate produces a low capital value and vice versa.
• When interest rates decline, business are inclined to invest in projects with more distant payoffs.
  • If interest rates are kept below their natural level, misguided investments occur or 'Malinvestment' as the Austrians economists say
  • Consumer behavior is also affected when interest rates are pushed below society's time preference. Cheap credit encourages households to take on too much debt; they borrow and spend, bringing consumption forward, but when the future arrives the cupboard is bare.
    • Hayek thought that periods of widespread malinvestment must end in an economic crisis
• Henry Thornton said that providing paper credits at below the natural rate of interest (That which they obtain too cheap they demand in too great a quantity) created the conditions of an unstable financial boom in 1810 in England.
• After Thornton, Swedish Economist Wicksell concluded that any discrepancy between market rates and the natural rate would be revealed by changes in the general price level: interest rates too low = inflation. Too high = deflation
• In truth, the natural rate of interest in unobservable, a pure abstraction.
  • Even though it cannot be known with certainty, it is useful to hold in mind how the world would look if the natural rate held sway. A rate set by individuals freely lending and borrowing money in the market, like any other commodity; a rate that accurately reflects society's time preference and ensures that we neither borrow too much or save too little; which ensures capital is used efficiently, and provides savers with a fair return and not so low as to subsidize bankers and their financial friends, nor so high as to bite borrowers.
• John Locke was the first writer to consider at length the potential damage produced by taking interest rates below their natural level.
• When interest rates are too high, business won't borrow, creditors gain at the expense of debtors, capital values are depressed, workers remain idle and the economy stagnates
• When interest rates are too low, the economy has inflation, prices bubbles proliferate, credit booms, finance crowds out honest endeavor, savings collapse, capital is misallocated on a grand scale
  • Financiers and executives would benefit at the expense of savers
  • Wealth would be redistributed from savers to borrowers
  • Creditors would be inadequately compensated for risk
  • Bankers would hoard money rather than lend it out
  • As the velocity of money circulation declined, prices would fall
  • Too much borrowing would take place
  • Money would flow abroad
  • Asset price inflation would make the rich richer
  • The reduction in interest rates wouldn't revive a moribund economy
  • In short, Locke argued that forced reduction in interest rates imparts no benefit to society
• John Law conducted the world's first experiment with easy money. His story of boom and bust is a cautionary tale.
• Law suggested that central banks could lower interest rates by printing money; that would alleviate the position of heavily indebted borrowers, create jobs, and revive the economy. At the same time, the cost of servicing debt would fall. After 2008, the worlds central bankers acted similarly
• Richard Cantillon wrote Essai Sur La Nature du commerce in the 1730's about Law about his time as finance minister of France and owner of the Mississippi Company
• In the short term, a national bank could drive down interest rates by purchasing government debt with newly printed money. Expectations of further declines in interest rates would induce the public to acquire bonds, further lowering market rates and rising the prices of securities. Such operations though, were fraught with risks. The economy would prosper only as long as the newly printed money stayed within the financial system and not enter general circulation. Because once the money escaped into the wider economy, consumer prices were bound to rise. And, it is easy for the bank to buy securities in a rising market, but who would it sell to in a falling market? And, you also have the danger that the speculators would lose confidence in the paper money and demand gold/silver as payment.
  • In the decade after the financial crises, central bankers justified their monetary policies on the grounds that consumer price inflation was quiescent. But as Cantillon pointed out, when a national bank turns on the printing press and buys up government debt, the newly created money is trapped in the financial system, where it inflates other financial assets rather than consumer prices, and only slowly seeps into the wider economy.
  • Central bankers, who resort to printing money, manipulating interest rates and fueling asset price bubbles fail to heed Cantillon's warning that there is no painless exit. What central bankers are doing now is exactly what Law recommended stated Law's biographer Antion Murphy in the wake of the financial crises.
• Bagehot observed that outbreaks of financial recklessness did not occur at random. Rather, they tended to appear at times when money was easy and interest rates low. When interest rates fell to such a low level, investors reacted to the loss of income by taking greater risks. In modern language, they engage in "yield chasing"
• Whenever money becomes very cheap, experiences teach us it will be misspent.
• Irving Fisher – Easy money is the great cause of over-borrowing. When an investor thinks he can make over 100% per annum by borrowing at 6%, he will be tempted to borrow, and to invest or speculate with borrowed money
• James Grant – There is nothing so unstable as a stabilized price level
• The federal reserve act stipulated the new central bank would 'furnish an elastic currency'. What that meant was interest rates would no longer be determined by the requirement of banks to convert their notes into gold. This implied the possibility of fine-tuning monetary policy.
• In the early 1900's of the US Treasury under Secretary Shaw, he frequently intervened in the money markets. He was said to conceive of only 3 evils; high interest rates, a decline in the price of stocks, and a contraction in credit. These evils were so serious they were to be corrected whatever the costs. This had raised the tower of credit to a tottering height, and now the slightest agitation of any sort would bring a collapse.
• This resulted in the Knickerbocker Panic of 1907. These were unregulated trust firms (shadow banks) that paid out higher interest rates than savings banks and invested deposits in illiquid and speculative investments.
• The new central banks first test came during WWI. The federal reserve reduced the rediscount rate to half its pre-war level.
• Once the war was over, inflation took off. The feds response was brutal and effective. In early 1920, the rate was taken from 4.5% to 7%. Commodity and consumer prices collapsed, industrial production contracted, over 500 banks failed. The U.S economy bounced back by 1922. But the toll was high. Unemployment had risen to 12%.
  • Nearly 60 years would pass before the Federal Reserve would attempt to purge inflation with high interest rates.
• In its classical version, the gold standard had served as an automatic regulator of interest rates. When an economy overheated, gold left the country, whereupon, the central bank, observing a decline in bullion reserves, was required to raise interest rates.
• When the central bank had ample reserves and business was dull, rates were maintained at a lower level.
• At the onset of WWI, central banks suspended gold payments (except for the US). They decided on a modified version called the gold exchange standard, which was more 'elastic'.
• Under a gold exchange standard, both gold and government securities were counted as assets on a central bank balance sheet
  • This allowed credit imbalances between countries to run longer without being corrected. Interest rates were no longer automatically determined by international bullion flows.
  • French Economist Jacques Rueff later said the gold exchange standard reduced the international monetary system to a child's game in which one party had agreed to return the loser's stake after each game of marbles
    • For the first time in history, it became possible for central bankers to have an "active" monetary policy in pursuit of certain objectives. But these meant setting interest rates inevitably became politized.
• The new monetary system was designed to prevent deflations and consumer prices from falling
• Ben Strong (NY Fed) said that interest rate policy should be guided by the goal of price stability
  • Strong said that 'that our whole policy in the future, as in the past, would be directed toward the stability of prices so far as it was possible for us to influence prices.'
    • Strong wanted stable prices and he got them. From 1922 to 1929, the index of US consumer prices scarcely budged.
      • This allowed the federal reserve to adopt a less restrictive policy. It lowered interest rates from 4.5% to 3%. It also started open market operations, buying 500 million is US government assets.
    • Benjamin Anderson at Chase Bank said that monetary policy was too loose. The fed had been created to help with financial crises, now it was being used to finance a stock market boom.
    • By 1927 Anderson was bemoaning the growing boom atmosphere but Strong said it wasn't the banks responsibility to dampen the animal spirits. Besides Strong feared, that rising interest rates to curtail margin loans would produce collateral damage. Something being said today
      • Although the natural rate is unseen, it can roughly be surmised from an economy's trend growth rate. The US in the 1920's was growing at 8% per year. But the federal reserve fund rate was less than half that.
      • Consumer price index was low because of improvements, which generated productivity gains, keeping inflation at bay.
      • Easy money fostered credit growth, and credit growth fostered speculative excesses.
        • Property bubbles popped up all over the US. Charles Ponzi was active in his scams.
        • Investors placed too low a discount rate on future earnings and ended up paying too much.
        • Max Winkler described – 'The imagination of our investing public was greatly heightened by the discovery of a new phrase: discounting the future. However, a careful examination of quotations of many issues revealed that not only the future, but even the hereafter, as being discounted.'
• In 1927, Hayek criticized the feds experiment. Hoover stated that inflation of credit is not the answer to European difficulties. Hoover also said that this speculation can only land us on the shores of depression. But President Coolidge, a supporter of easy money and rising stock prices, declined to intervene.
• By late Summer 1927, the NY Fed stepped up its purchases of US Debt and lowered its interest rate. S+P was up 20%. Strong is said to regret giving the stock market its little coup de whisky.
• In 1928, the Fed raised rates from 3.5% to 5%. Easy money may kindle animal spirits, but a slight tightening of monetary policy is rarely sufficient to extinguish a speculative inferno.
  • The higher interest rates in the US had one unintended consequence. It caused the flow of international capital from Europe to the US.
  • This eventually ended with the October 1929 crash in the US market
• Interest is necessary so that investment and consumption decisions are coordinated over time.
• Bohm-Bawerk said when interest is determined in a free market, time preference and the return on capital should equalize. When interest rates are pushed too low, credit takes off and bad investments (malinvestment) abound.
• Austrians embraced the concept of a natural rate of interest, but disagreed that it could be divined simply by observing changes in consumer prices
  • Oskar Morgenstern – 'the idea that as complex a phenomenon as the change in a "price level", itself a heroic theoretical abstraction, could at present be measured to such a degree of accuracy is nevertheless simply absurd.
  • And even if it could be measured, Austrians still didn't believe that central bankers should aim to stabilize price levels
• Hayek thought the policy of price stabilization by Fisher and Strong at the Federal Reserve was misguided.
• In a capitalist economy, Hayek said, continuous advances in productivity mean that consumer prices have a natural tendency to decline. Especially during periods of rapid technological development. Like the 1920's
  • Hayek stated (1928) Monetary policy directed at stabilizing prices, administers an excessive stimulus to the expansion of output as costs of production fall, and thus regularly makes a later fall in prices with a simultaneous contraction of output unavoidable.
    • In effect, Hayek was predicting that the 1920's would end in a deflationary bust
• Hayek criticized the Fed Reserve in 1933, which he accused of setting interest rates below its natural rate. But the Feds error did not show up in overt inflation in consumer prices. Instead, a 'relative inflation' accompanied by destabilizing credit growth and malinvestment.
• Chester Phillips concluded that the credit inflation of the 1920's, the distortion of economic activity and the stock market boom and crash, 'all had their origin in the price stabilization policy of the Fed Reserve Board.'
  • Hayek argued that new technologies and efficiency improvements brought about a 'good' deflation. When policymakers ease monetary conditions to ward off such a benign decline in the price level, people are incentivized to borrow more. Thus, any attempts to avoid a 'good' deflation only make a 'bad' deflation more likely. And the 'bad' deflation that occurs during a crisis, should be viewed as a symptom, rather than the cause. Debt deflation is a secondary phenomenon, a process induced by the maladjustments of industry left over from the boom.
    • Fisher believed that the slide into deflation after a crisis must be arrested, Hayek argued that attempts to resist a fall in prices would hinder the curative process of a recession and keep the economy in a state of imbalance.
    • Keynes thought Hayek and the fellow "liquidationists' was sadistic. But the historical evidence suggests only a tenuous link between deflation and economic weakness.
      • James Grant points out in his book "The Forgotten Depression (1921)" that the price level dropped at an annualized rate of 15% and real rates reached 20%. But the economy corrected quickly.