Edward Chancellor - Ideas Lab Series - August 10th, 2022

[00:00:07] Edward

Very low interest rates are like fertilizer. They over fertilize the environment and lead to, in a way, a weak and fragile ecosystem. I discuss, in the chapter on creative destruction, a metaphor that’s quite commonly used of how the central bankers, when they prevent the process of creative destruction, they’re a bit like the US Forest Service that prevents forest fires, and in the end, you get a buildup of understory and so forth, until eventually, you get more fires and more severe fires as a consequence, and a less healthy forest.

[00:00:47] Intro

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Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:43] Niels

For me, the best part of my podcasting journey has been the opportunity to speak to a huge range of extraordinary people from all around the world. In this series, I have invited one of them, namely Kevin Coldiron, to host a series of in-depth conversations to help uncover and explain new ideas to make you a better investor.

In this series, Kevin will be speaking to authors of new books and research papers to better understand the global economy and the dynamics that shape it so that we can all successfully navigate the challenges within it. With that, please welcome Kevin Coldiron.

[00:02:20] Kevin

All right. Thank you, Niels and welcome, everyone to episode number 6 of the Ideas Lab Series. I’d like to start this one by reading a quote: “Our Earth is degenerate these days. Bribery and corruption are common, children no longer obey their parents, every man wants to write a book, and the end of the world is approaching.” It could have been taken from the Wall Street Journal editorial pages, but it’s not.

It’s from an Assyrian tablet written 2800 years ago, and it’s one of the many anecdotes that enliven the book that we’re going to discuss today. I like it because it connects us to our past. It reminds us, reminded me anyway, that the problems we’re facing today are at their core, not new. They’ve been faced repeatedly by human societies, and solved by human societies as well.

So the person who is going to help us think about and frame, I guess, if you will, the modern versions of some of those issues today is our guest, Edward Chancellor. He is a financial historian. He’s a journalist. He’s also worked as an investment strategist. He’s worked in investment banking for Lazard Brothers as well, as investment management as an asset allocation strategist for GMO. Many of you will have read his works that he’s published in the FT, The Wall Street Journal, MoneyWeek, among others.

He’s currently a columnist for Reuters Breakingviews. In 1999, I believe I got that right, he published Devil Take the Hindmost. It’s on my bookshelf behind me. It’s an award-winning book on the history of financial speculation. We’re here today to talk about his latest book, which was just published in both the UK and the US, called: The Price of Time: The Real Story of Interest. So Edward Chancellor, welcome to the Ideas Lab.

[00:04:24] Edward

Pleased to be with you, Kevin.

[00:04:29] Kevin

Early on in the book, you tell a story about an experiment that happened in Stanford in the 1960s, called the Marshmallow Experiment. They got a group of kids together and they said you can have one marshmallow now, or you can defer consumption and get two marshmallows in 15 minutes. About two thirds of the kids took the marshmallow now, and about a third waited.

I’m guessing that you are a two-marshmallow guy, and the reason I’m guessing that is because it must have taken you an enormous amount of time and patience to put this book together. Just because I’m somewhat of a nerd, I counted up all the endnotes and it was 1,241. The amount of work really comes through the pages. So I was hoping maybe you could start off by just telling us about your process. How long have you worked on the book? How did you manage to do it while holding down full-time jobs along the way?

[00:05:33] Edward

Well, you mentioned the book I published in ’99, called: Devil Take the Hindmost: A History of Financial Speculation. That was written at the time when the dot-com bubble was going on. I suppose, when I was thinking about speculation, I was perhaps quite entranced by the contemporary vogue for behavioral finance, and the psychology of investment, and investment manias.

In the same vein of looking at speculative manias from a crowd mania perspective goes back to Charles Mackay in the 1840s. After I finished the book, I was at a conference in New York in late ’99, 2000, and Dr. Henry Kaufman, formerly of Salomon Brothers, was there.

[00:06:35] Kevin

Dr. Doom, right?

[00:06:36] Edward

Dr. Doom. Kaufman started talking about the role of interest and the Federal Reserve’s manipulation of the Fed funds rate in the late stages, if you remember, after the collapse of the long-term capital management in September 1998; how the Fed cut rates, supplied liquidity to the markets, and then you got the final leg up with the dot-com boom. I started to think then about the monetary aspects of speculative manias. Then we had the dot-com bust, and the Fed, as you remember, put its foot on the gas pedal once again, took Fed funds rate down to 1%, and we got a global credit boom.

I was then commissioned, at the time, by a London hedge fund manager called Crispin Odey, to write a report on the global credit boom, which came out as a specialist report called Crunch Time for Credit, which we published in 2005. I was doing journalism in New York and went to work for GMO in Boston during the global financial crisis.

After the global financial crisis, interest rates went down even lower. I was working on the asset allocation team and we kept on thinking that interest rates were going to come up again, and they weren’t coming up. I initially belonged to that school that thought that inflation was going to come with all the QE, and it didn’t come. I was working with my assistant who is also your co-author, Jamie Lee, and Jamie and I, we did the interest rate project; a long-term interest rate project, because at GMA we kept on making poor forecasts for the direction of long-term interest rates.

Jamie and I made a certain headway, I think, on that project. One of the things we found is that interest rates are not mean reverting. If you’re an equity guy, and the asset allocation team was mainly equity, we worked with mean reverting models, but we also had completely erroneous mean reverting models for bonds. I realized that our models were worse than a stop clock. They were right once every 40 years, which is not good enough. So I began to understand these long bond cycles.

Also, if you remember at the time, just after the global financial crisis, the financial markets came back in 2009 very strongly, not just equity markets, but also capital flows into emerging markets, and also, if you will, carry trading into the domestic financial markets. Which is what you, Jamie, and Jamie’s dad, Tim Lee, wrote about in your book, The Rise of Carry. That was sort of where I was at. I came back. We decided to relocate to England, and I left GMO and got back to full time writing.

I was with a friend of mine who is the chief investment officer of a London investment firm called Ruffer, also an asset allocation business, a guy called Henry Maxey. I said to him, “A decade ago, I was sitting with Crispin Odey and Crispin was saying it’s all about credit.” And I said, “Yeah, it’s all about credit. Now, it seems to me, it’s all about interest rates. Through the prism of the interest rate, you can begin to understand all the extraordinary low interest rates of the last decade.” This is 2015 when the conversation took place.

You could have a holistic picture of both what was happening in the financial world in the broader economy, and to some extent, you could begin to understand where some of the roots of popular discontent were coming from. There was one other aspect to it. You probably know that Jamie and I also did a lot of work in China at the time, and we became entranced and fixated on the incredible credit boom that was going on in China, the epic real estate boom, and the accompanying investment boom.

The credit boom, the property bubble, and the investment boom, were together, the greatest booms I had ever come across in history. I was thinking of writing a book on China. Actually, in the end, I’m not really a China specialist. I’m not a sinophile. But you could explain a lot about what was going on in China, as an outsider, through the perspective, again, of the interest rates and the monetary policy. It seemed to me that that was a project that was worth undertaking.

There was another aspect to it, which is back when I was doing my work on the credit boom, I came to the belief that the central banks, by fixating solely on short-term inflation and allowing that to be the guide to where they set the interest rate; that was creating the conditions, in a low inflation environment, for these speculative and credit bubbles.

That’s the position I find myself in. Then, from a work perspective, I found myself reading both the history of interest and the history of economic thought about interest. Which takes you into, really, in earlier periods all great economists would think about what interest was, what it did, what it reflected. It seemed to me that the question of interest was no longer of, let’s say, much interest to the contemporary economists.

As it would ceased to be an interest (I’m a historian by training, not an economist), I had this feeling that many contemporary economists, academic economists, don’t really read enough of the history of economic thought, and therefore, they deprive themselves of the rich insights of earlier writers on interest.

[00:14:26] Kevin

Yeah. I’m going off script here because I kind of wanted to end our conversation with a question about that. But since you brought it up, I’ll ask it now, which is, why do you think that’s the case? What is it about the contemporary policymakers where they don’t have that curiosity about history in the same way?

It’s funny because, say, someone like Ben Bernanke is an economic historian. I guess he looked at history and took some lessons, but I don’t get the sense that people have that kind of willingness to look back at history and use the experiences of the past to inform decisions. Do you think people are just like, “Well, this time is different. The world has changed.” Or is it, “Hey, we just have to act now and we can think about broader lessons later.” Why do you think that is?

[00:15:22] Edward

Well, look, you teach economics, don’t you? And I don’t. So you probably have a better idea of the answer to your question than I do. The way I see it is that the economists are under possibly a misapprehension that their subject is a science, and that once a question has been addressed, and so to be solved, you no longer need to think or reexamine that question. If you consider your subject to be a science, then the history of the development of that science is a minor consideration. So you’re constantly lifting up the ladder behind you as you scale higher.

Tell me if I’ve got this wrong, but I understand they downgraded the teaching of both economic history and the history of economic thought in the academic departments. The other thing, I think, is there is this drive to make everything comprehensible within an economic model, a mathematical model. Economic history and the ideas of earlier economists are often not tractable to models. For instance, I realized that when I wrote this report on the credit boom back in 2004, I actually leaned quite heavily on Hyman Minsky and a bit on Hayek. I was in New York shortly after I finished the report and I saw another old, distinguished, Wall Street economist called Al Wojnilower. Have you ever come across him?

[00:17:22] Kevin

I have not.

[00:17:24] Edward

Al Wojnilower was at Credit Suisse, and he was the Dr. Gloom to Henry Kaufman’s Dr. Doom. In the 70s, they were the most…

[00:17:35] Kevin

It must have been a lot of fun to go out for drinks with those guys.

[00:17:38] Edward

Wojnilower, he’s a charming fellow and a very good economist. Anyway, why doesn’t anyone pay attention to Minsky? He said, “Oh, he’s difficult to model.” Now, if you remember, they said the same about Hayek. Then you had the crash and then almost the first thing that happened with the subprime crisis is that Minsky was the man of the moment. I’m not even sure he’s that difficult to model. I’m not a modeler but I can imagine how you could make a fairly decent Minsky model.

Anyhow, so it’s the desire to make economics about the illusion that you’re dealing with a hard science rather than a social science, and the desire to make your understanding tractable through a model that I think makes people tend to forget economic history, but also, which seems to be much more serious, is to ignore the past economic thinkers. That’s my thought.

[00:19:02] Kevin

I really liked that visual of pulling up the ladder once you’ve reached a higher spot. I think about that a lot with the notion of bank runs. You sort of felt like, well, we’d solved that problem. If you’re sitting in 2004 or ‘05, you’d say there are no more bank runs. Then of course, there were. It’s just the banking system had shifted from regulated banks to shadow banks. That’s where the credit is created, and bank runs are still a problem. In fact, they’re a worse problem because we’ve now created a market-based credit system that’s much more liquid.

You kind of, I think, answered partly, but I had another process question for you, which is the book is called, The Price of Time, so that kind of gives away how you think of interest. There are many, and you say at the beginning of the book, there are many different ways to think about interest. It’s a complex subject. There’s risk, there’s relative balance of power, there’s even notions of insurance in there. I guess my question was, did you start off your work as a journey of exploration? Was it like, hey, there are lots of different ways to think about interest, I wonder which one is right? Or was it, hey, interest is the price of time and I’m going to collect evidence to prove that’s the case? How did you approach it (or neither one of those maybe)?

[00:20:40] Edward

Given that my strongest specialty is in the field of speculative bubbles and manias, I suppose the area I understood best, starting out on the project, was the relationship between monetary policy and asset price bubbles. Which is a theme that goes through the book, as you know, starting in detail with John Law and the Mississippi bubble of 1719, 1720 running up to the current day. I suppose that was my presupposition. Then, as I read more broadly on the subject, I became interested in the other roles where interest seems to be most important, namely the allocation of capital.

As I mentioned, when you go into the 19th century, there are two strands of economic thinkers talking, both the Austrian School, I think it’s Carl Menger and Eugen von Bohm-Bawerk, the Austrians, the early Austrians, who talk about how interest affects the amount of capital that will be tied up for a period of time. They talk about how, as the interest rate falls, businesses will engage in what they called more roundabout methods of production. In principle, that would improve productivity, but you can have too much of a good thing.

If you took the interest rate down to a certain level, you would get, if you will, a misallocation of capital. But that idea was also arrived at independently by the English economist, W.S. Jevons, who said more or less exactly the same thing. So that role of interest in the allocation of capital and how the low interest rate can lead to what the Austrians call malinvestment, it became quite an interesting and, to me, quite rich area of research.

One of the things I point out in the book is that a lot of focus was on the conventional narratives on the Great Depression; on the very high real interest rates of the Great Depression period, although nominal interest rates were low, the deflation led to high real rates of interest. But it was followed by, if you will, a cleansing of the industrial processes in the US and very strong productivity growth in the aftermath. People tend to overlook the fact that the US actually returned in, I think, roughly a decade and a half, back to its trend GDP growth.

I think I mentioned somewhere in the book, I’m sure you’re familiar with the Chicago economist called Victor Zarnowitz, who has this idea that the recovery is the inverse of the depth of a recession. The faster you get down, the quicker you rebound. What we were finding in the aftermath of the great recession is that we went down pretty quickly. Financial markets came back very, very quickly but the real economy staggered back. Both in the US and in Europe, we had extraordinarily weak productivity growth.

This is the argument that people will be burned at the stake for is, were the low interest rates a reflection of the lackluster productivity growth, or did they in turn contribute? My thesis is I think they probably did contribute, but as Hayek says, there are no great experiments in economics. You’re dealing with a petri dish which a thousand people have put their thumbs into. We’re always going to have different opinions about these things. I think it’s a very rich vein, the allocation of capital and interest.

[00:25:53] Kevin

Let’s talk about that idea, because I had written down that as being really the animating idea behind the second two thirds of your book. Which is that low interest rates, they basically have a causal, long-term effect on the economy’s performance. You quote Ben Bernanke, I think, at the beginning of that second third of the book. Bernanke is saying it’s important to recognize that what monetary policy affects is not the potential rate of growth, but rather the cyclical part. Really, I think what you’re saying is, that’s not right. That low interest rates, particularly ultra-low interest rates, have this feedback effect on the economy and can actually impact, if not the super long term 50-year growth rate, certainly the growth rates that we kind of care about 5, 10, 15 years, etc.

I was hoping that we could go through some of the ways that you think that feedback mechanism operates. Perhaps we could start with just the basic one, which is savings. So the, I guess, conventional approach, the conventional idea of low interest rates is when a recession comes, when the economy slows, people want to save more. Companies who are run by those same people also want to save more so they do that by investing less, and then you get this potential reinforcing the economic slowdown, less economic activity.

The idea is, let’s lower interest rates and that will increase spending and increase investment. Maybe that works in some circumstances, but at ultra-low rates, you can actually have people wanting to save more when interest rates are low. Can you explain that?

[00:27:56] Edward

Yes. The relationship between the role of interest in savings is very important. I have a chapter where we elaborate. In the 19th century, one of the early English economists, Nassau Senior, first professor of political economy at Oxford, talked about interest as the reward for abstinence and encouragement. You need it. It’s not just a reward for abstaining, but it’s also a way of compounding your wealth or capital over time.

I’m going to leave aside, for a moment, the question of whether a very low interest actually causes you to save more. But if the low interest actually slows the compounding of your wealth, then everything else being equal, you will have less consumption in the future. Now, that would be compounded if the low interest also encourages you to take on more debt. I think we came to realize that with the subprime crisis. It was not just a US phenomenon. US private sector debt increased by about 50% of GDP in the decade up to 2006-07. That was British household debt, roughly the same order, increased. Spanish and Irish, on the periphery of Europe, much greater, and Iceland was off the charts.

These levels of private debt increases were either, in the US case, roughly on par with Japan at the end of its bubble economy period, and in the case of Spain and Ireland, much worse than Japan. You’re aware of Richard Kuh, the Nomura economist. He came out with this thesis called, The Balance Sheet Recession. The idea that after a boom period, your balance sheet is out of order. You could say it’s a sort of Minsky and Keynesian idea in a way. You’ve got too much debt relative to your income and you need to improve your balance sheet, and that is going to be a drag on demand.

There is one of your ways in which the low rate encourages a lack of savings and a buildup of private sector debt. When you get to a turning point, you find that consumption going forward is lower than it would have been otherwise. So that’s one area, one pretty clear area in which the buildup of debt and the lack of savings lower consumption. That was also underlined in a book called, The House of Debt, by two American economists. I think they’re called Atif Mian and Amir Sufi. I think they show, in that book, that in the counties in the US that had the biggest buildup of debt, household debt in the period prior to the GFC, they had the biggest dinks to consumption going forward.

This is an area where you see the asset price bubble, in this case prior to 2006-07 in US real estate, being associated also with dissaving and the accumulation of debt. In that case, you can see the interest working twofold: one, to encourage the asset price bubble, and two, to encourage households to take on more debt. In that case, as you know, it was the American households, in aggregate, taking out $500 billion a year in mortgage equity withdrawal to boost that consumption.

[00:32:41] Kevin

So we’ve got low interest rates, in that explanation, encouraging taking out of debt which ultimately leads to lower consumption when the bubble bursts and balance sheets need to be repaired. So it’s kind of lowering future consumption. There’s also an argument that it lowers current consumption in the sense that you have this long-term goal in mind of how much money you need to retire, and then with interest rates at zero or 1, or something very low, then you need to save more. It’s another argument.

[00:33:25] Edward

No, no, no. That’s quite right, and I do mention this. I think perhaps one of the problems with economics is this assumption that every nation, every person in the world responds in exactly the same way to the same economic factor. As I point out, in the book, in the US, households have greater exposure to real estate because there tends to be high levels of household ownership and more exposure to the stock market, whether direct or through pensions. Whereas in Germany, more people rent. Actually, German households keep more of their assets in cash or bonds.

I think what we see is that the Germans actually felt the pain of the negative interest rates; well, of low and then negative interest rates in the last decade, much more than the Anglo Saxons, because the Anglo Saxon said, “Hey, I’m not getting any money in my bank account, but my house is getting up 10% and my equities have gone up 15%. So who cares if bond yields are low and interest rates are low?” I think there was a slightly different response depending on where you were, and again, back to the composition of your personal balance sheet.

[00:35:19] Kevin

So a cultural difference in the willingness to tolerate abstinence, I guess. The Anglo Saxons don’t really feel that abstinence pain a little more than the Germans. I wanted to talk about, just to segue a little bit. you talked about different responses depending on the country and the culture. Another way that you talk about, which I think is quite important and not something that I always think about with low interest rates, is this notion of zombification or zombie companies.

You say that if you look at what happened after the Euro debt crisis and the insolvency rates, actually, the lowest insolvency rates were in Greece, Italy, Spain, places where one might have expected higher insolvency rates. You talk about companies being allowed, because of low interest rates, to continue to limp along. I wonder if you could just explain that process, but please explain why that matters in terms of the feedback loop of low interest rates begetting continued low interest rates and then continued slow economic growth, because that’s really what we’re worried about here.

[00:36:50] Edward

Well, the zombie corporate phenomenon was, actually, first identified with the savings and loans associations, the threats that got into trouble in the 1980s. But as a widespread phenomenon, it was described in Japan in the 1990s. If you remember, there was a lot of criticism of the Japanese authorities for allowing the banking system to engage in what was called, “loan forbearance,” of allowing companies that had too much debt, that had too low returns on capital, they were allowed to stay in business. But then, if you think about it, Japan was also the first country to introduce the zero-interest rate policy, ZIRP. Ultra-low and zero interest rates are themselves a policy of loan forbearance.

You fast forward 15 years and various international bodies such as the OECD and the Bank of International Settlements start putting out some quite interesting papers on the zombie phenomenon. They note, as you say, that in countries that had the most severe financial sovereign debt crisis, in 2010-2011, such as Italy and Greece, those were the economies that probably needed a shot in the arm and the reallocation of resources.

Instead, once the ECB got round to promising to do whatever it takes, once the markets and the banks and the governments realized that the ECB had their back, so to speak, there was a policy of loan forbearance instituted through the very low interest rates. What the OECD and the Bank of International Settlements economists looked at is they found that sectors that were full of zombie companies, the more efficient companies ended up paying higher interest rates than they would have done otherwise, that there was less job creation, there was less investment, and so forth.

If you’re getting less investment, less jobs, less new entrants. Not only were firms not leaving the industry, but the corollary of that was that there were fewer new entrants. This goes back to the Schumpeterian creative destruction. I would ascribe it, in large measure, to the policy of loan forbearance aspect of zero interest rates. It was actually contributing to the zombie phenomenon, and the zombie phenomenon was in turn contributing to low returns on capital and declining and stagnant productivity. There you get this low rates begetting low growth and low growth begetting lower rates, so to speak.

[00:40:34] Kevin

It’s interesting just listening to that description. You can almost think of these zombie companies as being state sponsored entities in some ways. If you’re a new entrant, why do you want to go in to compete against the government or a company that the government has an interest in to keep going? As I was reading the book, it struck me that maybe there’s another type of zombie company out there that we don’t call zombies. Maybe we should call them white walkers or something. They kind of should be dead, but they can kill you.

Those are companies like Uber and WeWork, which you talk about. You think, well, how can Uber be a zombie company because it’s growing so fast? You talk a fair amount about it, and I don’t want to mischaracterize what you’re saying. You may not think of it as a zombie, so I’m putting that question forward to you. Companies like Uber that are unprofitable and where there’s not a clear path to profitability, yet they’re able to grow because of lower interest rates, ultra-cheap capital. Do they have that same kind of feedback effect on the economy?

[00:41:58] Edward

Yeah, I think so. By the way, in the chapter where I talk about the classic zombies, they tend to be in industrial firms. I then segue into the misallocation of capital in the tech sector, and argue that yes, the unicorns (not every unicorn- unicorns are these great companies with billion-dollar valuations that have yet to come to the market), in most cases are yet to turn a profit.

So, to go back to what we were saying earlier about the length of time in production. If capital is, in effect, free, it doesn’t really matter how far in the distant future your profits are going to be, you will encourage the most speculative investments. A highly speculative investment which never actually meets fruition is a form of misallocation of capital, and that capital could have been used elsewhere. I think Uber probably is quite a good case. I mentioned Uber in certain detail, and there are interesting things about Uber. I probably didn’t say it in the book, because the cost of borrowing and car leasing was so low, anyone could get too many Uber drivers. The Uber drivers were earning extraordinarily low returns. Their own productivity was extraordinarily low.

As for Uber itself, it was blowing billions of dollars on autonomous cars and flying taxis. If you hadn’t been drinking Kool-Aid in the boardroom, you might have thought that these projects were never going to fly. It’s very difficult to say, but I don’t think that a lot of the capital that went into Silicon Valley, in this period, has actually been productivity enhancing. There are too many, if you will, pie in the sky ventures. That then, again, links back to the high asset valuations that you get during periods of the speculative bubbles that accompany ultra-low rates.

You have to remember that the Silicon Valley businesses, they’re not really created to generate useful economic function at some stage in the future. They are purely financial. I sound a bit cynical, but I’m saying this having read the memoirs of people who actually work in Silicon Valley. They say it’s all about solving for the capitalization rate, it’s all about preparing for the IPO, and so forth. They’re sort of casino chips, these businesses, but they can suck in a lot of capital in the process. Everything is sort of related.

Why are people donating a huge amount of money, pouring it into these tech ventures? Because in a time of very low interest rates, you need to hit the ball out of the ballpark. So you go for the long shot bet. Because markets have a sort of Ponzi scheme aspect to them, as long as other people were coming in after you, you had these ramping up of pre-market valuations in Silicon Valley. That was a sort of Ponzi scheme and, obviously, fun while it lasted.

[00:46:17] Kevin

I’m going a little bit off the script that I had thought about, but as you’re talking about that, I was reminded of Bill Janeway who had a really interesting book that he published about 10 years ago. One of the things he talks about is there may be some long term benefits to bubbles, because low interest rates or bubbles generate a lot of investment (and I’m thinking here in particular about the telecoms boom in the late 1990s, early 2000s), yeah, the companies go out of business, but we still have the fiber optic cable that they laid underneath the Pacific Ocean, and the society benefits from that infrastructure investment that is facilitated by the ultra-cheap capital in the bubble, etc.

I wanted to ask you the extent to which you agree with that. Now, it sounds like, just in that last answer, you were saying that the kind of investment we’ve seen fueled by ultra-cheap capital recently hasn’t been laying fiber optic cable underneath the oceans. It’s been more, I don’t know, focused on rent seeking or consumption, and therefore, there isn’t that tangible capital base that we’re left over with after the bubble that might benefit us.

[00:47:42] Edward

Yeah. I have thought about this question over the years. In Devil Take the Hindmost, I talk about the British railway mania of the 1840s when a huge amount of new railway rail track was authorized, and it seems that the result of that was there were too many poorly designed rail routes, sometimes competing, and it seemed to permanently lower the return on capital of the UK rail system. In the case of the dot-com fiber optics, if you remember, there was massive initial oversupply. They talked about dark fiber being 95% of the fiber optic cable that was not being utilized. The slack got picked up a few years later, as far as I understand.

But really, insofar there is a benefit, there is a transfer of wealth from the investor to the consumer. Ideally, let’s say, in a balanced economy the investor should be doing something that is useful; investing in a business that provides some utility to consumers and that both parties should get something from it, and the consumer should pay enough to deliver a positive return on capital for the investor.

In the case of all those telecom companies in Britain (they were called alt-nets and so on), when they went down to zero it was probably not an efficient allocation of capital for society as a whole, even if the consumers end up with some benefit. I think that’s a more judicious view than, hey, bubbles are fun and afterwards we get all this great stuff.

[00:50:08] Kevin

I just remember reading that, and when someone’s presenting the flip side of an argument, I don’t think I’m a good enough economist or historian to really have a firm answer. But I could see that, particularly because I lived through the telecoms bus and lost a little bit of money on a few telecom companies that are no longer around, but then we’re here having this conversation that’s being facilitated by technology investments. So yeah, I’m not really sure how I come down on that one.

[00:50:46] Edward

Kevin, let me give you another case in the railway mania, Britain, which is quite interesting. The leading figure of the British railway mania was a guy called Hudson out of York. They operated, up in York, on a narrow track railway. As he took over all the other railways, they moved everything to the narrow track, and narrow track actually turned out to be very inefficient.

It was as if, during the takeover mania that accompanied the railway boom, we were actually put onto the wrong railway system. If you ever taken a train in England, you’re sort of huddled together in a narrow carriage and, might I say, the trains don’t carry as much freight. That was a case where not only am I saying you get too much capital invested, but you also actually end up with a suboptimal railway technology. There is a case for investing rationally. If you invest rationally, you’re likely to satisfy all parties, I think.

[00:52:11] Kevin

Let’s talk about just one or two more examples, subtle examples of, again, trying to keep on this theme of the unintended longer-term consequences of low interest rates. One that I hadn’t really thought about, it made a lot of sense once you explained it, was I think you might call it a globalization bubble, how low interest rates facilitated the existence of quite complex global supply chains. That, in the short term, is good in the sense that you basically can get things produced where labor is the cheapest, which reinforces the low inflation, which keeps interest rates low, etc. But it also creates this sort of fragility, which obviously, we’re experiencing now, and means that, potentially when interest rates are higher, then maintaining those supply chains is not so easy. Could you explain that?

[00:53:22] Edward

Yeah, I can try. The relationship between interest and what we call globalization is interesting. The first phase of globalization, the second half of the 19th century up to just before the First World War, was associated with declining interest rates. There was basically, I’m talking roughly, from 1850 to 1900 in the US and the UK, a very long bull market in bonds, falling long-term rates. At the same time, this was a period of rampant globalization. There does seem to be a link between them in that the more we trade with the rest of the world and access cheap labor in the rest of the world, there will be a disinflationary or deflationary impact on the cost of traded goods, and there will be a dampening of the bargaining power of the domestic labor force.

That combination of weak bargaining power and falling traded goods prices induces a decline in the interest rate. So that’s a 19th century example. Then you go back to a more recent period where global trade is largely financed in dollars, and these global supply chains, they’re dollar funded, the dollar being the global reserve currency. As the interest rates fell, as you had globalization, as you had a move towards globalization, that had a dampening effect on domestic wage growth and inflation and interest rates. That brings down the dollar, the cost of dollar funding. It’s much cheaper to say let’s expand our supply chain a tiny bit further.

Think of it this way, it goes back to, as I was mentioning earlier, the roundabout production methods. Imagine tying up capital in a very long supply chain. Well, if the cost of funding that supply chain is very low, you’re going to have a very long supply chain, but the longer you create the supply chain, the more potentially fragile it is to, say, for instance, a rise in interest rates but also to other fragilities of the type we’ve seen more recently with the COVID pandemic supply shocks.

Then there’s the other element, which is you have the political backlash against it. Suddenly, the workers who haven’t had a decent pay rise for a decade or two suddenly think, “Hey, hang on. Why are they outsourcing all my jobs to the far end of the world?” And hey, presto, you’ll get a man with ginger hair saying he’s going to solve all your problems. The point is, one can try and analyze where the source of the discontent comes from. As I said, the linkage between globalization, low interest rates, and then the feedback into political discontent seems to be not provable, but it seems that you can observe something along those lines.

[00:53:23] Kevin

Yeah, it’s funny because that’s why I think economics is such a fascinating subject to study, because you push in one area and something else happens. It’s a social science. It literally evolves with society. Central bankers have been criticized a lot in your book and our book just generally, but they have a hard task. You can see why they would say, “I’m just going to focus on inflation because all this other stuff is too complicated.”

We had Andrew Smithers on the show, the last show, I think his hope is that, eventually, central bankers could get to the point where they could say, “Hey, I can’t lower interest rates anymore, because if I do, I’m going to push other relationships out of whack.” Andrew is talking about one particular relationship, which I know you’re aware of which is the Q Ratio. But more broadly speaking, what we’re saying is that a narrow focus on interest rates risks destabilizing other areas.

Oftentimes, we don’t even know, until further down the road, that we destabilize. I think this globalization example is an excellent one in that sense. It takes a bit of thought and almost ex-post observation to realize we’ve created another aspect of fragility here.

[00:59:09] Edward

Yeah. One way I think of it is that the very low interest rates are like fertilizer and they over-fertilize the environment and lead to, in a way, a weak and fragile ecosystem. I discuss, in the chapter on creative destruction, a metaphor that’s quite commonly used of the central bankers, when they prevent the process of creative destruction, they’re a bit like the US Forest Service that prevents forest fires, and in the end, you get buildup of understory and so forth, until eventually you get more fires and more severe fires as a consequence, and a less healthy forest.

The question of what central bankers should be doing is a deep and complex one. Jim Grant refers to the interest rate as the universal price, the most important price in the capitalist system. Now, I really think it is an issue that we have to think about if we think we’re living in a market economy, and think that that is the type of economy that we want to live in. Do we want any body of people determining what the universal price is that affects everything else in the system? If so, if we do want a committee of people making that decision, how are they to be judged? What inputs are they going to have? I think I’ve long been of the view that the inflation mandate, in particular, the inflation mandate then became a narrow specific target, it was flawed.

The early criticisms of what used to be called price stabilization, as the aim of central banking, that early criticism was put forward by Friedrich Hayek who was a young economist working actually at NYU I think on his PhD in the 1920s. At the time, when the Federal Reserve, under Ben Strong, had adopted a policy of price stabilization, it was supported by really all the leading economists of the day: Keynes, Ralph Hawtrey who was a distinguished economist at the UK treasury, Gustav Cassel, and the greatest American economist of the 20th century, Irving Fisher. So the great and the good were in favor of price stability, and the experiment with price stability ended in 1929-30 with a great crash and depression, and severe price instability.

That lesson doesn’t seem to be learned. You mentioned earlier that Ben Bernanke is a historian of the Great Depression. Well, I don’t want to be too harsh on Bernanke, but he has a sort of very narrow, rather dogmatic interpretation of what occurred in the 1920s, which is pretty much borrowed from Milton Friedman and Anna Schwartz’s Monetary History of the United States. In particular, the famous chapter they wrote which was then published as a standalone book called, The Great Contraction, with the idea that there was nothing wrong in the 1920s. Everything was going hunky dory until the Fed tightened a tiny bit too much in ’28, ’29, allowed the stock market collapse, and then allowed money supply to collapse.

The Bernanke reading of history, leaving aside Bernanke, I don’t know if you read it but Alan Meltzer wrote a sort of hefty two or three volume history of the Federal Reserve. They all leave out the Hayekian criticism of the price stability policy of the 1920s, which was a critique delivered in real time, rather than ex-post one. As I mentioned in the book, we like to think that history is written by the victors, and you could have said that Hayek analytically was a victor of that period. But he also didn’t win the arguments in the 1930s. He’s been airbrushed out to the histories, even though he won a Nobel Prize forty-five years later.

[01:04:28] Kevin

It’s funny you mentioned how deeply embedded the Friedman kind of view of the Great Depression was. The first business class I ever took, I think it was in high school, it was taught by a high school business teacher in Harrisburg, Pennsylvania who believed in Milton Friedman. I came home with a copy of Capitalism and Freedom at the age of 16 and told my dad this is what I was learning in the business classes. He’s like I thought you were going to learn what a balance sheet was, not what was going on with money supply in the Great Depression.

You talk about Benjamin Strong, who was the president of the New York Fed in the 1920s. There’s a quote from him where he, basically, in 1927, is saying (because I guess they were getting a lot of criticism for stoking a stock market bubble), “It’s not really our business, what’s going on with the stock market. There’s nothing we can do about that. Even if we were worried about it and we tried to sort of prick the bubble, we would have collateral effects and we couldn’t control that.” It really echoed the way the Fed, I think, saw the world post the 2008 crisis. It’s another example of not really pulling the full lessons from history.

[01:05:51] Edward

Well, Kevin, we can go back earlier. The same view was held in the late ’90s during the dot-com bubble.

[01:06:02] Kevin

That was the Alan Greenspan, “We’ll clean up afterwards,” view.

[01:06:06] Edward

Exactly. Bernanke wrote a paper, which I think was ’98, ’99 on that, with someone called Mark Gertler, which was, don’t deal with the aftermath of bubbles and don’t try to lean into the wind, or whatever they call it. My guess is that’s why Bernanke was brought into the Fed to buttress the de facto, given, if you will, an ideological gloss on the de facto position of the Fed. Having done it then, they let the dot-com bubble go to its extremes, they then tried to clear it up and they sort of got into a mess again, and then they did it a third time.

There is a nursery rhyme that the English school children used to learn. I don’t know if the Americans know it. There was an old lady who swallowed a fly. Do you know that? There was an old lady who swallowed a fly, I don’t know why she swallowed a fly.” And it goes on, “She swallowed a spider to catch the fly, and then she swallowed a bird to catch the spider to catch it. Eventually she swallows a horse.” It ends with, “She’s dead, of course.” So you build up a bigger problem to solve the problem that you were dealing with in the previous year.

I’ve been of that view, the nursery rhyme view, for almost 20 years. If I felt I had grounds to change it, I would have. It does seem we build up the Fed policy of trying to clear up afterwards, and then not really being cognizant of the unintended consequences of the clear up, gets you into what one might call a deeper state of disequilibrium than where you would have been otherwise.

[01:08:24] Kevin

Yeah. That’s the major theme that runs through the Rise of Carry is this kind of ratchet effect where each intervention encourages carry trades to grow, encourage fragility debt to grow, and then the next intervention has to be bigger and bigger. I guess it’s a little disturbing that two or three years of work could be summarized in a nursery rhyme, but there you go.

Listen, I think we’ve got to wrap it up.

You had a quote, in the book, along the lines of capital is the discounted value of future interest or future income. Capital is the discounted value of future income, and to do that calculation, we need interest. If interest rates are at zero, then there’s no capital, and if there’s no capital, there’s no capitalism. Is it that serious in your mind, this policy of zero interest rates? I know we’ve moved away from it, at least temporarily, but was it a genuine threat to capitalism in your view? Is that how you saw it, or see it?

[01:09:48] Edward

Yeah. I don’t suppose I would have written that if I’d been insincere about it. I had this last concluding chapter where I call it “The New Road to Serfdom,” because it draws on Hayek’s book, The Road to Serfdom, written in, I think, 1943. Hayek is just talking about wartime controls, and he has this fear that these wartime controls once in place will never be removed, and one thing will lead to another, and we’ll all end up in a socialist state. Hayek, as we’ve been talking about earlier, also had these views (and probably of all the economists, all the great economists), he had the deepest views both about interest but also how knowledge and information is decentralized in a society, which is why one needs the market system to market prices in order to coordinate activity.

In the last chapter, I tried to point out that if you have interest rates going lower and lower and the system malfunctioning; malfunctioning both due to low productivity, low investment, low savings, and the financial fragility that you’ve written about, then you require greater and greater state intervention to offset this. This is really what we’ve seen with the central banks not just taking interest rates to zero, or negative in some places; not just buying government bonds, but then intervening in the credit markets, and then more recently feeling they had to have a say about green investment or decarbonization.

It was a creeping advance of what you might call central bank capitalism. I think that’s because the modern monetary theory has been put to the side for the moment. If you want a capitalist system to work, it’s one in which it has to deliver, as Hayek says, productivity growth and economic growth. It has to be a system in which ordinary people, who don’t have great advantages in their life to begin with, can accumulate capital, buy houses, and save for retirement.

People have to have a stake in the society. Zero interest rates make retirement savings difficult, almost impossible. Actually, as Jamie, my assistant, your co-author says, that the low interest rates made the price of security more expensive; whether it was your retirement security, whether it was your house, whether it was the cost of your education. Security becomes more expensive and out of reach of many people. Then the people, once that happens, fewer and fewer people support the system and then the system is likely to atrophy. It’s corroded from within, I would say.

[01:13:42] Kevin

Well, I very much appreciate that summary. I would say, what I’ve tried to do is direct the conversation to some of the unintended consequences that we might not all have thought about of low interest rates. People may or may not agree with it. I’d say pick up the book, read them, think it through, and make up your own mind. The book is called, The Price of Time. Thank you for your time, Edward. We really appreciate it and wish you all the best.

[01:14:17] Edward

Thanks, Kevin. Nice to speak to you.

[01:14:20] Kevin

Okay. With that, I’ll pass it back over to Niels.

[01:14:24] Niels

Thank you very much, Kevin and Edward for a very insightful conversation on the topic of the price of time and money. Edward has really a wealth of fascinating historical references and has a wonderful way of putting them into a narrative that is easily accessible.

As we learned today, he can even put central bank policies into old nursery rhymes. I must say that his view that zero interest rate policies really are a threat to capitalism was very interesting, as well as how he ties together the unintended consequences of low interest rates with globalization and the fragility that we see today in the global supply chains.

Make sure you go and follow Edward’s and Kevin’s work, as well as getting a copy of their books, because as you can tell from today’s conversation, some of these ideas and topics are not being discussed enough on mainstream media. From Kevin and I, thanks so much for listening, and we look forward to being back with you on the next episode. In the meantime, take care of yourself and take care of each other.

[01:15:30] Ending

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