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Richard Sylla is a Professor Emeritus of Economics and the former Henry Kaufman Professor of the History of Financial Institutions and Markets at New York University Stern School of Business. He teaches courses in financial history, economic and business history of the United States, and comparative enterprise systems. Today he joins the commentary to discuss:
- Interest rates are the trade off between the future & the present.
- This repressed interest rate season is unlike anything in 4,000 years.
- Modern Monetary Theory takes inflation far too casually.
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Richard Sylla: The Economics Of Time
August 20, 2019
“It is true that we don’t have a system anymore where the government, itself, has to pay you gold and silver if you want it, it just gives you paper dollars. It makes it a little easier for the government to borrow money, so we could spend a lot of money on infrastructure and that might be good if we have excessive unemployment, but I’m a little skeptical. Modern Monetary Theory recognizes the inflation problem, but I think it dismisses it too casually.”
– Richard Sylla
Kevin:A few weeks ago, Dave, we talked about what interest rates are, because to the uninitiated, a person might think of reading A History of Interest Ratesas very, very dry, but actually, the rate of interest worldwide over the last 4,000 years has been a great measure of the drama of human history. Interest rates rise when risks rise. Interest rates fall when risks fall. So you can actually see the pattern of human history if you just simply look at the pattern of interest rates.
David:Richard Sylla has added so much to that. Whether it is a book on Alexander Hamilton and finance of the period, or the evolution of American economy, he has looked at interest rates from a long-term perspective. I was first introduced to him through a book that he co-wrote with Sidney Homer, A History of Interest Rates. He is a Professor Emeritus of Economics at the Stern School of Business at NYU and has spent a lot of time thinking and working as an economist.
He has done research with the National Bureau of Economic Research and loves to curate. You can tell it not only in the books, but now as Chairman of the Board of Trustees for the Museum of American Finance, which is a Smithsonian affiliate museum there in New York. He loves for people to know what the history has been and I think also, what it tells us about where we may be going.
Kevin:And we talked three to four weeks ago about how interest rates are, in a way, a measure of humility, and basically, admitting you don’t know, certainly, what the future will bring.
David:Interest rates tie together the universe of lending in every form, across geographies. So the history of interest rates is, by necessity, a significant endeavor. It is not only significant to write (laughs) if you look at the size of the book, it is also a significant endeavor to read. And as I was explaining to my kids, the intriguing aspect of rates is that they punctuate the stories of innovation and of enterprise and of trade, and of migration, of war, of financial market pressures.
Interest rates are worth observing, I think, in part because of the drama that they indicate all around them. So to be intrigued by them is to be intrigued by indicators, to be intrigued by signs, to be curious about the clues which are a part of the ongoing human story which looks back ancestrally, but also to our heirs, what they will receive from us.
There are two men who capture and convey that intrigue with interest rates in their book, and the title of the book is A History of Interest Rates, now in its 4thedition. Sidney Homer, a Solomon Brothers veteran, is no longer with us. Richard Sylla joins us today as the coauthor of this guide on rates to explore the past of interest rates, the present circumstance, and perhaps the future, as well.
* * *
I would love to start with the fact, Richard, that you are now in the 4thedition. Between the 3rdand 4thwe had the Cold War come to an end, we had massive improvement in the reduction of capital controls, an increase in international trade. What else can you think of that shifted in that period, the 1990s to 2005, when the 4thedition came out that was important to the discussion of rates?
Richard:I think, in general, the much-used word globalization was important. We used to have a very segmented world. There was the Western developed countries, which would include Japan. Then there was the communist block of countries, principally, the Soviet Union and China. They didn’t have a whole lot to do with each other in terms of economics. And then there was the third world, India, Latin America, that wasn’t choosing up sides but just was the third world. Often these countries, I think of India and Latin America, in particular, were very restrictive in terms of their economic interactions with the rest of the world.
And then we had a phase of globalization which got going, I guess, in the 1980s and picked up steam in the 1990s, and really became a big thing in the 2000s, the decade from the 2000s to before the crisis, anyway, up to 2007-2008. So globalization just changed everything. Instead of having these three compartmentalized parts of the world that interacted politically, but much less economically, suddenly the whole world opened up. Most of the capital in the world was in the developed countries, a lot of the labor was in the communist block, like China, in particular, or in the third world, India, in particular.
And then suddenly, the capital of the developed world, the West and Japan, had the whole world opened up to it by globalization and it had various manifestations. You could buy securities in the emerging markets, invest in them, maybe set factories there. That had implications for the United States. We imported more and more from China. Basically, our capital began to use Chinese labor. It was just a very different world from the one I grew up in up to the 1980s and 1990s.
David:What does the 5thedition look like? There are things in the 4,000 years of interest rate history which have only now in the last 5, 10, 15 years appeared. So what political, what geopolitical, what social and market-related shifts might get included in a 5thedition?
Richard:I think we would have to talk about a pretty detailed analysis of what has gone on for the last decade or so in terms of the major financial crisis and the reaction of political authorities and central banks to that crisis. That seems to me the big change of the last ten years where we had a major financial crisis and the way that it was handled was by massive central bank interventions, purchases of government bonds, which central banks always did, but then in the case of the U.S. Federal Reserve, they bought mortgage-backed securities, and I think in Japan they are buying equities, and the European Central Bank is buying a lot of sovereign debt in Europe. So that is the big change of recent years.
Now, can that continue? Will that keep going on in the future? We started to normalize, the Fed began to increase its rates in 2017 and 2018 and reduce the size of its balance sheet, but Europe, which is growing more slowly than the U.S., has continued to have central bank interventions, and I think the Bank of Japan is now even buying equities in Japan, so we’re getting a little out of sync with some of our major trading partners, and I want to see how that plays out. But I told the publishers that it was much too early to contemplate a new edition of the book because we were in this unusual period and it would be better when we get a little bit back to normal. Assuming we do, that would be the time to evaluate the period we have been through.
David:There is a famous Austrian economist who once said that the cultural level of a nation is mirrored by its rate of interest. The higher people’s intelligence and moral strength, the lower the rate of interest. Does that suggest that we are the most brilliant of any age, with the greatest morality in history (laughs)?
Richard:Well, I don’t know about the greatest morality in history. We certainly have the highest economic development in history and that includes financial development. Modern financial markets are pretty sophisticated even though they can have their troubles, as they did a decade ago. You could argue that the level of economic development would say we are at a peak of civilization. I’m not sure about morality. I’m not sure that that has gotten improved all that much more. But historically, if you look at the sweep of history, even going back to Babylonia, and Greece, and Rome, there was a pattern that rates go down, and when those civilizations were at their peaks they had the lowest rates, and then as they began to decline – we talk about the decline and fall of the Roman Empire – well, the rates went down and they were at their lowest in the Augustine age at the beginning of the Common Era, and then they went up as Rome declined. You see that pattern, a sort of a U-shaped pattern of rates are high when a civilization first gets going, then as it improves and reaches its highest level of civilization rates bottom out, and then as the civilization declines the rates move up. That pattern has repeated over the 4,000 years or so of interest rate history that we are able to document to some extent.
So what I would say is that our rates are very low now but they were kind of repressed in a way because these massive central bank interventions pushed them way down, and I think that if we get back to more normal levels, and we can talk about what that might be – history is something of a guide there – but I think that we certainly are at a peak of economic development in our civilization and we will have to see whether we can get through this unusual period and get back to something that looks more like the 4,000 years of previous history.
David:So you have the U-shaped pattern, which tells the story of the rise and fall of nations, and that is on an empire-by-empire basis, yet the grand sweep of rates seems to be something of a shrinking through time. If you look back to ancient Greece through the medieval and renaissance periods to the present, you could set aside the spikes which have marked whether it is the end of empire or significant short-term upheaval. How is it that rates changed course so dramatically, and defied that downward trend in the 20thcentury – 20thcentury circa 1960s, 1970s, into the early 1980s – almost on a global basis a significant rise in rates in contrast to that steadily declining trend since ancient Greece.
Richard:Oh yes, the 20thcentury, particularly the period you refer to from the mid to late 1960s into the early 1980s was very unusual. It ended up containing the highest rates in U.S. history. There was, I think, an over 20% prime rate, and government bonds got up to 14-15%, maybe even a little bit above 15%, and that wasn’t so long ago. At least, I remember it very clearly. Perhaps you do, too. So that was an extreme, I would say, in my lifetime.
As an author of A History of Interest Rates, I have been pretty lucky to have actually observed the highest rates in U.S. history around 1980-1981, and now we’re looking at the lowest rates in U.S. history, and in some places in the world, not the United States, rates have even gone negative, which is really an unusual thing that the economists had a hard time imagining.
David:So what are rates supposed to tell us? Remind us of the message implicit in a rate. What is the importance of an interest rate as a signal?
Richard:I think the basic economics of it is that it is a financial theory, or a capital theory, we might call it. It’s the economics of time. And the interest rate shows you the trade-off between present and future. Modern financial markets make it possible to transfer money from the future to the present. A good example of that is a home mortgage. A young person getting married and starting a family doesn’t really have enough savings accumulated to buy a house, but they can pledge their future income to paying mortgage payments and thereby transfer money from the future to the present, and the mortgage interest rate represents that.
Other people are thinking about retirement when they are not able to work anymore, or don’t want to work anymore, or shouldn’t have to work anymore, and they are thinking about transferring income from when they are working to the future when they’re not working. So the modern financial system allows people to save now and then draw on those savings later on in life when they retire.
I think those two examples, a mortgage transfers money from the future to the present to enable us to buy a house, and retirement savings and retirement funds allow us to transfer income now to income in the future when we won’t be working anymore. So the interest rate is this kind of trade-off between the future and the present.
David:I thought it was interesting, and this is just picking up on … the grand sweep of your book starts with the ancient world – Sumerian, Assyrian, Babylonian and Egyptian – I thought it was interesting that the credit markets remained under-developed in ancient Egypt. It was an authoritarian state, but by contrast you had very developed credit markets in the Sumerian, Assyrian and Babylonian cultures. This is where enterprise and free trade were a driving force. Do you have any thoughts on the healthy development of credit markets in particular political contexts?
Richard:I think the development of credit markets, of course, is one of the reasons why there is a long-term trend toward lower interest rates. The financial development in the modern era – I could think back to the medieval and Renaissance Italians who invented modern banking, to the Dutch Republic of the 17thand 18thcenturies when the full range of modern financial institutions and markets developed. The Dutch had a government debt market, they had a Bank of Amsterdam as sort of a central bank. They had an equity market, you could buy stock in the Dutch East India Company, Dutch West India Company. So the Dutch had companies and banks and, in particular, well-developed securities markets so the Republic could borrow money. It actually won its independence from Spain by being able to borrow more money than Spain could, at lower rates than Spain could.
And then you see the same thing. Basically, the English adopted Dutch finance at the end of the 17thand early 18thcenturies. The United States under Alexander Hamilton duplicated these institutions. And then you see Japan, when it modernized in the 1870s and 1880s, looked at the rest of the world and they founded a Bank of Japan in 1881, and they had a government debt market in the 1870s, and the banking system. And so, civilizations do develop better ways of financing entrepreneurship and financing governments. And I think, if you look back into ancient history, the Greeks and the Romans improved on the Babylonians and the Romans, in particular.
If you remember The History of Interest Ratesstudies the full range of interest rates that existed at any time, but the real goal of the book was to say what the lowest rates were that you would observe in any civilization. And the Romans actually got down at the time of Augustus where people could borrow money at 4%, so that Roman civilization developed pretty good financial markets, and then, as I say, the modern civilizations, from the Italians of the Renaissance to the Dutch, to the English, to the Americans, and the Japanese.
And in the 20thcentury, of course, in our own time we see these markets being extended all over the world to emerging markets we talk about, and the independent states of the old communist countries. We’re seeing a lot of spread of modern financial technologies throughout the world. The Egyptians, apparently, did not adopt these technologies to the same extent that the Greeks and the Romans, and maybe the Babylonians did. Not everybody is equally developed financially.
David:When I think of rates, going back to that earlier question, and a message implicit in the rate, is it fair to say that an interest rate is an indication of risk?
Richard:I think the structure of interest rates tells you about risk. The lowest rates are usually on the safest, least risky assets, and in modern times we consider that to be government bonds, sovereign debt, and in the case of the U.S. national debt market, which is probably, well it is, I think, the largest financial market, and the assets of one issuer that has been observed in world history – what do we have, a 21-22 trillion dollar national debt now? And the government, of course, owns part of that, so maybe it’s only 15 trillion or so out in the hands of the public. But that is considered safe, and when there is financial turmoil in the world people sell riskier assets and buy U.S. government debt, and I guess they buy German debt and French debt and Italian debt, as well.
So the safest assets in the modern world seem to be these debts issued by sovereign governments, which, in some cases, like in the U.S., they have the ability to print their own currency, which seems to make them safe. There is very little default risk as long as the government can print its own currency. So these are the low rates we observe, but then anything that has more risk to it – corporate bonds have a higher yield than government bonds, and stocks which are riskier still have higher total returns.
And of course, there are real assets as well – oil in the ground and housing stock has its own level of riskiness to it. So there is always the structure of interest rates. At the lowest rates you can get on the least risky assets and then the more risk, usually the higher the rate – the risk premium, we call it in economics.
David:So we look at the risk premium and obviously with central banks playing a pretty significant role in the markets today, over in Europe we have 14 commercial entities with negative rates, alongside lots of governments, a total of 13 trillion dollars in debt with negative yields, and that has brought that rate structure down across the board, almost a crowding out effect, and I just wonder what the understanding of the market is of maturity risk, of credit quality, and of things like that when the variable, the interest rate, all of a sudden isn’t speaking as loudly as it used to.
Richard:Well, that’s right. I think the rates are repressed, or you might even say rigged today by the central banks. They say they’re fighting the economic slowdown, they’re recovering from the financial crisis, but they are really pushing rates down to extremely low levels. I kind of wonder why people accept them and go along with them. We haven’t had negative rates in the U.S., but we had close to zero rates on the short-term stuff a few years ago.
I think economists need to think this through. Why would people put their money into an asset that had a negative yield? The negative yields at really nominal terms are really quite low, fractions of a percent, and I think it is because ten years after the crisis people still remember the crisis and the difficulties of borrowing money, the drying up of liquidity then, and that’s our short-term memory. It can last a decade. Rates were extremely low at the end of the 1930s and beginning of the 1940s in the United States when people still remembered the Great Depression and bankers in particular remembered the Great Depression of the 1930s, and then they were holding excess reserves. Today banks have a lot of excess reserves mostly created by the central bank actions of buying up assets and adding to bank liquidity.
But I think one of the reasons is, bankers remember ten years ago when many of our major institutions, household names, were in danger of failing, and people still remember that. And so, they are being very cautious. I think that can change. It changed, certainly, from the 1930s and early 1940s to the post-war development. It may change again, but most people are forecasting slower growth in the future, particularly in the developed countries, than we have had in the past, so that tells me that when interest rates normalize they may not get back to the levels people were used to in the 1950s and 1960s.
David:This again goes back to the older world of Sumer, Assyria, Babylon. Do you have any thoughts on the sociology of temples playing the role of lender? Do we in the modern era somehow treat central bankers the same? They have a secret knowledge, they have a unique prescient insight into the future, mathematical wizardry and skills that, again, are almost reflective of the old world of temple lending as you go back to Sumer, Assyria and Babylon?
Richard:I think there were religious reasons for that. You mentioned temples and priests and so on, and so their religion caused them to support these temples and sometimes put their assets into the temple’s donations and things like that. That is a little different from modern central banking. We don’t rush to give our money to banks, and we can’t really give it directly to the Federal Reserve. There is not much of a religious reason attached to it, but there is a sort of mystique of central banking.
I think Mark Twain once said the greatest inventions in history were fire, the wheel, and central banking. So that shows you that people pay attention to the central banks and think that they are powerful, but sometimes mysterious institutions. And that is what we have done, and maybe we should think of the modern central banks as equivalent to the Babylonian temples, and in fact they often built buildings that are very impressive and look almost like temples. There is not much religion attached to it, I think, but there is the same kind of mystique that probably persisted in the past.
David:You mentioned a moment ago the issue of quality in the top of the structure in terms of risk. The best quality is sovereign debt. Quality is one aspect of a debt instrument. At one point in time there was no such thing as sovereign debt. There was the merchant, there was an enterprise, and that was considered the best quality credit. Now sovereign debt is at the top of the heap. Could that ever change, where commercial paper is of higher quality than sovereign paper?
Richard:Oh yes. Go back to medieval and early modern Europe. There were countries, with kings, usually, and the records show that merchants who had a kind of mercantile code of honor and fair dealing could borrow at lower rates than the kings could because the kings often defaulted on their debts. So it is very clear that a country, or a king, had to pay a higher rate of interest than merchants who trusted each other charged each other. So, certainly, sovereign debt has only become the safest of assets in the modern era and I think that relates a little bit to changes in the monetary system, too.
You know, money used to be based on gold and silver. Today it is something that governments create with the stroke of a pen, unrelated to the amount of gold and silver they have in reserve, and that makes the modern sovereign debt – take a country like the United States. It borrows 22 trillion dollars, and that is what the national debt is now, and people buy and hold that because it’s a promise of the government to pay you in dollars and the government that created the debt has the ability to create the dollars to pay that debt. We could talk about what those dollars might be worth and the markets think about that, but they don’t seem to be that worried about it of late.
David:There was a politician in the Midwest – this goes back 30 years or more – and the debate at the time was, devaluation of the currency, and one of the questions asked of this politician during a stump speech was, “What about social security? Will I get my check?” And his answer was, “Of course you’ll get your check. I’m just not sure what it will buy you.” (laughs)
Richard:That’s the inflation risk, see. I think for some reason inflation has been under control for the last ten years, and in the United States the Federal Reserve is on record as saying the inflation is lower than it wants it to be. That is something that we might talk about. But in any case, that’s the issue. What will your dollars be worth in the future? Sure, you’ll get your dollars.
There are past instances when people bought government bonds in World War II, prices went up in later decades and they got back less in purchasing power than they contributed, particularly in the great inflation, we call it, of the late 1960s through the early 1980s, when prices went up to basically 6% a year. The dollars people got who bought government bonds in World War II and the couple of decades after World War II – those dollars came back to them buying much less than the dollars would buy when they bought the bonds.
David:On that issue of inflation, this is a novel thing, at least that I am aware of, but how does a historian such as yourself, an interest rate expert, reflect on central bank inflation targeting, as a stated goal?
Richard:I’m skeptical of where they state the goal to be. The Federal Reserve, for example, seems to say that we should have 2% inflation, not more than that in the long run, and not less than that. I, and people like Paul Volcker, the former head of the Fed, wonder why 2% is a magic number. There is an argument that they make, and that is that the economic machinery works a little better, it’s like putting oil in the machinery if you have 2% inflation. The economy functions a little better.
I’m skeptical of that view. We’re often victims of our past, and I think when central bankers say we have to have positive inflation today they are remembering the 1930s when, of course, we did have drastic deflation and economic disaster that went along with it. But there are other instances in history where the economic growth exceeded monetary growth and so prices went down gently. The late 19thcentury in the United States is a good example of that. In other countries, in Europe, as well, there was a gradual deflation that didn’t seem to harm the economic growth of that era so much. In fact, people called it a Second Industrial Revolution.
So inflation targeting – I would like to see them target something closer to zero, and in that case we could say our money will be worth as much if they are successful in keeping inflation around zero, money 20 or 30 years from now would be worth as much as money today. But if you target 2% inflation, then money 36 years from now is worth half of what it is today. And then the investor, I think, has to say that that is the goal of central banks so I know my money is going to be worth half of what it is today, minimum, 35 years from now and I have to plan accordingly.
David:So that fights against the stated goal of price stability. Perhaps they can justify inflation targeting with the second mandate, full employment.
The spectrum of rates, as you list in your book, the range of rates studied there is from 10,000% at the upper end, to as low as a 10thof 1%. And as I read a recent IMF paper earlier this year, the academic argument was that we have misunderstood the natural rate of interest, and in fact, we can go significantly below the zero bound – the zero is not a limit, we never should have had it as a limit, not in nominal terms. What are your thoughts?
Richard:I’m skeptical about that. I think we have been through this period of unusually low interest rates and just marginally negative interest rates, and that has made economists think there is no reason why we can’t have negative interest rates. But I’m skeptical of this in the long run. I would view the last ten years and negative interest rates as a bit of an aberration, at least by the measures of all previous history.
Theoretically, I guess, certainly in real terms, if you have a lot of inflation and low interest rates you can have deeply negative real interest rates, and I would say our real interest rates even in the United States are close to negative now, and if you have a 2% yield on a 10-year treasury bond and the Federal Reserve would be successful in reaching its 2% target, then basically you’re getting zero for locking up your money for ten years, or buying that asset that matures in ten years.
So I’m not sure we fully understand the recent period we have been through, which has been very unusual, but it has caused economists to rethink some of their views, and I’m not surprised that some people say we could have negative interest rates, but I don’t think there is a strong basis for it in history.
David:(laughs) Your comment is: by the measure of all previous history this is an aberration. And yes, so that’s where the avant-garde would say, “Yes, but perhaps we can throw out all of history. We’re in a brave new era.” We’ve always had the possibility of negative real rates, and as you say, we’re basically there here in the U.S. Of course, that factors in inflation into the return equation. By present count there is probably 25 trillion dollars in bonds that fit that category of negative real rates.
The new experience is with this negative nominal yield, 13 trillion, and literally, we met in New York in April and I think it was closer to 10 trillion at that point. Can you walk me through how we continue to expand this universe of negative nominal yields? It certainly seems like we’re at the end of a pendulum swing. Am I missing something?
Richard:I think the explanation is that the central banks are buying up a lot of these assets to the point where they have negative yields, and like the Swiss say, if you put money into a Swiss bank the bank is going to give you back less down the road than you are putting in right now. And that is true for a number of the sovereign debt markets in the European Union. I think it iss basically rigged or repressed by the central banks, and why are people putting up with it at all because it seems like if you are offering me negative interest rates, I’ll just hold cash. I’m not going to put my money in your financial institutions if you’re going to give me back less than I’m giving you. But when you look at the huge size of these sovereign debt markets, not everyone – you and I as individuals could probably drain our bank accounts and get $100 bills and store them under a mattress or in a safe deposit box, but major corporations and major financial institutions can’t do that very easily. So the reason I think we see these nominal interest rates is that with negative nominal interest rates these are very slight, fractions of 1%. If you try to avoid it by holding cash then you have to have truckloads of cash in storage and the total cost of trying to avoid getting a negative interest rate may be greater than the negative interest rate.
I also think that government bonds have an option value. People went through the financial crisis, and in many cases businesses found they couldn’t borrow very easily, and if you have a lot of government bonds, which are considered safe assets, you have good collateral. So even if there is another financial crisis you will be able to get a loan because you are owning these government bonds.
Even if the government bonds are returning you a slightly negative interest rate, there is an option value there – “I remember not being able to borrow in 2008-2009, and that’s because I didn’t have good collateral, but now government bonds are good collateral, so if I hold a lot of them, even at a slightly negative interest rate, I don’t have to worry about not being able to borrow in the future because I will always be able to collateralize that government debt for a loan.”
David:That’s a good point. And we’ve gotten to these points with negative interest rates using central bank balance sheet power, a little bit more buying power than you and I have as individuals, as you note. It is interesting, too, we have achieved the price of the bond. The price is the opposite part of the equation from the yield. We have achieved the price, which is a record-high price in many instances, particularly in Europe.
Now the question is, what does it take to maintain that price, because you have a lot of value tied up at a particular price, at a particular rate structure. You see any normalization, there is an impact to price, and all of a sudden, now what are we talking about in terms of a knock-on effect, a potentially deflationary knock-on effect?
Richard:Well yes, that’s the problem. The negative nominal interest rate of a quarter of a percent, or I guess it got up to about two-thirds of a percent in Switzerland, that’s a small price you pay for having that asset. But the return you get on your bond, it’s like what you’re suggesting, David, is that if the interest rates do go up, well then the value of the bonds falls in the market, the value of old bonds falls when the interest rate rises, therefore you suffer a capital loss, and so your return from holding the asset can be much less than the negative interest rates you were getting. That could be not a fraction of a percent, but it could be several percent.
I look back – in The History of Interest Rateswe talk a lot about what happened to the U.S. government debt market in the 1960s and 1970s and prices of U.S. government debt came way down when interest rates went up to double digits, 10-15%. There were huge capital losses on those bond portfolios. And I think that is a danger which people are not thinking about today. A normalization might push rates up a little bit and the capital losses would be rather minor, but we could have another bout of inflation like we did in the 1960s and 1970s and that would make holding long-term bonds really a bad thing to do from the point of view of the return you get from holding that asset.
David:The section dealing with the United States in the 20thcentury starts by saying – I’m going to read a passage here – “During the 20thcentury, many persons impressed by the success of science in controlling the physical environment have urged the advantages of also controlling the economic environment. The old doctrines of laissez-faire have given ground in most countries of the world, and were at times abandoned altogether in some.” And then you go on to say, “It soon became apparent that controlling an economy, unlike controlling the physical environment, required controlling possibly uncooperative groups of people.”
This is to my question because a minute ago you said, “Well, if you don’t like negative rates, we could put money in the mattress and maybe it’s not efficient, it takes a lot of space, and it’s too much space for a safety deposit box.” But this is the question: How do you do this? How do you control groups of people and control an economy in peacetime where a tradition of freedom is known or practiced?
Richard:I think it is very difficult to do that. We’re celebrating 50 years of landing a man on the moon just now in July 2019, and that shows the control that modern science and modern engineering technologies have. That was a triumph of modern science and engineering to put a man on the moon, but that was based on our understanding of physical laws.
Now, I think when we’re talking about economies, we’re made up of all kinds of groups, producers and consumers, it’s not that easy to control. And I think that is one of the things we have learned. We could go too far to the other side. We could say that the government always messes things up, therefore we should try to keep government as small as possible. That’s the neoliberal view. I wouldn’t go to that extreme either, but the notion on the other side, what we were referring to in that passage is that the people in the central banks and government fiscal agents, even Congress, were told that we can have more control than we probably can, and some mistakes were made.
The best example – I hate to keep coming back to it, but I remember it very well – is the inflation of the late 1960s and 1970s when the Federal Reserve basically was responsible for it by increasing the money supply that was based on a faulty theory that if we create more money in trying to lower interest rates the economy will perform better. In fact, what happened, instead of the economy performing better, price levels just went up, even to double-digit levels by the end of the 1970s. So I think we have learned lessons that controlling an economy by pulling levers at the Federal Reserve, or in Congress and spending, fiscal measures, is not as easy as putting a man on the moon.
David:I grew up in a family where we talked about this kind of stuff routinely – what are some of the probable outcomes of putting too much debt into the system? Today we have quantities of debt which continue to grow, private, corporate, governmental, credit growth being one of the keys to economic growth. Would you anticipate, at some point, some sort of an explicit default, maybe a sector specific explicit default? Or how would you weigh the probabilities of the more implicit inflationary default?
Richard:I think the inflationary default, the implicit default, as you call it – that’s a good way of putting it – you’re not really technically defaulting. What you are doing, though, is giving people much less than they expected by inflating the currency and paying back in cheap dollars what people invested when the dollars were more valuable. So that, I think, would be a major worry, and of course people worried when the central banks started to do these quantitative easing measures five to ten years ago, that it would cause inflation.
It is an interesting issue why we haven’t had more inflation, given the amount of central bank interventions, and I think one of the reasons is that a lot of the currency central banks created, the money they created, was held on the balance sheets of banks. Excess reserves used to be 50-100 billion, then they went up to 2.5 to 3 trillion as the central banks were creating this liquidity. There was a potential for inflation there, but for some reason the banks – I think they were shell-shocked a bit from the crisis and they held those excess reserves. Normalization would say, “Well, the banks want to get back in the business of banking, they won’t want to hold a lot of excess reserves. They want to make loans to businesses, that’s what banks are supposed to do – and to consumers, for buying cars and buying houses – that’s what the business of banking is about.”
I think it becomes inflationary when the amount of credit increases faster than the monetary authorities would like and prices begin to rise. And there, of course, the Federal Reserve thinks it can control that by paying interest to the banks on reserve So that is a new tool of monetary policy – the Federal Reserve pays interest on reserves to the banks. And so if it doesn’t want J.P. Morgan Chase, or Bank of America, or whatever, to lend more money to us, it raises the rate it pays them, which induces the banks to hold those reserves instead of lending them to you and me.
I don’t know if it’s the greatest innovation in monetary control history. It seems to transfer money to the banks and politically that could have problems. If the banks start lending more money to the private sector, there is an inflationary potential there. We haven’t seen it for the last ten years, but I think it is lurking there in the shadows, and might come out into the sunlight in the years ahead.
David:I think one of the things that I love about reading your book, Richard, is that ten years is a very small period of time in the scope of interest rate history, so what has happened in the last ten years, there may have been some meaningful events, but in the context of 4,000 years, we need to wait and see.
Richard:Yes. One of the things we say in the book, and document, is that there are interest rate cycles of, I would say, maybe even 20-40 years. From the late 19thcentury on, interest rates went down, let’s say, from 1870, not long after the Civil War, to around 1900 – that’s about 30 years. Then they rose to 1920 – that was 20 years. And then they fell from 1920 to 1946 – that’s 25 years. They rose from 1946 to 1981 – that’s another 35 years, I guess. And now we’ve had, I guess the most recent lows in our interest rates were 2016 from the highs of 1981, so that is another 35 years.
So there are interest rate cycles, and I think people should keep that in mind. Interest rates don’t go straight down or straight up, they fluctuate a lot. So if you think there is an interest rate cycle of 20-40 years, ten years, really, is a very small part of interest rate history.
David:What that suggests, too, is that this bull market in bonds is not atypical. Starting in 1981, the 4thedition, you mention that maybe there is the end of that bull market cycle in 2003. Well, we could amend that – maybe 2016 with the ten-year treasury getting…
Richard:Yes, I have to admit, that’s a mistake I made, because what happened was that the Federal Reserve was raising interest rates from, I guess, the mid to late 2003, 2004, 2005, and going up 25 basis points at every meeting of the Federal Reserve, so rates went up from 1% to 5.25%, something like that. And then, of course, the financial crisis hit and the rates came down as they did.
But when I was working on that 4thedition back in 2004 and 2005, I noticed that the average rate of a ten-year treasury bond was about 3.33% in May of 2003, and it was substantially higher when I was looking at that. So knowing this cyclical behavior of interest rates, it looked to me like we might be moving back toward more normal rates from the lower rates we had after the collapse of the dot.com bubble.
But of course, what I didn’t foresee, and I suspect many others didn’t foresee, was the major financial crisis that was going to befall us starting in 2007 and continuing through into 2009. So we didn’t foresee the financial crisis, and then we didn’t foresee how central bankers would respond to it. Today that 3.33% on the ten-year treasury bond looks pretty good, but I think it is more like 2.1% now. So yes, I definitely made a mistake there.
David:Here is something that is also difficult to predict, and yet it is here. We have the political will to perpetuate a business cycle, and I think perhaps an overconfidence of gerrymandering with rates, suppressing them, pushing them lower, in order to perpetuate a business cycle trend. So again, these are experiments in control which may be unique to the 20thor 21stcentury. Is this an experiment in control, where economic outcomes – how far do you think they can take that? 2016? The present? We’re kind of waiting for a turn in interest rates if we are thinking of them having a cyclical nature. But also different, perhaps, this time is the political will to make it different this time.
Richard:The central bankers certainly think that they can control things, and there are some controversies about central banks. Not everyone likes the central banks. But I think that is part of the political will, allowing the central bankers to use their judgment to control our financial economy, and by that, try to control the real economy. And I think they can feel pretty good that what we’ve had now – we’re talking about a ten-year economic expansion in the U.S. since 2009, and that is a record length expansion. I know, in the 1990s we had a long expansion, and in the 1980s we had a long expansion, and in the 1960s we had a long expansion.
I think some of this is not due to control so much, but it is due to the changing nature of our economy. We were once an agricultural economy, then we were an industrial economy, and now we’re a post-industrial economy where, really, a small portion of the labor force makes things. Mostly, we perform services for each other, and I think a service economy is inherently more stable than an economy that has industrial production where the automobile dealers make a lot of cars, and then people stop buying cars so they lay off their workers, and so on. We used to have business cycles of three to four years, and now we have these long economic expansions of a decade or so.
So I think while the central bankers may like to pat themselves on the back for making the world more stable, I think it has to do with the underlying economy they are dealing with, as much or more than their own expertise in stabilizing things.
David:That’s a great point. I wonder, with the change not only toward a service economy and as you say, being a post-industrial economy, information and computation, these are things which today are vital. I wonder if information and computational power create a context for lower rates over a longer period of time. You chart the influence of information, the transparency piece, financial sophistication, all of these things being contributing factors to that broad sweep of lowering rates from the 13thcentury to the 20thcentury, particularly. Have we gotten to the point where information – let’s even call it big data and computational power – can, in fact, keep rates lower for a longer period?
Richard:I think that’s a possibility. Certainly, I’m impressed by the amount of information that is at your fingertips now when you have a smart phone. And then, of course, we have our laptop computers and the Internet. It is so much easier to gather information on investments, or just about anything else. My wife and I talk to each other and if we have a question about something we say, “Well, let’s just get on the iPhone and check it, and often you can get an answer like that.
So what that tells me is that we really are in a pretty sophisticated, advanced economy now, and some of the computing power has made our lives easier. It may not have increased the GDP all that much, but it certainly made us more productive, and therefore I think we are in a sort of new informational revolution. A lot of people have talked about that. I think back when I was young, 50-60 years ago, everything was totally different. You didn’t have a cell phone, you didn’t have calculators that you could hold in your hand.
I was at a conference not so long ago and a professor there was talking about the cost of a super-computer and as recently as the 1980s it was 25-35 million dollars. Then he pulled out his iPhone and said, “You know, this thing that you can buy for $1000 or less has about as much computing power as those supercomputers that cost 35 million dollars did in the 1980s. So we live in a very different world now than even when I remember earlier in life.
David:So let’s talk about something that is being proposed as being different in this world, as a popular conversation among politicians, even a few academics, proposing the idea that you can spend what you want, deficits don’t matter so long as the debt issued is in your own currency. Welcome to Modern Monetary Theory. As a Professor of History of Financial Institutions and Markets at NYU, and as the past President of the Economic History Association, what say you to these new ideas of unbound spending and unlimited political promises?
Richard:I don’t think it is totally so new. What is sometimes called Modern Monetary Theory is basically money printing, and we used money printing to finance the American Revolution and some of the colonies before we became an independent country issued fiat currencies, state bills of credit. In some cases these worked all right because the colonial economies were, in fact, growing very rapidly at 3-4% a year. We know that because the population growth alone was around 3% a year.
So they needed more money, and one of our gripes against the British was that they didn’t allow us to have our own money system. They wanted us to be on gold and silver, and in particular, they wanted to drain us of our gold and silver. So we invented paper money to get around that, and the British cracked down on the paper money, too.
So anyway, Modern Monetary Theory, or money printing, is certainly not new. The question is will it cause inflation? And I guess the Modern Monetary Theorists say that if the U.S. government can borrow money at a low risk, then investors should buy it because the government can print the dollars to repay the money it borrowed. The question is, what would be the impact of that on the price level? So I don’t think Modern Monetary Theory is really all that new, it just raises some of the issues that we saw previously in history and I’m a bit skeptical about it.
It is true that we don’t have a system anymore where the government, itself, has to pay you gold and silver if you want it, it just gives you paper dollars, so it makes it a little easier for the government to borrow money. And the idea is, let’s say we need to fix our infrastructure in this country – our roads are bumpy and our bridges are falling down, and our airports are third-world some people say – so we could spend a lot of money on infrastructure, and that might be good if we, in fact, have excessive unemployment. But I am a little skeptical. The Modern Monetary Theory recognizes the inflation problem, but I think it dismisses it too casually.
David:Confidence seems to be right there. We were talking about a unit of account. Does it maintain itself as a store of value, and perhaps you can print and print and print until that moment where confidence all of a sudden shifts? Again, in the 4,000 years of rates being a part of your history in this equation, has there ever been a time, as you look back at that history, when the scale of debt didn’t matter?
Richard:Oh, I think it always mattered, but it matters much more. In the modern world there is much more credit than there was. It is one of the distinguishing features of our modern world is that credit flows much more easily. It is partly due to modern financial technologies. It is partly due to the fact that people are richer, and so they have more, let’s say, discretionary funds to invest. But I think the amount of credit always mattered. And there were defaults, too. There were defaults throughout the 4,000 years of history, and usually the defaults caused problems. But the scale of modern financial markets and modern financial institutions is unprecedented. We didn’t see anything like that before our own era.
David:It takes me back to one of your earlier comments, which is, perhaps we have reached an economic development peak. We’ll see, and time will tell.
I have two more questions for you before we wrap up. One of them is just, where do we go from here? We’ve had a bull market in most financial assets, which has been aided by the lowest rates in recorded history. As an academic, (laughs) or even as a betting man, where do rates go from here, and what is the impact to asset prices?
Richard:Well, I have been expecting them to normalize for a few years now, and of course we started toward normalization, I think, starting in 2016-2017 with the Fed raising its rates and reducing its balance sheet. And I’m still waiting for that normalization to occur, but as of right now I think the characteristic of the long expansion of the last ten years from the lows of the recession of 2007-2009 and the stock market bottom in, I think it was March 2009. We have had this long expansion, and asset prices, especially, have expanded a lot. And I think that has a lot to do with the unprecedented low level of interest rates.
My own view is that the stock market, especially in the United States, is a bit over-valued, and as interest rates move up, what I would say is that the outlook for stock market returns which have been 6-7% real in the 20thcentury, and maybe early 21stcentury, and maybe closer to 9-10% nominal, I don’t think from today’s levels we should expect those kind of returns based on the kind of flow or economy that we have now. And part of the reason, as interest rates move up, I think debt assets will look a little more attractive relative to equity assets. So my view is the outlook for stock market returns isn’t really all that great from today’s levels. But of course, you don’t want to have a lot of bonds, either, if interest rates are going to move up particularly rapidly because then you can suffer those capital losses that will give you a low, or even negative, return.
So I think we should be glad that the central bank interventions which have produced these low interest rates have avoided a great depression, or even recessions, but we shouldn’t be very happy about our low rate of economic growth and some of the inequalities that seem to come up along with that, too. There is a lot of worry about the 1%, or the 1/10thof 1% getting most of the gains from what growth we have. I think that’s related, also, to very low interest rates. The top income earners and top wealth holders tend to have most of the financial assets, and so low interest rates have certainly given them great gains. They haven’t done a lot for retirees living on fixed incomes. As a matter of fact, the low interest rates have reduced those fixed incomes. So we have some problems to sort out here.
David:So, if you had to choose an allocation appropriate to the times – you mentioned some things to avoid. Obviously, bonds are vulnerable, stocks may under-perform. Still, a balanced portfolio is probably going to have some exposure to both. But what do you want to own? You have 4,000 years of history in your back pocket, and maybe two quarters in your front pocket – what do you do with those?
Richard:I think that asset allocation depends on where you are in the life cycle. Based on my own experience, if you’re a younger person, maybe even less than 50 years old, history would suggest that if you’re 20 years away from retiring, or more, probably you should hold mostly equities, even at today’s prices, because history will show that 10 or 20 years later you will probably have done better than you would with anything else.
But if you’re older, let’s say 50 or above, if you’re eligible to be a member of the American Association of Retired Persons, you want to be a little more cautious. So there, just looking at today’s market, there are some dangers in holding long-term bonds, and equities are unlikely to give you great returns. So I would say there you want to hold maybe shorter-term debt and what people call value stocks, ones that pay a pretty good dividend yield and have a low price earnings ratio, and so short-term bonds, I think, would make sense in today’s environment because there is the risk in long-terms bonds if rates do normalize or go up to more than normal like they did in the 1970s. Now, you can get waxed if you’re holding long-term bonds. So I think value stocks and short-term bond investments would be my recommendation for people 20 years or less from retirement.
David:Looking back at various financial panics, in the 19thcentury there was a significant one in 1825, and one that kind of spanned the globe in 1857, and people would get out of securities, stock and bonds, and move into cash. Cash in that era was the same thing as gold. Gold is now a cheap commodity, two-bit, nobody cares about it. In the next crisis, with some of these loaded issues of lots of debt, the likelihood of inflating the burden of that debt away, do people move to cash with the same energy that you might expect, or does gold have a play as a liquidity store?
Richard:I think if we’re going to have a lot of inflation like we had in the 1970s, there is an argument you could make for having some gold in your portfolio, or basically, hard assets. If there is an inflation risk, and I think there is probably more than most people think today that there will be inflation down the road. Just because inflation has been low for ten years doesn’t mean that it can’t pop up again. It has, periodically, in U.S. history, especially during wartime, and then even in the relative peacetime of the 1970s.
There is an inflation risk there, and gold tends to do well. It’s a store of value, it has been that for a long time, and of course its price is up quite a bit from the beginning of the U.S. when the dollar was defined as about 1/20thof an ounce of gold, and then President Roosevelt in the 1930s changed it to 1/35thof an ounce of gold. But now, today, an ounce of gold goes not for $35, but for $1300-1400, and so that shows you that gold is a bit of an inflation hedge in the long run.
I think the point is that if there is an inflation risk, real assets are something that one should probably pay more attention to – land, houses, precious metals – something that is real. Because what is inflation after all? It is just a rise in the prices of the things that we normally see in front of us – the houses we live in and the land we walk on. People aren’t worried much about inflation now, but if there is an inflation risk out there, then I think real assets, precious metals being one, are something that is a little bit safer than owning stocks and bonds.
David:I’m so grateful for academics like you and Mr. Homer,who condensed a universe of information into one tome. It’s not only a great resource tool – and I think my kids thought I was a little crazy, I told them I was reading this like I was reading a thriller, because there is so much packed into the history of interest rates, the story lines, what is implicit and what is between the lines, is absolutely fascinating. So I thank you for the years that you’ve put into creating this book, and updating it, and when the 5thedition comes out I’ll be one of the first buyers.
Thanks so much for your time today.
Richard:You’re welcome, David. It was a great pleasure to converse with you today.