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Chapter 8 - “Interest - the most powerful force in the universe” 

    15 min read

Do you spot it? The mistake in the title quote? Albert Einstein supposedly quipped that “compound interest is the most powerful force in the universe”.  In another version he is credited for deeming compound interest the 8th world wonder.  

Truth or myth, Einstein seemed to assume that the force of compounding was at work no matter what. He didn’t fathom a future with no compounding.

Compounding is earning interest on interest. For compounding to happen interest rates must be positive. And preferably higher than inflation. Otherwise, you may end up having more money … only for it to buy less.

Einstein was not alone with his view. Pretty much nobody did foresee a time with no compounding, a time when interest rates would go to zero … and even negative for many borrowers. But this is what happened after the Great Financial Crisis of 2008. Money was no longer multiplying but self-destructing. Sort of disappearing in a black hole! Of which Einstein was quite an expert.

Still, Einstein was close to nailing it (again). Whether positive and so compounding, zero, or even negative, interest is arguably THE most powerful force in the universe. Excluding love of course. The “rental price of money” or simply the “price of money” is at a minimum the most important price in the world. And has been throughout history.

The concept of interest is old, older than coined money – which only arrived in the 8th Century BC[1]. The holy scriptures testify to the perennial importance of interest. Bible, Quran and Torah have plenty to say about interest and usury, i.e. unreasonably high interest. From times immemorial, humans have fallen into the debt trap. Borrowing capital at higher rates than they could earn when investing it. And so owing ever more and becoming debt serfs. Some of the holy scriptures offer a clear-cut solution: outright prohibition of money lending at interest.

A few clarifications upfront. When we talk about interest rates, we generally mean “nominal” interest rates, rates stated on contracts or quoted on screens. Conceptually, nominal rates may be broken down into two components, one compensating the lender for inflation, i.e. the loss in purchasing power due to rising prices, and another for forgoing consumption, i.e. “real” interest. After all, money lent is not available to the lender to pay for consumption. This real interest rate (or simply “real rate”) is obtained by subtracting inflation from nominal rates.

In the era before coined money, interest was typically charged as a share of the yield from a venture, say seeds or animals lent and returned with “interest”, i.e. more seeds or a calf. Once coined money was in use, interest was generally due in the respective coins.

Before WWI, when a big chunk of the world operated on a metallic money standard, money was scarce. With high population and productivity growth fueling high economic growth throughout the 19th century, output of gold and silver mines did not keep up. Money supply was not growing as fast as the economy. That led prices of goods and services overall to fall. The 19th century was broadly one of deflation.

To borrow the “scarce” metallic money required borrowers to pay high real interest. Real rates averaged over 5% from 1800 to 1888[2] in the US. Up until WWI the real rate stayed at this level for all major economies[3].

With this backdrop, Einstein becomes easier to understand. Assuming he had his enlightenment about compound interest in the same “miracle year” 1905, when he published four groundbreaking papers in physics, he had history to back his claim. Compounding at a real rate of over 5% meant money was doubling in real value every 14 years! A most potent force, indeed. Alas, this force was not one set to last. The arrival of central banks, and the FED in particular, changed the fundamentals of money and its rental price, interest.

When the FED was founded in 1913, it got the monopoly to issue paper money. It also got the mandate to enhance the stability of the banking system. To keep banks and the banking system safe, the FED requires banks to keep money in reserve with it. Banks can borrow and lend reserves among themselves to meet their respective reserve requirements. Crucially, central banks like the FED control the interest rate at which banks borrow and lend reserves among each other. This rate is called the Federal Funds Rate. It is the base rate that the FED periodically adjusts … with huge impact on the economy and financial markets.

Reserves are arguably the safest investment for banks since reserves are a short-term loan from the banks to the central bank. As a result, reserves generally carry the lowest interest rate of all short-term loans. Nobody worries about the central bank’s capacity to repay a loan, since it can always produce more money to repay it. You wouldn’t worry about lending bread to the baker if you expected to be repaid in bread, would you?

Central banks’ discretion to change interest rates, in particular the Fed Funds Rate, was constrained during the gold standard in place before WWI. Remember, the gold standard produced fixed exchange rates among currencies convertible into gold. If a central bank lowered interest rates to support lending and borrowing in the economy, speculators would be quick to exchange this country’s currency for gold and exchange the gold for the currency of another country with higher interest rates on offer. In short, the gold standard came with “golden fetters” [golden handcuffs], limiting a central bank’s room to jack interest rates up and down without paying attention to interest rates applicable to other currencies.

During war times the rules of the monetary game changed as sure as day follows night. Restrictions were imposed on citizens, usually including the suspension of their right to exchange paper money for gold. With that stroke of a pen money became FIAT money. This allowed governments to print it in high quantity to pay for the cost of war. Once rationing and price controls typically in place during war times were lifted after war, prices rose strongly as a lot of paper money was in circulation to purchase scarce goods. This happened most notably in Weimar Germany after WWI.

To contain inflation after WWI in the US, the FED hiked rates swiftly in 1920, which led to a sharp economic contraction and deflation. After prices had broadly fallen, the FED loosened the monetary reins and lowered interest rates … and kept them low. Many deem the low interest rates in the 1920s the key reason for the spectacular stock market boom during that decade which was followed by a spectacular bust and the Great Depression.

In the depressionary 1930s the US government adopted a highly interventionist policy mix. Congress passed an avalanche of laws to regulate the economy. Institutions such as the Securities and Exchange Commission were set up to supervise financial markets. Massive government stimuli programs – broadly summarized with “New Deal” – were implemented. To little avail. Economic growth remained lackluster. The Great Depression in the 1930s was marked by deflation, i.e. falling prices.

WWII changed it all. Massive government spending on armament and the recruitment of men into military service and women into factory jobs jolted economic activity higher. Prices rose sharply.

By the end of the war in 1945, public debt had shot up in all belligerent countries including the US. But the US was in a fundamentally better position than other nations. The war never reached its mainland, leaving the US with the world’s leading industry and most competitive economy. On top of this, US gold holdings had skyrocketed. The US was on the receiving end of gold flows as it sold weapons and food to its allies for this hardest asset.

The US was now in the position of unrivalled superpower, allowing it to set the rules, including those for the world’s monetary system. Those were first sketched out in a conference of 44 allied nations in the resort town of Bretton Woods, New Hampshire. The Bretton Woods system put the US dollar front and center in the new global framework. The USD was now the reserve currency everybody needed to trade internationally.

This elevated the role of the Federal Reserve. The FED was now not just setting interest rates for the most important currency, the US dollar, but its monetary policy impacted everyone else disproportionately. The FED’s hands were now much less tied by “golden fetters”. It could set interest rates more freely irrespective of other countries’ interest rates. 

The FED promptly took advantage of this discretion, mostly to serve its key constituent, the US government. It set interest rates low in the decades after WWII. Savers got a bad deal, getting little in return for putting money into bank deposits and bonds. Interest rates did not even compensate for inflation. This is called Financial Repression: money is moved from savers to borrowers. Nicely for the government, the giant debtor after the war, low interest rates allowed for cheaper servicing of the public debt. This also brought down the public debt to GDP ratio. In short, the US government’s finances were improved at the expense of savers. Einstein’s most powerful force took a looong break.

War is costly – then and now

The US entered costly wars first in the 1950s in Korea and later in Vietnam. This led to higher US government deficits in the 1950s and 1960s. The US economy stayed strong with imports surging along with inflation. Dollars left the country as did gold. On August 15 1971, President Nixon closed the “gold window”.  Foreign central banks could no longer present US dollars at the Treasury’s gold window and receive gold in return. An attempt to resuscitate the link of the US dollar to gold was short-lived. In 1973 the US dollar was no longer linked to gold for good. That meant currencies were now freely floating.

By then inflation ran rampant in the US. The oil shock of 1973, which raised gas prices throughout the world, was widely viewed as a key driver of inflation. Even after the abatement of the oil shock, inflation readings trended higher. Consecutive US administrations attempted all kinds of fixes, including price freezes, to contain the rise in prices. Nothing worked. The inflationary 1970s seemed to corroborate the long experience that money not backed by a real asset such as gold was destined to lose its value quickly.

We will never know to what extent the negative real interest rates, i.e. lower rates on savings deposits and bond investments than inflation, contributed to the inflationary outcome in the 1970s. “Financial Repression” was certainly extensive: “Between 1945 and 1980, interest rates in the United States and the United Kingdom averaged in real terms (i.e., after inflation) minus 3.5%”[4]. For other countries, the experience was similar. The following graph depicts the average development of Real Interest Rates in 19 countries (including the US and the UK).

 

Source: Borio, C. et al (2017, December). Why so low for so long? A long-term view of real interest rates. BIS Working Papers, 685; arrows with monetary regimes added by author

Then a MIRACLE happened: Inflation and interest rates trended down … and down … and down. For decades.

Many have attributed the MIRACLE to the FED and its governors, foremost Paul Volcker. Volcker took the helm of the Federal Reserve in August 1979 when inflation was running rampant. He promptly raised interest rates to the maximum pain threshold. By December 1980, he had raised the FED Funds Rate to almost 19 percent. With lending costs at this high level, demand for credit collapsed. And with it the US economy. A deep recession took the unemployment rate into double digits. The high cost came with the targeted payoff: inflation fell. Rapidly.

The “Volcker-killed-inflation-for-good” view has many firm supporters. Warren Buffett argued so in 1999: “You will remember Paul Volcker coming in as chairman of the FED and remember also how unpopular he was. But the heroic things he did – his taking a two-by-four to the economy and breaking the back of inflation – caused the interest rate trend to reverse, with some rather spectacular results.”[5]

Better still, inflation would not stop falling for the next four decades. Inflation measures would never revisit those reached in the late 1970s. This was a FIRST in human history. Money backed by nothing yet holding its value … over decades. FIAT money standing the test of time. At least till the time of this writing. A true MIRACLE.

As the following graph shows, inflation (red line) trended down since the early 1980s.

US Consumer Price Index (red line), FED Funds Rate (blue line), Yield on 10-year Treasury Bond (green line): 1968 - 2024

 

 

 

 

 

 

 

 

 

 

The chart also shows that the FED was highly activist over the period, jacking up and down the FED funds rate (blue line). Long-term interest rates, as measured by the yield on a 10-year US Treasury note (green line), also trended down too, but rather steadily over this period.

FED officials have justified their activist approach by pointing to the ever-present danger of inflation that required constant “fine-tuning” of monetary policy. Sure. There were hiccups and mini-inflationary bouts as the chart shows. Yet, overall the activist FED’s moving of interest rates is hugely at odds with the rather slow-moving down trend in inflation.

FED officials would point to another reason for its activist approach. They would highlight that financial crisis required their intervention. Financial markets turned topsy turfy on a number of occasions:

  • Black Monday: the stock market crash on October 19, 1987

  • The Savings & Loans crisis: late 1980s to early 1990s

  • Bond Rout: 1994/1995

  • Asian Crisis and its spillover to the US: 1997

  • Collapse of Dotcom bubble: 2000 – 2003

  • Great Financial Crisis (GFC):  2007/2008

  • Covid: 2020 – 2022

Indeed, with every crisis the FED became more activist: From making only small adjustments to the base rate in the Crash of ‘87, the FED went into full combat mode when the Dotcom bubble burst in 2000. It lowered the FED funds rate in short order from 6% to 1% by 2003. This likely helped inflate a bubble in real estate that the FED’s interest rate hikes starting in 2005 did not stop. The resulting Great Financial Crisis (GFC) of 2008 was the worst financial crisis the world had seen since WWII.

In response to the GFC, the FED lowered the base rate to zero in 2009 and implemented other extreme support measures for financial markets. In a nutshell, the FED extended insurance and funding schemes for pretty much all types of participants in financial markets. With that it suspended capitalism. On top, the US Treasury implemented its own giant support packages for businesses and the economy at large, many of which the FED paid for. This policy of “monetization” of government debt by the FED is called Quantitative Easing (QE). No matter how big the appetite of the US government for spending in light of the crisis, the FED picked up the tab. Taxes were not raised.

 

The GFC hit a swath of European and Asian countries equally if not harder than the US. Their governments resorted to huge deficit spending too and relied on their central banks to print the money to pay for it all. Many foreign central banks followed the FED’s lead and lowered their base rates to zero, and some even to negative ones. They had little choice. With the FED pursuing an ultra-loose monetary policy, the US dollar weakened, making imports more costly for Americans and favoring exports from the US. That was toxic for other countries suffering from the same malaise as the US: high unemployment, weak demand and falling prices (deflation). A weaker currency was part of the solution for them too. And that required lower interest rates. The FED had duly unleashed a global currency war.

In the entire developed world, inflation appeared to be, if not dead, at least soundly dormant after the GFC. As a result interest rates hovered around zero and for some borrowers even in negative territory for a decade. Yes, some borrowers could borrow money and be paid for doing so. They had to repay less than they borrowed. Einstein’s most powerful force had truly disappeared in a big black hole … and would stay there for a decade.

  

Inflation rose its head for the first time again in 2021. With the arrival of the novel Covid virus in 2020, many countries put their societies under various degrees of lockdown. To maintain citizens’ income, governments handed out generous benefits. But with restrictions in place, much of the money couldn’t be spent and was stuck in the banking system. When economies did reopen, the vast increase in money combined with lacking supply of many goods did send inflation indicators higher. Just like happened in any “after-war” period when price controls were lifted, and commerce was freed. In that light, the spike in inflation in 2021 and 2022 was low by any historic standards, such as after WWI in Germany and elsewhere. Post-Covid inflation was more like a whimper than a whopper.

 

While the inflationary impact of the government response to Covid seems rather benign and temporary, the financial cost isn’t. Budget deficits in the US and elsewhere reached extreme levels in 2020 and 2021, similar to those during and following the GFC from 2008 to 2011.

Budget Deficits as % of GDP (General Government Fiscal Balance)

 

 

 

Source: Japanese Ministry of Finance Handbook (2023 edition)

 

How were the giant budget deficits during Covid financed? As during the GFC, the printing presses of the central banks did the job. Taxes were not raised. The spigot of “free FED money” remained open … yet inflation subdued. This amounts to a suspension of classical economics. Kind of like as if you could eat as much chocolate as you wanted … but not gain weight. Marvelous.

To understand the MIRACLE of massive deficit spending and FIAT money creation yet little inflation of prices of goods and services, we have to visit Japan. For there, we find the clue to this MIRACLE.

References

 

[1] Chancellor, E. (2022). The Price of Time: The Real Story of Interest. Penguin Books, p. 3

[2] Siegel, J. J. (1992). The real rate of interest from 1800-1990: A study of the U.S. and the U.K. Journal of Monetary Economics, 29(2), 227-252.

[3] Borio, C., Disyatat, P., Juselius, M., & Rungcharoenkitkul, P. (2017, December). Why so low for so long? A long-term view of real interest rates. BIS Working Papers, 685.

[4] Chancellor, E. (2022). The Price of Time: The Real Story of Interest. Penguin Books, p. 290

[5] Fortune Magazine, Nov 22, 1999

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