Interest Rate Elephant!
Interest rates like many other things have been rarely understood. Not because they ride on a black swan but because humans are economic beings that are steeped in short-sighted gains driven by instant gratification. This is why the cycles of history keep rhyming because the new generation does not learn from the previous generation. In some ways, history works because of this poor societal memory.
Interest rate is one such elephant for the blind men. This is why we have no idea where society is going because myopia is generally about immediate persistence, it can’t see secular trends. One such secular trend that society can’t see is the interest rate trend.
The 40-year interest rate trend that seems to have surprised the masses after hitting zero is because the expectation was for the cost of money to stay zero and life to go on happily ever after. But this is not how nature works, it persists but then unexpectedly changes course. Sometimes, it changes course on a secular basis. One can debate about the 40-year trend reversal and call it fleeting, but it is because opinions are easy to formulate, studying history, and assimilating the past is for the random researchers, who don’t tweet about their pondered discourse because they suffer from the Dunning-Kruger effect.
Long-term interest ratesTotal, % per annum, Apr 1953 – Jan 2021
Paul Schmelzing's paper, "Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311-2018", explores the long-term trends in real interest rates over the past eight centuries. The paper provides a comprehensive analysis of data on global real interest rates from 1311 to 2018, highlighting the significant decline in real interest rates over this period. One of the key findings of the paper is that real interest rates have declined by around 1.6% per century since the 14th century. This decline has been driven by a variety of factors, including an increase in the supply of capital, changes in the risk premium associated with investing, and changes in the relative demand for capital.
Paul Schmelzing's paper is a brilliant read and it gives us another missing part of the Interest rate elephant, the one which extends from 1311 AD. However, Schmelzing made a critical error. He got biased with the seven centuries of negative persistence. While the paper does not offer a specific forecast of future interest rates, Schmelzing does suggest that the low real interest rate environment is likely to persist and that this will have important implications for debt sustainability, asset prices, and inequality. He argues that policymakers, investors, and society as a whole need to adapt to this new low-interest-rate environment, and that new policy frameworks may be needed to address the challenges posed by this trend.
Paul Schmelzing - “Financial conditions” in public credit: Easing vs. Tightening episodes, 1320-2019.
It's worth noting that Schmelzing's paper was published in 2019, before the COVID-19 pandemic and the associated economic shock. Surprisingly, the paper does not talk about the 1918 Spanish flu. Causally, the pandemic can be believed to have had a significant impact on the global economy, but how much influence the multi-century low rate legacy has had on the current interest rates is not an easy interpretation for either humans or machines.
The elephant story does not end here. It’s an impossibility to go back beyond 700 years, but there is a study done by the Foundation for the study of cycles, with this 5000-year interest rate estimation going back to 3000 BC. More work is needed to interpret this chart, but the leg from the year 1311 has an uncanny similarity to Schmelzing's work. This means that the respective year was likely a part of the larger cycle and to expect a likely peak in interest rates before that could be a low probability considering the global population was merely 375 million.
Foundation for the Study of Cycles
Credit, or the concept of borrowing and lending money, has been around for thousands of years. The earliest recorded evidence of credit dates back to ancient civilizations such as Sumeria, Babylon, and Egypt, where farmers and merchants would borrow seeds, tools, or other resources to finance their businesses and repay their debts after harvest or trade. The Code of Hammurabi, a set of laws created by the Babylonian king Hammurabi in the 18th century BCE, included provisions for lending and borrowing money and establishing interest rates. Over time, credit systems evolved and became more formalized. In ancient Greece and Rome, moneylenders began to offer loans at interest, and the Roman Empire developed a complex credit system that included private lenders, pawnbrokers, and state-run banks. In medieval Europe, guilds and merchants also used credit to finance their businesses and expand their trade networks.
The period from 1 AD to 1300 AD saw numerous conflicts and military campaigns across different regions and civilizations. Major wars and invasions included the Roman Empire's conquests, the Arab conquests and the spread of Islam, the Viking invasions and raids, the Crusades, the Mongol invasions and conquests, the Byzantine Empire's wars with neighbouring states, and the various conflicts and wars among Chinese dynasties and states. These conflicts had significant political, social, and cultural consequences and contributed to the shaping of the world as we know it today.
Debasing currencies for war can lead to higher interest rates. When a government debases its currency, it reduces the amount of valuable metal in the coins, which makes each coin worth less. This can lead to inflation, as prices for goods and services rise to compensate for the decreased value of the currency. Inflation can make lending and borrowing riskier, as lenders are less likely to be repaid in full and borrowers are less likely to be able to pay back their debts (assuming they don't lock into a fixed rate). To compensate for this increased risk, lenders may demand higher interest rates. Higher interest rates can also attract foreign lenders, who may be willing to lend money at a higher rate to compensate for the risk of lending to a country that has debased its currency. Thus, debasing currencies for war can create a cycle of inflation and higher interest rates, which can have significant economic consequences. It's worth noting that this is just one potential scenario and that the relationship between currency debasement and interest rates can be complex and multifaceted. Other factors, such as supply and demand for credit and changes in government policies, can also play a role in determining interest rates.
It is hard to ever know what really triggered the interest rate cycles and how much of the influence was the cycle itself and how much of it was the human perturbations. And nobody knows the future. But reversion - diversion is nature’s mechanism. And interest rates are part of a socio-economic mechanism. The trend of the last seven centuries is an undeniable economic history, which has its nature, larger than what we can perceive as blind men. Hence secular double-digit interest rates lasting more than a decade or a few decades are not a zero probability event. This interest rate elephant can redefine everything we know about economics, markets, credit, real estate, and commodities, not to mention inequality and war.
The good news. A part of society will see this potential interest rate calamity as an opportunity to adapt, innovate, and find solutions, daring to diffuse the interest rate generational cycle as our ancestors did when they built a dam on the Nile to harness its power and diffuse the cycle of floods. Even if we understand a few elephants, nature will continue to surprise us. Because it knows that the inefficient has to die for the efficient to emerge.
Bibliography
2] "Interest rates and inflation: A long-term perspective" by Paul Schmelzing (2017). This paper, published in the Bank of England's Staff Working Paper series, provides a comprehensive analysis of interest rates and inflation from 1311 to 2015, including a discussion of interest rate trends in the 16th and 17th centuries.
3] "Real interest rates over the long run" by Paul Schmelzing (2019). This paper, also published in the Bank of England's Staff Working Paper series, extends Schmelzing's analysis of interest rates back to the 14th century and includes a discussion of interest rate trends during the Renaissance.
4] "The Rise and Fall of Interest Rates in Medieval Europe" by Richard S. Grossman (2008). This paper, published in the Journal of Economic History, focuses specifically on interest rate trends in medieval Europe, including the 14th and 15th centuries. The paper also explores the factors that influenced interest rates during this period, such as the Black Death and the decline of feudalism.