How long can low rates last?

The charging of interest on loans is one of the most hated and worst understood concepts in human history. Aristotle claimed that money cannot beget money because it is dead, so charging interest on loans is immoral. Moses’ law forbid Israelis to charge interest on loans to the poor, but the Church interpreted that prohibition according to Aristotle’s economics and made charging interest on loans one of the worst sins that Christians can commit. Aristotle’s writings had almost equal weight with the Bible in many matters until Copernicus and Galileo trashed his astronomy.

But kings, nobility and popes needed to borrow money occasionally in order to keep up their conspicuous consumption, so Jews were allowed to commit the sin of usury. That gave Christians an excuse to persecute them regularly.

The church didn’t reform its economics until the 17th century when theologians from the University of Salamanca abandoned Aristotle for common sense. A letter from John Calvin to a friend on the topic may have helped. Calvin wrote that interest on loans was no different from charging rent on land, which everyone could understand.

Recently, an investing newsletter increased the confusion over interest rates for its readers. It claimed that interest rates have fallen naturally from roughly 50% in 5000 BC. “Fast-forward a bit and we see the Greeks expanded the credit system. In 600 B.C., they paid rates of around 16% in a quickly modernizing monetary system. By 100 B.C., though, a typical loan came with a rate of just 8%. And then things got interesting...”

The author claims that interest rates in Rome fell to between 5% and 12%. Rates rose to 10% or more in the 15th century then fell back to 8% in 18th century England. “The erosion-inducing realm of central banking was upon us.” Banks pushed rates as low as 3% in the 19th century. The Fed’s discount rate didn’t rise above 4.6% until the inflation of the 1970s. Today the Fed’s benchmark rate is 0.25%. The author concludes:

To believe we're somehow going to reverse this centuries-old trend within our lifetimes is preposterous. Interest rates have been falling for millennia. With the exception of a few fits and starts, they'll keep falling. It's especially true that negative interest rates have become a new normal.

Mises warned economists about comparing nominal interest rates of vastly different periods of time:

It is useless to arrange data concerning interest rates of the open market or the discount rates of the central banks in time series. The various data available for the construction of such time series are incommensurable...The institutional conditions affecting the activities of various nations' central banks, their private banks, and their organized loan markets are so different, that it is entirely misleading to compare the nominal interest rates without paying full regard to these diversities. (Human Action, 542)

Four components make up the market rate of interest – opportunity cost, entrepreneurial, inflation and money supply. Opportunity cost is what Austrian economists typically call “time preference.” People prefer to consume things today rather than in the future, so they place lower value on things they have to wait for. Since time preference is a tradeoff between present and future consumption, I toss it into the opportunity cost barrel. Opportunity cost is one of the most important concepts in economics. It’s simply what you gave up to do what you’re doing now. If people give up future consumption for more today, interest rates will soar, ceteris paribus.

The entrepreneurial component is the profit that business people think they can make from a venture. This component rises, and causes market rates to rise, when inventors offer a slew of innovations that promise economic profits – that is, profits greater than the prevailing interest rates.

Inflation causes market rates to rise as lenders try to recoup the loss in purchasing power of the money used to repay the loan.

Opportunity cost and money supply determine the availability of loanable funds. If people value future consumption more they will save more and make those savings available as loanable funds. Central banks can increase the money supply by lowering the discount rate for loans between banks and buying bonds from banks (QE). The entrepreneurial component increases the demand for loans.

Opportunity costs probably have changed little because human nature doesn’t change. Younger people tend to be less concerned about the future than older people, so if your population is young then interest rates might be high compared to countries with a lot of old people.

So why are interest rates low today? Inflation is low by historical standards primarily because people and businesses want to hold more cash in uncertain times and this has been one of the most uncertain recoveries in history. The entrepreneurial component is low because businesses see no reason to invest in new or greater output, which has driven most expansions in the past. Instead, they’re buying back their own stock. And the federal government keeps knocking its head against borrowing limits. The entrepreneurial component is low because of regime uncertainty, high taxes and crushing regulation.

The supply of loanable funds is growing at a rapid rate as the Fed tries to float boats with a flood of new money. Can this situation last forever as the investment adviser claims? That depends on how long it takes mainstream economists to change their minds.

It took the destructive stagnation of the 1970s to convince mainstream economists to give up on paleo-Keynesian nonsense. But they adopted the neo-Keynesian approach of money printing. It will be more difficult for them to give up on neo-Keynesianism because it is their last tool in the box for controlling the economy. Giving up money printing would mean surrendering to Austrian economics and admitting that they really can’t control the economy, for the better anyway. Mostly likely they will resuscitate paleo-Keynesian emphasis on state spending.

Japan has suffered from both forms of Keynesian econ for the past generation and their sad failures have prompted no confessions or repentance on the part of mainstream economists. Like gamblers, they demand that central banks double down on their losing bets. It’s likely that the US will follow in Japan’s rut. That means frequent recessions and continued volatility in the stock market.