CHATS: Interest Rates Through Time A Story of Stability and Chaos

For this month's CHATS segment, financial historian Edward Chancellor leads us on a captivating exploration into the evolution of interest rates, showcasing their pivotal role from ancient civilizations to the capitalist era. Chancellor uncovers how the disdain for usury transformed into a tool for economic development. Hear how iconic figures like John Maynard Keynes have shaped modern economic policies with their advocacy for low interest rates and why Chancellor believes the balance of interest rates is crucial for guiding economic behavior.

We also journey through history to understand the impact of low interest rates on financial stability, drawing parallels from John Law's 18th-century France to today's financial crises. Chancellor dissects how artificially low rates have historically spurred speculative bubbles and risky financial behavior, leading to economic turmoil. By reflecting on events like the global financial crisis and the Latin American debt bubble, we unravel how low interest rates incentivize yield chasing and can misalign with growth, becoming a catalyst for instability.

As we navigate the implications of prolonged low interest rates today, we scrutinize the resilience of financial markets despite central banks' interest rate hikes. Chancellor sheds light on the unexpected optimism in the investment landscape, fueled by AI innovations and government interventions. We delve into the intricacies of central banks' policies, questioning the effectiveness of inflation targets and considering how technological advancements could naturally lead to deflation. This episode is an enlightening journey through the complexities of interest rates and their profound impact on economic landscapes throughout history.

If you'd like to learn more about the show, have a topic or speaker to suggest, or would like to leave us a comment, email podcast@cfa-sf.org.


This podcast is produced by CFA Society San Francisco, a not-for-profit professional association, providing professional learning and career resources to over 13,000 investment industry professionals worldwide. To learn more about CFA Society San Francisco, visit our website or connect with us on LinkedIn.

The information contained in this podcast does not constitute financial or investment advice. Please consult your own financial advisor for information concerning your specific situation.

Chapters

• 0:05 The Evolution of Interest Rates
• 12:15 Financial Crisis and Low Interest Rates
• 31:19 Implications of Low Interest Rates
• 40:58 Central Banks and Interest Rate Manipulation

Transcript

Speaker 1: 0:05

Hello and welcome to this month's chat segment of the Financial Perspectives podcast. Our chats episodes feature dynamic conversations between industry experts from some of our recent and most popular webinar recordings. This month you'll hear from Edward Chancellor and Ken Fryer as they discuss the evolution of interest and the broader financial landscape.

Speaker 2: 0:29

It is a great privilege and honor for CFA Society of San Francisco to welcome Edward Chancellor, the eminent financial historian. Mr Chancellor was educated at Cambridge and Oxford and worked for Lazard Brothers and GMO, in addition to his work as a writer, and Fortune magazine has called him one of the greatest financial historians alive, and with good reason. We all know it's difficult to predict turns in markets, especially if your predictions come in the form of books. But Mr Chancellor wrote Devil Take the Hindmost, a history of financial speculation which was well-timed for the peak of the speculation in tech stocks in 1999. He wrote Crunch Time for Credit.

Speaker 2: 1:15

A story about the excesses in credit markets came out in 2005, a prescient warning of what then became the global financial crisis, a prescient warning of what then became the global financial crisis. And now Mr Chancellor has written Topic of the Day's conversation the Price of Time, a masterful survey of the history of interest rates, and that warns of well, we'll find out today. So, Edward, if we could easily find on the Internet 55 pieces that say interest rates are just too high and another 50 thought pieces that say interest rates are just too low, and based on your book, I expect we could pick any day in the last 5000 years and that debate would be going on in some fashion. And so I want to start by just asking you in the history of finance and of interest rates, you know sort of what have been the main camps or theories about what level of interest rates are right?

Speaker 3: 2:12

Well, it's a good question, Ken, of lending at interest, which goes back, as you say, five millennia. The most vocal proponents have always been for lower interest rates and if you go back into the ancient world, you can find it in the Bible and you find it in really, you find in the Bible the fact that usury or lending at interest was considered illegitimate. You find it in Greek philosophy like Aristotle and Plato both decrying lending at interest, that's taken on in the early Christian church and then becomes established in the Middle Ages the idea that lending at interest was illegitimate, that usurers or bankers in Dante's Inferno or in I don't know, the third or fourth circle of hell. And then, when lending becomes progressively legalized from the 16th century onwards, there is still a debate as you know I mentioned the book with people demanding lower interest rates, and in that case they were actually demanding in Britain in the 17th century that the maximum legal rate of lending be reduced. However, there's actually something quite interesting that comes in here is that by the 17th century, the advocates of lower interest charges are actually business people in the City of London. I mentioned this fellow, josiah Childs was rich banker who was head of the East India Company who was really speculating in East India Company shares and borrowed money, so naturally he wanted low interest rates. Then if you sort of fast forward into the 19th century, you get the socialists. And I said you remember the beginning of the book, socialist anarchist Frenchman Proudhon arguing, debating for zero interest lent by a central bank, quite similar to what the, let's say, into the 1920s where John Maynard Keynes pops up as an influential economist.

Speaker 3: 4:54

And Keynes, as I say, never saw an interest rate that he considered too low. He was always calling for low interest rates, always calling for low interest rates. And actually I think that sort of Keynesian view of interest being something rather sort of that one should keep as low as possible has prevailed into policymaking circles in the post-war period and then, as I also mentioned, in emerging markets. Emerging markets interests often very unpopular. If you remember the, the turkish president erdogan is always decrying what he calls the, the interest rate lobby. He calls them a sort of sinister cabal of people around the world trying to push up higher interest rates, whereas I say, if there was, if an interest rate lobby actually existed, erdogan himself was the main mouthpiece and they were always calling for lower rates. And that really has been the case and to some extent my book is an argument against that, not an advocacy of high rates in themselves, but, as we'll discuss, it's an argument to say well, actually the interest rate serves a number of vital functions of communicating to economic agents how they should behave.

Speaker 3: 6:22

And if you're too high, yeah, pretty obvious, it's a thing because you know you crush the, that you crush the um, the debtors. And and again, if you go right back to the ancient world, it was quite grounded the idea that very high interest rates were about an abomination. Because if you're in a primary, primarily um agricultural economy with Because if you're in a primarily agricultural economy with no growth, if you have a high interest rate compounding over time, it is simply unbearable. And in the ancient world, as in certain parts of the modern world today, high rates, the compounding of debt at high rates of interest, could send people into debt, bondage or even slavery in the ancient world. So that's, you know, obviously a pretty bad thing.

Speaker 3: 7:13

On the other hand, in a, once you get into the modern world of sort of, you know, capitalist world, which we might say starts sort of sometime in the 15th century in Europe, then you know, of course, you know, people are borrowing money for commercial purposes. They can earn a decent, you know, if they're competent, they can earn a decent return on their borrowing, and it's therefore legitimate, to my view, that the lender should share in the gains of the of the borrower, have some share of that. And and so I think that you know, as you say, that there are people always arguing that interest rates too high, too low. But what? And it's very, very difficult problem to solve, and it's a very, very difficult problem to solve, it's perhaps almost an insoluble problem to discover the correct rate of interest, which is an issue.

Speaker 2: 8:30

However, as I say in my book, you can probably tell when they decimal points, but you can probably get it within a percentage point or two. So, speaking of that, as you say, the camp advocating for lower interest rates has had more sway in the outcome than the camp advocating for higher interest rates, than the camp advocating for higher interest rates. And one thing that the book demonstrates is that the winning camp, when they succeed in having rates below, sometimes that leads to unintended consequences and I wonder if you could share with us some of the instances in your grand survey of interest rates where there was a stretch of very low interest rates and it turned out badly Well.

Speaker 3: 9:06

So first of all I'd say the. I mean, as you know, I make the point in the book that the that interest rate is, you know, influences the valuation of assets, the capitalization rate or the discount rate used to value assets. And what I argue in the book is that the great speculative bubbles, really all the great speculative bubbles in history, have occurred at periods when interest rates were abnormally low, during periods of what we call easy money, and that I hadn't you know. You mentioned my earlier book, devil, take the High Moats, which have a whole chapter on the tulip mania. Central Bank of Holland was issuing more notes and there were large capital inflows into Holland at the time, so there was clearly a monetary aspect to even the tulip mania.

Speaker 3: 10:20

But if you go, I mean the case I give most space to in the early parts of the book is John Law of the Mississippi Company fame. And again, I hadn't realized before writing the book that John Law said I mean for your, for your members who are not really familiar with John Law. He's a Scotsman, a brilliant mathematician, an economic theorist, a gambler, who travels around Europe in the early 18th century and he comes to France around 1710, and he's full of ideas and of his ideas. He wants to modernize french finance finances and he wants to relieve the government debt, which at the time was very high owing to the fact that louis cato's, the so-called sun king, was always engaged in in costly foreign wars, dies in 1715, and law has his opening. He manages to persuade the new ruler of France, who's the regent, to start a bank and that becomes the first central bank in France, the first central bank in France. And he also starts his Mississippi company, as we call it, which merges a whole load of French corporations together. And what Law does is he replaces gold and silver money in France with a paper money and he also offers, via the Mississippi company, to take over all the French government debt, and this is funded really through paper loans made by the Royal Bank.

Speaker 3: 12:15

Now, the key point about this, about Law's experiment, is that he was, as his academic biographer Antoine Murthy says. He was a low-interest advocate, just like the modern central bankers were up until recently, and he engineered a decline in French interest rates from about a range of 6% to 8% down to about 2% in 1720. And at that time he also lent a lot of money from the Central Bank to pump up the Mississippi Company stock, and the Mississippi Company stock then went to a price earnings multiple of 50 times and as it paid out all its profits, and perhaps a tiny bit more, its dividend yield was 2%. So you can see that the dividend yield was brought down in line with the interest rate and law at the time said ah, you know, don't worry about the price of Mississippi stock, it's justified by the low rate of interest. Then, you know, inflation seems to. You've heard it before. Yeah, it's what we call the Fed model. Now, it's the earnings yield of the market above the treasury yield and then. So then inflation seeps into the system.

Speaker 3: 13:35

Law has to sort of engage a bit of monetary tightening and the system collapses and law has to flee the country at the end of 1720. And this actually is, you know, disaster for France, because they scrap all laws, innovations bring out the good ones and some modern finance with the bad ones, and that really means that France I don't write about this in the book, but in France through the rest of the 18th century remained with a very backward financial arrangements and government debt arrangements, no central bank, no bond market and so on. And then, you know, the French insisted on funding the Americans in their revolution and became crippled with their debt and that really engendered the French Revolution. So you can see that a financial mishap can have a very long tail. And then later in the book I argue that the ebbs and flows of financial crises through the 19th century tend to coincide with periods of low interest rates, century tend to coincide with periods of low interest rates, and that in the 1920s, although nominal and real rates of interest appeared relatively high, um, they were actually low regard in relation to the extraordinary economic growth of the 1920s.

Speaker 3: 15:01

I think economic, I'm saying that I think sort of productivity growth was running in the range of sort of 7 to 8% a year in the 20s and rates were kept below nominal GDP growth. And I think, although I say, one doesn't really know what the fair rate of interest is, if an interest rate is kept below the growth rate, the nominal GDP growth rate, that's often a sign that the rate is too low. And then what do we have? In the 1920s we had you know, obviously you know the stock market, that you know the great stock market bubble, funded initially with margin loans. You had real estate speculation across the country.

Speaker 2: 15:47

So that's one of the mechanisms whereby your book has a number of instances where interest rates were kept at a low level for a period of years and then there's a crisis, and the Mississippi bubble is one of many in the book where that happened, and I think it would help the audience to just elaborate on sort of what's the mechanism whereby, like very low interest rates, as you say, perhaps interest rates lower than the nominal growth of GDP, sort of lead to the conditions that become a crisis.

Speaker 3: 16:22

Yeah, well, so I say that interest serves a number of functions. We've discussed capitalization rate, in other words, the relationship between the interest rate and the valuation of assets, how easy money can lead to speculative bubbles. Interest also affects risk appetite. I have a chapter, as you know, where I cite an 18th century Italian intellectual called Fernando Gagliani in which he says that interest is. I love it. He calls interest the price of anxiety and that all lending involves some anxiety, or at least it ought to, and that the lender should be compensated for anxiety. And I say, well, actually, let's put this in modern language, interest is the price of risk, and it's also, if you want to be a bit more boring about it, it's obviously the cost and price of leverage. And that works two ways. You lower the interest rate, and we all know this from our professional lives. If you lower interest rates down to very low levels, you create an incentive to chase yield and once investors get engaged in yield chasing, they begin to become. They tend to lower their lending standards, and we saw that.

Speaker 3: 17:56

You know, very clearly, in the run up to the global financial crisis and you know it's tend to be people have tended to forget that. You know that the origins at least to my mind, the global financial crisis lie with the easy money that followed from the dot-com bust when the Fed took its policy rate down to 1%. Anyhow, if you think back to the global financial crisis prior to it, the reason all that subprime lending was popular and the reason CDOs became fashionable is that was funded by banks and investors who were seeking an incremental yield pickup. And then you know, on the other side, you know you've got the borrowers and who, who, who, when interest rates will low, will, will lever up, you know, and so so that is problematic. And there's another function. If you remember, I have another chapter in my book on capital flows, and this is important because when interest rates are low in the core of the financial system and that would be in Holland, you know, in the 17th century, in Britain from the 18th and 19th century, and then United States thereafter when rates are low at the core of the financial system, there's a huge incentive for this yield chasing to take place across borders, this yield chasing to take place across borders. And so you get these um foreign lending booms.

Speaker 3: 20:01

And the first one I chart is or mention again, which is also mentioned in devil take the high most. But it is the um latin american uh lending boom of the early 1820s. And what you see, and there you know, the newly independent Latin American republics all borrowed and they were at a time when interest rates were low in Britain and investors in the City of London were looking for higher yields. And there's a great surge of foreign lending. And every single one of those debts defaulted, including a debt, a loan raised by this Scottish buccaneer sort of con man called Gregor McGregor, who styled himself the kazik of poye, which was a little territory on the darien peninsula. Uh, and and um gregor mcgregor, the kazik claimed it had great prospects. They raised, I think, a half million pound loan. All these loans officially had a, a sinking fund, and they paid. They paid their coupons out of the thinking fund. So they paid. They tended to pay one or two coupons and then go bust.

Speaker 3: 21:15

And then we, you know, we see that through the 19th century, you know, the great argentine boom of the 1880s that collapses in the early 1990s and brings down uh the great, uh merchant bank, uh, bearings brothers, at least for the first time it got up off its feet and then got knocked down again a century later, but that was also induced by low interest rates in Britain and then the 1920s.

Speaker 3: 21:45

Again, the relatively low rates in the United States compared to the yields in available in Central Europe and in Latin America encourage massive capital outflows into those countries from the US. Basically, the Americans started tightening money in early 1928. Capital ceased to flow to Central Europe and Latin America. In fact, actually, the Europeans started lending their money into the US. Because you get high, you've got very high rates on these margin lends that are very popular. It's very important because Americans tend to oversee this is that the beginning of the Great Depression really comes from weakness in Europe and is triggered initially by the collapse of the Austrian and German banking system. So that's a nice example of low interest reading to capital flows, the reversal of capital flows leading to you know, after all, the greatest financial crisis.

Speaker 2: 23:01

Yeah, your book talks about that, about how, when rates are really low, then investors become more risk-seeking because they get such a paltry amount from fixed income. Then they end up doing as you say investing overseas or investing in more speculative ventures. But you also in your book talk about how low interest rates can lead to sustained misallocation of capital as well. I wonder if you could elaborate on that.

Speaker 3: 23:32

Yeah, I can. I mean, this is very important. To my mind. One of the functions of interest is to determine, as you know, whether an investment, a capital investment, is viable or not. So the interest rate is linked to the hurdle rate on an investment or to the payback. These are just back of the envelope calculations of whether a debt, whether an investment, is viable.

Speaker 3: 24:04

If you lower the rate of interest, you will then make certain investments viable that wouldn't be viable at a higher rate and, to my mind, that works two ways. First of all, it keeps businesses that have too low a return on capital in business that would otherwise be out of business. So a very low interest rate becomes a type of loan forbearance. And what you know, what I argue, is that we saw this in Japan in the 1990s, with the combination of the beginning of the zero interest rate policy with the, with the banks actually straightforwardly engaged in loan forbearance, of not pulling the plug on very weak, unprofitable, over-indebted companies.

Speaker 3: 25:00

And I argue that the ultra-low rates of interest after the global financial crisis encouraged the formation around the world of these so-called corporate zombies, a zombie being a company that, even despite low interest rates, is unable to cover its interest costs from profits. And zombies are, I argue, poor for productivity because they're associated with low firm exit within an industry, but also low firm entry because the industry is sort of clogged with relatively low investment levels and low productivity growth. So you can see, you don't really want to encourage the formation of too many zombies, so you could. I mean I've mentioned Jim Grant, the financial writer. He talks about the interest rate being like the tempo at which an economy is run, so that as you lower the interest rate you slow the tempo until finally, at zero rates, you get to a sort of death march.

Speaker 2: 26:13

And isn't what you just said, contrary to the notion that many people, including central bankers, have that. Well, if the economy is sluggish, then lowering interest rates is just the thing to get it moving faster. It sounds like what you just said Well, wait a minute, you're actually like going to a lower tempo.

Speaker 3: 26:33

Yeah, I think so, and I mean obviously I. You know I have two advantages over central bank, and one I have the benefit of hindsight, and the other is that, as I didn't implement these policies, I'm not responsible for covering up any policy error. Now I think the central bankers thought oh, we lower rates, companies will borrow more and they'll invest more and then, you know, economic growth will take off. It didn't happen that way and in part, as you know, ken and I write about it, but we all saw it is that when interest rates were extremely low, companies tended to turn to financial engineering by using the debt to pay back, to buy back their shares and lever up, which gives immediate return to stockholders. It tends to be applauded by, you know, your activist investors and um is um and is popular with, with senior management who have paid with equity-based incentives, whereas you know if, you if, and it has very quick payoff to that. Whereas you invest in a new plant, you know it's going to take longer and and take longer and it's, in a way, higher risk for a manager with short term horizons. Capital allocation story is not just about zombie companies, although zombie companies, as I say, you know, slow creative destruction, and that slow creative destruction, slowing of creative destruction, which the Austrian economist Joseph Schumpeter calls the most vital force in capitalism, is in itself a bad thing. But the other aspect of very low interest rates is that they encourage investment in long dated assets.

Speaker 3: 28:38

And I would say, as you're you know, none of you so far from Silicon Valley that Silicon Valley was one of the prime beneficiaries of the ultra low rates, for two reasons really. One is, um, you know, sort of returns chasing, uh again with low rates, um threatening to depress returns on portfolios, uh, there was an incentive to to go in you know more into onto the vc side of things. But also because venture capital investments by their nature produce profits in the long, distant future not all of them, but in general and therefore those long dated profits have a higher value, current value, at times of depressed interest rates. And I think what we saw then was a sort of slew of investments. You know, a great Silicon Valley boom that became, you know, I think, sort of, to my mind, rather sort of you know it became rather irresponsible in its last years and funded a lot of businesses that probably shouldn't have been been funded.

Speaker 3: 29:49

So you've got sort of capital trapped in, uh, in low return businesses and then capital diverted to sort of high you know, potentially high return but very distant return uh ventures that then get, um, you know that. Then the plug is pulled and we see that I mean I think really you know, you see that with you know, with you know, then the plug is pulled and we see that I mean I think really you know, you see that, with you know, with a whole load of the funding of electric vehicle businesses. You look at the Wall Street Journal on almost a weekly basis you see another EV company going to the wall. You see, actually a lot of the alternative energy, very long dated, you know, these wind farms and so on, where all capital costs are up front but returns in a more distant future.

Speaker 3: 30:38

So if you have a low rate of interest, these businesses become viable and suddenly you change the rate of interest and that business loses its viability and that business loses its viability and you have a lot of and we haven't mentioned it yet, but we can do obviously a lot of money going into commercial real estate, because the real estate developers love easy money more than anyone else on earth and you're sure that the marginal developer will borrow and lever up to the highest possible rate and overbuild at rates Q&A, and I'll try to get to them. First, though, I want to ask about the recent period of low interest rates, a long period, and then there was a crisis got me thinking.

Speaker 2: 31:26

Well, we just now, recently, had the lowest interest rates ever, you know, a large portion of the sovereign bond market, uh, having negative yields, in fact, and, and given the pattern that your book establishes, it suggests that we could be in store for some trouble in financial markets. It doesn't seem, other than the bond market. It doesn't seem that that trouble has manifested itself yet. But I'm very interested in having you comment on, like one of the reviewers of your book said well, now that I've read, you know, mr Chancellor's book, I'm just going to sell everything because you know, we know what happens when interest going to sell everything, because you know, we know what happens when interest rates are really low for a long time. Uh, what do you think will happen this time?

Speaker 3: 32:37

I wouldn't. I wouldn't actually necessarily advise that, but everyone could do do what they want to be. So so this is interesting. Um, I mean, I have to say, you know, say there is an element of sort of there's a doom-laden element to my book. As you get towards the end, I think, when I was sending it to the publishers, they had some sort of blurb which they'd written saying well, unless policymakers come to understand this, will the world move towards another financial crisis. And I said no, forget it, this is far too late to get out of this hole that we've dug ourselves in. And so then what? And it is, you know, it is interesting what's happened over the last couple of years, because I sent the book in to the publisher just yet, but really before the Fed and any other other central banks had tightened.

Speaker 3: 33:36

So in 2022, the Fed starts to tighten and as, as you mentioned, we get this huge sell-off in the bond markets and the bond market crash is really phenomenal, actually year since the creation of the first sort of long bond issued in Britain in the 1750s so-called consuls. And you have some of these bonds, like the Austrian 100-year bond, selling off 75%. And you have a UK linker index link bond 50-year bond also down 75%, 80%. So you get a pretty big bond crash. You get a sort of decent bear market, if you remember, but it doesn't last very long and the markets come back pretty quickly. You get this expectation of a so-called hard landing and a recession, and that hard landing and recession doesn't immediately arrive. And then you get this flurry of interest around artificial intelligence and a new sort of speculative boom in the market, initially concentrated around the so-called magnificent seven stocks, all of whom have some sort of AI story to tell. And so that is you know. That's sort of where we are. There are reasons. So why have we not had a hard landing? I think you know in part. Simply, you know the US federal government borrowed and spent a huge amount of money last year. They sort of preempted any hard landing before anything had come about. I think the AI I mean I would call it a bubble, but you know the AI boom has rekindled animal spirits.

Speaker 3: 35:40

As you see, meme stocks are back in favor, gamestop or whatever has risen from the dead, and my view is it takes you know I thought about this a bit more and it takes a while to readjust to the higher rates. I think you know corporations took advantage of the very low rates to lock in the very low rates and people got interest rate swaps when they borrowed, even when they borrowed a floating rate again to lock in for two or three years into low rates at very low costs. I think you could, real estate developer, could ensure that, you know, get an interest rate swap on one hundred million dollar loan for fifty seven thousand dollars back in 2021. So you'd have to be a sort of you know pretty dumb not to spend that fifty seven thousand to lock in the rates, not to spend that 57,000 to lock in the rates. And then you know a lot of in the US, a lot of the most homeowners you know, termed out their borrowing with fixed rate borrowing. And so what I think that means is that it's taking a while for the markets to really sort of you know, take on board the readjustment to higher rates. And you know I mentioned commercial real estate, I think, because a lot of commercial real estate funding is floating rate. That is actually pretty much, you know, a slow motion train wreck, pretty much a you know a slow motion train wreck, and you know you can read perfectly respectable analyses of the commercial real estate situation. That, look, you know, that makes it sound fairly horrendous.

Speaker 3: 37:33

You've got, you know, on a global basis. You've got China. China's real estate bust is going on. And to me, you know, as you know, I've got a chapter on China in the book. When I talk about the build-up of debt and the real estate bubble and the overinvestment, I think the China story again is quite slow play but really a very big story. And then look at Japan. Japan took, after the bubble economy, another boom that was created in some part by easy money from the Bank of Japan in the 1980s. It took, you know, a couple of decades to play out. So my, my sense is that there's a pig in the python, okay, slowly moving through it. You know we're talking about. You know the economies and financial markets. They're very complex systems, aren't they? And therefore one never quite knows when, you know when things are going to be triggered.

Speaker 2: 38:40

You have a question that kind of relates to this thread of the conversation. You know, of course, we're here in Silicon Valley, Many of us have worked at tech firms or have positions with tech companies and, as you said earlier, the very low interest rates sort of induces more investment in long duration assets, including, you know, startup companies whose profits are well down the road. The questioner is asking that made sense or that could be why many things were funded in, you know, 2020, 2021. But now that interest rates have risen quite a lot since then, we're still seeing recovery to record highs for NASDAQ 100 and other kind of tech indices. So then does that mean that the long duration assets get priced up? Low interest rates are high.

Speaker 3: 39:35

Well, I mean, it's pretty anomalous, I have to say, the rebound of NASDAQ and the insertion or the appearance of this AI frenzy, just as all these SPACs the SPACs that merge with the flakiest tech companies you'd ever heard Just as those SPACs were down 95% and going bust. You suddenly had this sort of bunny boiler of a new tech boom rising from the dead, and that I mean I have racked my head to see anything like it. And what we've seen historically is, you know, good old fashioned bear market rallies, and sometimes a bear market rally, you know, takes the market back, you know, quite close to its highs. This is, you know, if this is a bear market rally.

Speaker 3: 40:41

Even though new record highs are being set yeah, yeah, it was part of part of a longer bear market and then I mean I, if it were, I'd say it was the greatest bear market rally history uh and I don't know.

Speaker 3: 40:58

You know you can take. You know you said that someone read the book. A reviewer read the book. Know you know you can take. You know you said that someone read the book. A reviewer read the book and said you know, sell all your stock. It's actually not the message of the book. It's actually, I think, one of the problems that I identified from the low interest rate era.

Speaker 3: 41:17

And bear in mind, as you mentioned, I was working in the asset allocation team at GMO for the first half of the decade and you know we were finding relatively few you know investment opportunities. So you know, and whereas in the previous period, at least at the end of the dotcom bubble, there was huge investment opportunities in stuff outside of NASDAQ, the NASDAQ might have been fated to go down 75%, but you could make. If you had your head screwed on the right way, you could invest quite heavily. I think at the end of you know, going into 2022, it was very difficult to think of a. You know which assets were particularly attractively priced and therefore, I think under those circumstances, you need a tiny bit of diversification. You don't want to.

Speaker 3: 42:08

I think the good news from an you know, from an investment perspective over the last couple of years is that, while the stock market remains pretty expensive in the US, you know the bonds have repriced and in particular you know the inflation, inflation, protected bonds, the tips. You know yield, you know a really decent return to my mind. You know sort of in range. And even if you go to Japan, you know the 30 year bond is no longer yielding negative but you get 200 basis points. So from an asset allocation perspective now, I mean, my view is, you know I wouldn't put all your money on this, on there not being a next leg down in the bull market, but I think you can allocate capital. It's a somewhat better situation at least, than it was two years ago.

Speaker 2: 43:08

In the book. I'm going to riff on one of the questions the question is asking. In the Mississippi bubble example, the questioner is asking you know, were market rates, market, interest rates, market determined then, and now they're kind of engineered by central banks. Is that in the book? In the book you kind of it's a pretty strong critique of how central banks think and, in particular, if you know if the guiding light is managing inflation up and down. You seem to be suggesting that they're missing some other guiding lights. That might even be more important than that. Can you talk about the management of interest rates, what central banks have been doing in the last decade and what you would have them do? That's different.

Speaker 3: 43:59

Yes, I mean. First of all, I'd like to clarify that the under the mississippi company in the john law's period of preeminence in the past it was a paper currency. So law in effect was manipulating the interest rates under a um, under the sort of gold standard system. Um, which you know was sort of became predominant in the late 19th century, but you could say that the British was engaged in that from the early 18th century onwards. Basically, the central bank had to redeem its notes in gold with a certain fixed quantity of gold and therefore what the central bank would do is when its stock of gold was high, it would issue more notes, and when its stock of low was and interest and lower interest rates, and when its stock of gold was very low, it would raise interest rates and so that so the flow. You didn't need you know a PhD in economics to find out what your stock of bullion was. So in fact, actually I quite liked about the Bank of England in the 18th century. It was sort of run by merchants. There was no, there was no economist within you know 100 miles, economists within you know 100 miles. There were no bankers. Bankers weren't allowed near the court of the Bank of England because they were considered to be sort of likely to be undermining its purpose Anyhow. So there you know the. Under that system. You know I don't want to get into defence of the system because it does lead to very severe busts.

Speaker 3: 45:38

However, the interest rate is being set automatically by the relationship between, if you will, the amount of credit outstanding and the underlying monetary stock. And the underlying monetary stock cannot be sort of fiddled with. To go into the modern world, because you've got a fiat currency system which basically depends on the apex of which is the central bank and under which money can be created by the central bank. To determine the rate of interest, you can no longer have a merchant who left school at the age of 12 determining what the century, what the interest rate is. Instead, you have to employ, you know, you know, hundreds of hundreds of economists, uh, with their models, to um, determine what the what the right rate of interest is. And I suppose I come at it. You know, from the perspective that how would a committee, how could a committee of people know what the correct rate of interest should be? It's they set themselves to ground a task and then, and then they I think you know they. What's happened is everyone's clutched on to because the task was so difficult. They said we need to know, you know something to set the rate, so we'll just clutch onto this. You know inflation target That'll be our life vest tossed around in the uncertainties of the monetary world. And, as you know, I say that the interest rate is not a. The current near-term inflation rate is not a good guide for setting monetary policy.

Speaker 3: 47:27

You know the central bankers, to my mind, obsess far too much about deflation. I mean, you know, think about Silicon Valley and computers and this. And that you know huge Every year, falling prices. Falling prices are just, and that you know, huge every year, falling prices. Falling prices are just a result. You know, inevitable consequence of technological development, of productivity growth and a welcome. You know people like falling prices, believe it or not. And yet you know the central bankers did their best to prevent, to stop the price level from falling. Which means, frankly, if you've got let's just say you had you know two products, yeah, let's say you've got two products, a good and a service economy. One is your tech goods, goods, your computers, and the other is, say, college education and as as your, as the price of the tech product is um coming down, you're going to have to push up the central bank is going to have to push up the price of the college education in order to keep his average the same. It it's. It has a very um has a very corrupting effect. This, uh, near-term focus on, on, on um, on inflation targeting, uh, and I I mean I don't know the correct system to move to.

Speaker 3: 48:54

I I wouldn't advocate going back to gold standard. There is a friend of mine who was former chief economist at Deutsche Bank, called Thomas Meyer. He thinks that you could create a central bank digital currency that was limit, that grew only by a certain amount. You know was constitutionally created, that it would only grow by a certain amount a year, two or three percentage points, and that could you know that would, that would, that would create a fixed, a relatively fixed money at least, with a constant rate, and that, you could see, would allow for the interest rate then to be determined by the, by genuine savings and um and and the and the demand for savings. So I mean really one. I don't think enough thought has gone into if central bankers cannot determine, if no individual can determine, what the right rate of interest is and we wouldn't ask them to determine. You know, I'm holding a pen in my hand. We wouldn't ask any individual to say look, what are the components of this pen? How much should it be priced? We let the market determine the price of this pen.

Speaker 2: 50:10

We just got a question. I know we're almost out of time, but it sounds like the questioner says so. Data dependency is a pretty poor idea, but I don't think that's really what you're arguing. I think you're saying that just looking at one piece of data, which is the rate of inflation, and not looking at what's happening to credit creation or to stock prices and leverage, it's just kind of myopic. What data matters, right?

Speaker 3: 50:40

I mean, I don't look, I don't. What I know about the central bank models is second hand, but I think the central bank models also you know the huge amount of theoretical input into the very unrealistic is that their models don't actually include money in a financial system. They, there is, you know, there's one firm like the representative firm, so that one firm doesn't know all this zombie stuff I told you about, doesn't really recognize that you have, you know, one individual the representative investor. So the it's not. It's that the central banking is both a mixture of, you know, drowning in data but also having, you know, highly unrealistic models, of highly unrealistic models of how the world actually works.

Speaker 3: 51:26

But yeah, to go back to your point, you're going to be pragmatic and you're not going to have a new monetary system. You can at least step back from this near-term inflation target and say, you know, is the deflation, say you were in a period of deflation. Is this deflation, debt deflation, you know, which might be bad if it's going to crumble the financial system as it was in 2008, 2009? Or is it the deflation that comes from higher productivity growth? Because that's a very simple question to analyze. And if it's the deflation from higher productivity growth, you say, well, this is the way to go. Yeah, you don't. You don't fight that deflation.

Speaker 3: 52:07

Likewise, you know with the leverage and you know I mean I think you know they. As you know, after the financial crisis we introduced huge amount of you know of financial regulation. That you know I'm sure it made your job a nightmare. It it's a nightmare work and it became an increasing nightmare if you're working professional investor to deal with this regulation. But in the end, the regulation the financial system doesn't come properly from, cannot come properly just from printing new rules. It has to come from actually setting a rate of interest that prevents excessive leverage, that doesn't encourage the deterioration in underwriting standards and carry trades and the like. All right.

Speaker 2: 52:52

I think we could. We could carry on and have this fascinating conversation, but I think we've come to the end of the hour. Thoroughly enjoyed this book. I highly recommend it. But I think we've come to the end of the hour. Thoroughly enjoyed this book. I highly recommend it. It's not just informative, it's also an engaging history of interest and I learned a lot, and I expect that those of you in the audience would enjoy it as well. So thank you so much, edward, for spending your time with the CFA Society of San Francisco. Thank you, thank you sincerely for joining us today.

Speaker 1: 53:23

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