Interest rates are negative. Is the economy crashing?

Summary: Interest rates have again plunged to near-zero and even below zero rates in some nations. Doomsters predict horrific consequences. But the long-dead financiers who built the British Empire advise us to stay cool, and look to history and economic theory for reassurance. It shows we have entered a new world in our new century.

A graph of interest rates on investment-grade bonds, US and foreign.

BofA-Merrill Graph of Global Interest Rates

Interest rates are falling fast in the US and have gone below zero in many markets around the world. As with all unusual phenomena, doomsters warn that this means disaster – or even that it will cause an apocalypse.

This is more evidence that, as I have been describing since 2003, that we are entering a new economic regime – the inevitable and irresistible evolution of the global economy in a changing world. Like all futures, it is a new combination of things from the past. As for Interest rates, they have been negative in the past without damaging the economy. But swings to extreme rates, high or low, can painfully destabilize financial markets. Unfortunately, we cannot predict which markets – or when. History shows that even market crashes need not wreck the real economy.

This essay by Andrew Odlyzko, one of our era’s top polymaths and futurists, gives us a new perspective on the economy and its markets by comparing them with those of Victorian England. Insights like this can help us better understand what is happening and what lies ahead.

Leadenhall Street in the City of London
Leadenhall Street in London. By Thomas Hosmer Shepherd (1837). From Wikimedia Commons.

What would surprise early Victorian market players
if they came alive today?

By Andrew Odlyzko in the LSE Business Review, 30 September 2016.

“Perhaps the greatest surprise would be the combination of high equity prices and low long-term interest rates.”

What would early Victorians make of today’s markets? Such questions are more than just idle curiosities. For example, the recent wide acceptance around the world of negative interest rates was a surprise. Why didn’t the money go into cash? Yet observers should not have been startled by this development. In Britain in the early 1850s, Exchequer Bills effectively offered negative rates. The convenience of those paper instruments gave them higher value than stacks of gold coins, just as today the convenience of electronic ledger balances is worth something compared to having to handle containers full of banknotes.

The Exchequer Bills episode is just one minor finding from recent studies that integrate data from the ledgers in the Bank of England Archive with price reports, press coverage, and other sources. Previously unknown statistics about completeness of price reports, turnover rates, and dealer activity have been obtained. It has also been found that the London Stock Exchange was a key part of the “shadow banking system” of the time.

Aside from statistics, we can also obtain some qualitative insights about modern finance from these investigations. Our basic laws and institutions are clear linear descendants of those created at that time.

If some of those early Victorians were to come alive today, they would have no difficulty recognising all the modern financial instruments and services, although they would surely marvel at such concoctions as CDO squareds. Many current concerns would be familiar to them as well. While they did not talk about climate change, they did worry about natural resource depletion, and the effects of globalisation.

Queen Victoria by Franz Xaver Winterhalter (1859)
Queen Victoria by Franz Xaver Winterhalter (1859).

Inequality was even greater than today. Deflation and the analogue of our “Great Savings Glut” were visible, and seemed natural. The terms secular stagnation and liquidity trap had not yet been invented, but they corresponded to widely held attitudes.

Although the financial system was far smaller than today, public opinions about it were not dissimilar. Respect was often mixed with fear and loathing, as in an 1850 magazine article that called the London Stock Exchange “an institution destitute of moral principle, but at the same time omnipotent in its influence upon the moral and social condition of nations {source here}.”

So what would surprise those early Victorian observers the most, were they to come alive today? One candidate would surely be our touching acceptance of financial innovation as socially productive. Another would be our faith in central planning, in the presumed ability of policy makers to ensure smooth and steady growth. The Minsky Instability Hypothesis would be regarded as obviously true.

What we find in the 19th century are opinions, such as that of The Times {on 14 May 1866}, that crashes occur about once a decade, and that they lead people to “the reflection that they are at least the wiser for it, that they will not be taken in a second time,” and yet “the next fit comes on them like the rest, and they go through all the stages of the disease with pathological accuracy.”

The Efficient Market Hypothesis would seem to the early Victorians as amusing, but a fantasy. They understood that some semblance of efficiency could be achieved, but only through diligent efforts of experienced traders. And even those traders could not always control market irrationalities, and were themselves subject to limitations of groupthink.

Perhaps the greatest and hardest to accept surprise in modern markets would be the combination of high equity prices and low long term interest rates. Today’s commentators regard this as natural, and keep reassuring investors that low interest rates help sustain record-high corporate profits, which justify the high share prices.

There is certainly evidence that in the short run, low interest rates do boost profits. But on a long scale, basic economic logic says that interest rate and profits should move the same way. After all, bonds and equity are just different ways to fund ventures, and interest and profits are the cost of capital. There is a difference between the two, reflecting different risks. But there should be a strong positive correlation. And that is how the early Victorians thought about it. The theoretician Robert Hamilton wrote about it in the 1810s.

So did James Morrison, one of the richest merchant bankers of that era, in the 1840s. And so did others. Were they to come alive today, they would surely be astounded. They would wonder why, if Lloyd Blankfein, the head of Goldman Sachs, was indeed “doing God’s work,” why was he not mobilising all that low-cost money lying around in order to compete away the extravagantly high equity returns? And they would surely conjecture that once capitalism started working properly again, this anomaly would disappear, and either bond or share prices (or both) would crash.



Andrew Odlyzko
Presentation at Kent State, 10 October 2014.

About the author

“Andrew Odlyzko has had a long career in research and research management at Bell Labs, AT&T Labs, and most recently at the University of Minnesota, where he built an interdisciplinary research center, and is now a Professor in the School of Mathematics. He has written over 150 technical papers in a wide range of fields, and has three patents.

“In recent years he has also been working in electronic commerce, economics of data networks, and economic history, especially on diffusion of technological innovation. More information, including papers and presentation decks, is available on his web site.”

Also see these articles.

For More Information

Ideas! For shopping ideas, see my recommended books and films at Amazon.

If you liked this post, like us on Facebook and follow us on Twitter. See all posts about Victorian England, and especially these…

  1. What are the limitations of the Fed’s power? It’s neither impotent nor omnipotent!
  2. Will 21st Century USA have a surprise boom, as did the 19th Century UK? – by Andrew Odlyzko.
  3. Are conservatives right about the Fed? Is it a malign force in America?
  4. Did anyone predict the 2008 crash? Will anyone predict the next crash?
  5. Today’s mythbusting: the Fed is not suppressing interest rates.
  6. WWI warns us about markets’ ability to see the future.
  7. A look at the US economy, and the next recession.

See the big picture about America’s economy

The Rise and Fall of American Growth
Available at Amazon.

The Rise and Fall of American Growth:
The U.S. Standard of Living since the Civil War

By Robert J. Gordon ,
Professor of Economics, Northwestern U.

From the publisher…

“In the century after the Civil War, an economic revolution improved the American standard of living in ways previously unimaginable. Electric lighting, indoor plumbing, motor vehicles, air travel, and television transformed households and workplaces. But has that era of unprecedented growth come to an end?

“Weaving together a vivid narrative, historical anecdotes, and economic analysis, The Rise and Fall of American Growth challenges the view that economic growth will continue unabated, and demonstrates that the life-altering scale of innovations between 1870 and 1970 cannot be repeated. Gordon contends that the nation’s productivity growth will be further held back by the headwinds of rising inequality, stagnating education, an aging population, and the rising debt of college students and the federal government, and that we must find new solutions.

“A critical voice in the most pressing debates of our time, The Rise and Fall of American Growth is at once a tribute to a century of radical change and a harbinger of tougher times to come.”


8 thoughts on “Interest rates are negative. Is the economy crashing?”

  1. This is a very nice essay. I completely agree that we can learn a lot about the present from a study of economic history, including that of the 19th century or the more distant past. Too many of the economic data series that we rely on begin only after WWII.

    Having said that, a comparison of zero interest rates today and in the 19th century needs to take one factor into account that this post misses. Namely, as nearly as economic historians can determine, the average rate of inflation throughout the 19th century was negative. Apparently, the overall price level in 1900 was lower than in 1800 in both the US and UK. Both countries experienced transient wartime inflation episodes, but those were reversed when peace came. Very roughly speaking, the average rate of inflation appears to have been about minus 1 percent per year. (See here or here for example.)

    For many purposes in economics, what matters are real interest rates, not nominal rates. The real rate of interest is the nominal rate minus the rate of inflation. That means that a zero rate of interest now means about a negative 1 percent in Europe and positive 2 percent in the US, compared to the 19th century, in which a zero nominal rate would have meant about a 1 percent positive rate.

    If you are a reader of Jane Austin or Anthony Trollope, you will know that the idle rich of the time could live their entire life clipping coupons on government bonds from fortunes that seem astonishingly modest in today’s terms. I seem to remember from Austin that the interest from a fortune of 10,000 pounds provided quite a decent income for life. Today, no matter how much capital you inherited, trying to live off the interest on government bonds (or even top quality corporates) would provide you only with an income that supported a gradually declining real standard of living over your life, and even to manage that, your real capital would gradually erode.

    1. Ed Dolan,

      Thank you for commenting, and sharing your knowledge and insights!

      For the period discussed here – the second half of the 19thC, the high Victorian era – the UK inflation rate was probably almost zero, not negative. It was slightly negative in the first half (-0.2%/yr) by this calculator. Of course, that must be a large margin of error in these estimates (before modern data collection of price data).

    2. Ed,

      Follow-up note.

      (1) I see articles about the great deflation of 1870-1890 (Wikipedia).

      (2) The 19th C was a period of radical change, like the 20th. The roughly 1860 – 1920 period had changes in life drastically greater than anything since WWII (details here). So the paucity of data and change in index composition make calculating inflation a challenge. What would the 19th C US CPI look like since 1970 if calculated like that of the 19th 21st Century – without with hedonic adjustments? Perhaps like that of the late 19th C? Would be deeply deflationary!

      (3) The Global Financial Data website does not give details (eg, composition) or sources for their CPI’s, unfortunately.

  2. Larry, I agree with much of what you say but am having troubles believing that there will be no obvious consequences if the US fixed income yield drops below zero. What happens after that would certainly usher in a brave new world but I also suspect it could only occur after a very serious financial crisis had been recognized by the US financial community (as opposed to the 2-8 potential financial crises that the US financial community is currently choosing to ignore because they haven’t hit critical mass yet). At best there would be considerable damage done to current US financial institutions because nearly everything in the US financial system assumes that the US fixed income yield will not go below zero.

    Do I regard the current moment as a crisis? No, I do not because none of the many potential crises have become reality yet and they may NEVER occur. Please note that I am NOT saying that financial crises will never happen. I am just saying that the ones that I currently see may never happen (especially if they are sidelined by something I haven’t identified yet).

    Net result of the statements above (which I admit are confusing): I understand and agree with your comments about US fixed income yields dropping below zero. But at the same time, I’m noting that there will be considerable havoc on the current institutions if such an event occurs and that US financial institutions are very likely to do whatever they can (which is a quite lot) to prevent this from happening.

    My crystal ball is very foggy at this time due to all the potential crises so I have no clue as to timing or likelihood of this event. It could be two days from now (very unlikely) or 10 years from now (also very unlikely simply because the crisis point will probably have passed by that time and we’ll either be settling into the new world order or congratulating ourselves on having dodged that bullet). Only time will tell.

    If you ask why I say 2-8 potential financial crises, it is because they overlap quite a lot on some points and stand clear of each other on other points. The precipitating event will determine which of these issues become important and what impact they will have on the US and the rest of the world (the impact will likely be very different in the US vs the rest of the world because of the results of the 2008 financial crisis).

    Most of the most likely flash points have to do with the US stock market being somewhat oversold (which is logical in light of current interest rates but that darned balloon just can’t keep going up forever…).

    Donald Trump is another potential flash point, especially in light of how he handled Hurricane Dorian on Friday (by threatening to fire NOAA weather predictors and their bosses who know more about weather than he does and who did not agree with his statement that Alabama was threatened by Dorian).

    Boris Johnson is yet another potential flash point for obvious reasons but is more likely to trigger a European meltdown that might slide over into the US than a pure US-initiated event (least likely to occur in the US of the three that I’ve named so far).

    But, to be brutally honest, the precipitating event will probably not be from anything I’ve mentioned so far and will probably be from something I would never have predicted. That’s how the Universe teaches people like you and me modesty.

    1. Pluto,

      You don’t appear clear about the point of this post. First, it was just about negative interest rates. It does not discuss Trump, Putin, asteroids from space, or any of the thousand and one other threats to our peace of mind.

      Second, “financial crisis” are a normal and unavoidable aspect of free markets. As are recessions and depressions, inflation and deflation.

      The point of this post is that we have had negative interest rates before, they didn’t crash the economy (and probably won’t now), and are temporary. They might preceed a crash in the equity or debt markets – which are also normal events.

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