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.

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.

• “Negative Is The New Subprime” by Michael Lebowitz and Jack Scott at Real Investment Advice, August 14.
• “How Negative Interest Rates Screw Up the Economy” by Wolf Ricter, August 21.
• “12 Reasons Why Negative Rates Will Devastate The World” at Zerohedge (they’re not always wrong), August 29.
• “Negative Interest Rates Threaten the Financial System” by Jim Bianco (President of Bianco Research) at Bloomberg, September 3. Also see his interview at The Market: “Negative Interest Rates Are Extremely Toxic.“

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.

“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.

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.

Notes.

• Co-published with The Long Run, the blog of the Economic History Society.
• This post is based on the author’s papers “Financialization of the early Victorian economy and the London Stock Exchange” and Supplementary material for “Economically irrational pricing of 19th century British government bonds“. This research was presented at the annual conference of the Economic History Society in Cambridge, 1-3 April 2016.
• The post gives the views of its author, not the position of LSE Business Review, the London School of Economics or the University of Minnesota.
• Published by the LSE under Creative Commons license CC BY-NC-ND 2.0.

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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.

• “Technobubbles: Ancient, recent, and future” at GIGAOM.
• “The Internet and past and future communications revolutions” in IEEE Internet Computing, Jan/Feb 2010.

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:
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.”