Podcast: Play in new window
- Author Edward Chancellor Talks With David McAlvany
- Interest Rates Tell The Story Of Civilization For 5,000 Years
- Money Is A Powerful Instrument Of Freedom
“If you remember, the central banks justified their low—ultra low—rates, the zero rates and negative rates, on the grounds that they were fighting deflation. But actually, deflation, or falling prices, benefits the working family, and actually it’s not so good for corporations. The battle against deflation really could be seen as a battle against working people in favor of corporations. Again, it doesn’t come as a huge surprise that this last decade was one of very low income growth, but very bloated profits.” –Edward Chancellor
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
Our guest today, David, Edward Chancellor, has written a book that he calls The Price of Time, and I would also probably say the value of time. When we talk about valuation, price can sometimes show you what the value of something is, but value is something that actually is much deeper than price.
David: He says that, “all economic and financial activities take place across time. Interest is often described as the price of money, but it’s better called the price of time.” That’s where he gets the name of the book. Time is scarce. Time has value. Interest is the time value of money.
Kevin: When we talk about reading a book on interest rates, people can sometimes roll their eyes, but actually our very mortality makes us value time because we don’t have unlimited amounts of it.
David: It’s an incredibly engaging history. Of all the books I’ve read on interest rates, and there are a number of them which stretch to 7-, 800 pages, this one is entertaining. This one has scintillating facts and figures, and takes you on a whirlwind tour from ancient Mesopotamia to the current credit bubbles that we have both in the public and private sectors.
Kevin: Well, and written by a true storyteller and historian. This is a book that we do recommend our listeners read. This is not one of those too-technicals. This is definitely something that I would hand to a friend.
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David: Well, our guest, Edward Chancellor, read history at Oxford and Cambridge. He writes for Reuters, the Wall Street Journal, and the Financial Times, and has published a number of books on financial market history, including Devil Take the Hindmost: A History of Speculation, and most recently, The Price of Time: The Real Story of Interest.
I respond to book recommendations differently depending on the source and where the suggestion is recurrent. Jim Grant’s recommendation was a great start. Howard Marks’ mentioned of the book followed, and it was then that I requested it from the publisher.
The first pleasant surprise was perusing the bibliography and finding 15 of our past Commentary guests embedded as resources. You’ve captured a fascinating narrative in this history of rates, a narrative development of globalization, power, conflict, capital allocation, and a lot more. Edward, welcome to the program.
Edward: Oh, thanks for having me.
David: We’ve spoken with Doug Noland. We’re fortunate to work with him daily, and so many of the people in your book, Richard Sylla, William White, Carmen Reinhart, Antoin Murphy, Charles Goodhart, John Taylor, Andrew Smithers. In some respects reading The Price of Time was nostalgic. Certainly, a few years ago you could argue that interest rates were a bit nostalgic, too.
Having just experienced a period of zero interest rates, even negative rates, you provide a context for appreciating just how rare that is, how we got there, and what it implies about the world of today and tomorrow. You say that interest is required to direct the allocation of capital, and that without interest it becomes impossible to value investments. Elsewhere, you describe interest as the cost of leverage, the price of risk, and, I think more comprehensively, the price of time. Why is that the best definition of interest, the price of time?
Edward: Well, as you say, it’s comprehensive, and I think— Well, how did I get to it? If you remember in the book, I mention that the famous and powerful critique of interest, or usury, as it used to be called, from Aristotle, the Greek philosopher, claimed that money was to be used for exchange, and that it was unfair for a loan to increase in value through charge and interest. That view held, really, for a very long time—for roughly 1500 years or so. I really came to the understanding that Aristotle was wrong because Aristotle is imagining that if a person makes a loan at one moment, the loan is being repaid simultaneously. It’s clear that if I would lend you a hundred dollars and require that you paid me back $110 with a blink of an eye, that would be an unfair transaction. However, if I give you a loan of a hundred dollars and ask you to pay me back in a year’s time, it’s not unreasonable that I should ask for $10 a supplement.
So what is interest but a price charged for the use of something of value over a period of time—or the price of time. Namely, the difference, one way of putting it quite [unclear], is difference between the value of money today and the value of money at some stage in the future. I think that’s the key point. It’s best summarized as the price of time, and then all these other definitions of interest that I address—the interest used to value assets, the capitalization rate or discount rate, or interest as a yardstick for investment, the required rate of return, or interest as an incentive to save—these all really follow from there being a price for use of something over a period of time.
If you will, the other definitions of interest, which I can probably list half a dozen at least, are subsidiary to the general definition of the price of time. And then as you know, I ask in the book, “Well, why does time have value? Time has value for a human being simply because of our mortality, inbuilt impatience, or what economists often call time preference. Obviously, as we all know, the time preference is built into the net present value, the fact that you prefer some value today than value at some stage in the future. That was least recognized quite clearly in the 18th century.
I cite in the book John Law, the Scottish projector and monetary experimenter, but he had a very clear idea. He writes at one stage, “Anticipation is always at a discount.” I think that view has really been understood quite clearly since the 17th, 18th century. Even if you go back earlier, at a time when usury was not accepted and was banned by the medieval church— As you remember, I cite some medieval English cleric, Thomas of Cobham, saying that the usurers, the lenders charging interest, were sellers of time. I think that’s quite a nice way of putting it.
Now, it just so happens in the theocratic world of medieval Europe, medieval Christendom, that the clerics believed that time belonged to God. It was still illegitimate in their view to charge interest, but once you get to the Renaissance, people begin to realize that time belongs to the individual. Once you get to the 18th century, you have Ben Franklin banging on about time is money. You can see that that question of time and interest, and time, and the value of time is something that people have thought about and latched onto for a very long period of time.
David: Whether it’s the Mesopotamian credit, the Code of Hammurabi, or Ancient Greece and Rome, how do interest rates chart civilization’s development and ultimate demise? You referenced sort of a U-shaped curve.
Edward: Well, you said you had Dick Sylla on your podcast, is that correct?
David: That’s right.
Edward: I take this observation from [Sidney] Homer and [Richard] Sylla’s History of Interest Rates, where they show this consistent pattern of interests over the course of civilizations forming a U-shape. At the start of the civilization, the interest rate is high. As the civilization progresses, interest rates fall and they remain at a stable low level. And then as the civilization disintegrates and falls, interest rates rise. That’s where you get your U-shape.
It’s pretty easy to surmise why that’s the case because in the early stage of civilization there won’t be very many accumulated savings, there won’t be many lending institutions, and therefore savings to be lent or, if you will, the surplus of an economy will be relatively scarce, and the charge for loans will be relatively high.
And then, as the civilization establishes, we get what the economy is called financial deepening, which means that there are more banks around. You no longer have to put your savings in the form of some precious metal under your bed, but you can deposit it at a bank. That bank then lends out the money and the ease of depositing money and the ease of borrowing it naturally brings down the rate of interest charged by financial institutions.
If there’s a period of stability—and stability is often associated with price stability, political and price stability—that’s another reason why interest rates might remain low. And then when you come to the end of civilization, then the benign situation reverses itself, the surplus produced in an economy might evaporate normally through warfare. Savings is scarce, the risk of lending becomes much higher because if a society is falling to pieces, the chance of getting your money back is less.
If you remember, one of my definitions of interest is from an 18th century intellectual, Ferdinando Galiani, is that interest is the price of anxiety, or the price of risk. As a civilization is falling to pieces, obviously the risk of lending is that much higher. You have all those reasons for why interest might follow, or appears to have followed, this civilizational U-curve. Homer and Sylla noted for ancient Mesopotamia, Babylon, then Greece, and also for Rome, and then you can also see it for Holland in the early modern period, because the Dutch were really the first to pioneer financial capitalism.
In the 17th and 18th century, or early 18th century, their interest rates were much lower than everywhere else in Europe. And then the Dutch Republic loses its independence to Napoleon at the end of the 18th century, and interest rates in Holland soared. Although it’s not really the end of Dutch civilization, it is the end of the Dutch Republic. You see the familiar U-curve there. Given that you work with Doug and Doug frets about the collapse of civilization, I make the point that it wasn’t a very comforting thought to see these U-shaped course of interest rates, given that in the last decade, we were at extremely low levels. I’m not saying those extremely low levels definitely tell you the world’s going to come to an end, but they’re also not telling you that the world is safe in perpetuity.
David: Yeah. Clearly, we’ve benefited from globalization and a removal of certain economic frictions with improved trade and capital flows.
Edward: Let me start— On the globalization, that’s obviously more of a recent phenomenon than you can find the ancient one. But we do find in the second half of the 19th century, which is deemed to be a period of strong globalization and actually also large migration flows from Europe to the United States in particular, that globalization tends to depress traded goods prices. In other words, the more movement of labor and goods you have across borders, that has a depressing effect on inflation. That seems to go hand in hand with low interest rates. We saw that from roughly 1860 to 1900 in the US and, again, the process of globalization, which we might chart with the beginning of Deng Xiaoping’s reforms in China in, starting ’79. That beginning is coincidental with the peak in interest rates in the early 1980s, the peak of inflation in the early 1980s, followed by this very long 40-year period in which interest rates were going down.
And I do think about it a bit, and clearly, it’s not a hard and fast relationship between interest rates and globalization because, as you know, the 1930s was a period of complete collapse of the global trading system, and tariff barriers erected, and capital controls, and so forth. But it was also a time in which interest rates remained low. In fact, as countries came off the gold standard one after another, and as the US devalued the dollar relative to gold in 1933, that tended to coincide with low rates. So it’s not a hard and fast rule—as I say, the relationship between globalization and interest rates—but it works most of the time, let’s say.
David: So this issue of rates and whether or not they are determined by nature or determined by committee, the latter seems to be a more popular idea today. How do we understand the natural rate? Do we need to put air quotes around the word natural?
Edward: Yeah, it’s like— As Clinton would say, it depends on what you mean by natural rate. There are different ways of looking at it. I draw attention to how people thought about it in the 17th century, how English writers such as John Locke, the philosopher, wrote about interest in the 17th century. What they mean by natural rate then is the rate of interest as determined in the market. In other words, without a state imposing a rate of interest. Now, in the Middle Ages, actually in Britain right through to the 19th century, we had usury laws that restricted the amount of maximum interest that could be charged. And in the late 17th century, there was a debate going on about whether the usury laws should be changed to lower the maximum rate of interest. And Locke said, “No, this was a bad idea. It was much better that the rate should be set in the market by borrowers and lenders.” That’s one definition of the natural rate.
And the other, sort of economist, definition of a natural rate, and this is where I think you can put your inverted commas around it. It was really devised by the Swedish economist called Knut Wicksell. And there— It’s a very abstract idea. It’s the natural rate— The way the modern economists think about it is the return on capital in an economy without money. And that’s the idealistic view of a natural rate. Now, from Wicksell onwards, the economists have tended to say, “Well, if this is the case, then because we live in a monetary economy, we can tell when the interest rates are out of line with their natural rate because we’ll either have inflation or deflation. If the central bank rate is too low, we get inflation. If it’s too high, we’ll get deflation.” And I argue, as you know, that actually the presence or absence of inflation or deflation are not a reliable indicator of the natural rate.
And I then really go on to say, you are never going to uncover this economist’s ideal natural rate. It’s a sort of platonic ideal, and I say, at best you can really observe it from its absence. And in particular, that’s the focus of my book—written and researched mostly towards the second half of the last decade—was on the impact of ultra low rates. I used to say you can see when the market rates of interest and central bank rates of interest are below the, inverted commas, “natural rate”, because you will see asset price bubbles, you’ll see debt credit bubbles, and all the stuff that your friend and colleague Doug Noland writes about.
David: From Knut Wicksell, we have this impression that interest rates are natural expression of economic activity consistent with a return on capital. I guess it’s very like John Taylor’s rule. But if I read Michael Woodford as an example, there’s some suggestion that the natural rate is what you want it to be. We’ve gone from the gold standard era with sort of the automatically corrective element to that. Now, we have both the quantity of money, quantity of credit, and the price that’s put on that credit as discretionary. What do you think of that new orthodoxy?
Edward: Well, the point I tried to make in the book is that interest is a very complex phenomenon that is drawn from all sorts of different influences relating to genuine savings and genuine investment demand, but also related to how much money is created, whether by banks or by central banks. So there’s partly a real phenomenon, partly a monetary phenomenon. And my view is that it’s beyond the wit of a committee to actually gauge and set a correct rate of interest. Now, we understand that, and it would be generally accepted that, you wouldn’t have a bunch of economists in Washington, D.C. sitting around, working out how to price a bottle of beer, for instance, because they wouldn’t have the correct information about the cost of the inputs and so forth. Now, my own view is, it’s a harder task for a group of Woodford’s disciples sitting in the Eccles building in D.C. to set the interest rate if they choose to manipulate the interest rate for policy purposes, which is clearly what happened after 2008.
And in fact, as you know, it’s really been happening for a long time beforehand. It happened after the dot-com bust when rates were kept very low. It happened after the collapse of the hedge fund, Long-Term Capital Management in ’98. And you could argue that rates were kept very low in the early 1990s to help recapitalize the banking system after the savings and loan crisis. So you can go back much further than the post-crisis period.
And I think if you go down this route of thinking, when the policy makers think that they can set the interest rate to meet their narrow policy objectives, which in themselves might be quite laudable, such as reducing unemployment or whatever, if you go down that route, there will be unintended consequences to those actions. And the trouble is that the modern economists, it’s all very mathematical. You may have read Woodford, it’s beyond me. It’s too technical for me to read. Very technical, mathematical, abstruse stuff.
These people tend not be able to comprehend the unintended consequences of their action. And I think that is problematic. I’m not in favor of this view of interest, as what they call a policy variable. I think it goes back to John Maynard Keynes, and Keynes, to my mind, didn’t really have a fully formed or coherent view of interest. I think his view was—as far as I can see, reading Keynes—didn’t see an interest rate that he didn’t consider too high. See, in that sense, he was quite— The economists after 2008, the central bankers, were very much in the sort of Keynesian line. a And I don’t think Keynes comprehended the important and various functions that interest rates perform.
So it’s the legacy of Keynesianism. I’m not saying this in a particularly partisan way, but you can clearly see it in people’s writing about interest, that after the Second World War, when Keynesianism becomes ascendant, there is a sort of tailing off of people writing and thinking about interest. The economists cease to think deeply about interest. Whereas if you look at the writings of economists before the Second World War, there tends to be a much more thinking about interest.
Not everyone, I mean, for instance, Adam Smith, great economist that he is, all he has to say about interest is that it’s probably around half the rate of profit. He leaves it at that. So Smith, genius that he was, doesn’t have profound insights about interest. But a lot, as you know from reading the book, a lot of the other great economists have thought very deeply about the subject. And then, in the second half of the 20th century and through into this century, the writing and thinking about interest completely died off. And that’s why I wrote the book. I wouldn’t have written the book if I felt this was a subject that was alive in people’s minds.
David: There’s a really important point there because it’s analysis which helps bring context and depth of understanding to the decisions that investors need to make. And for me, it recalls Andrew Smithers’ and Stephen Wright’s Valuing Wall Street. It recalls Russell Napier’s The Anatomy of the Bear, where, if you get the content of those books, of your book, The Price of Time, you’re doing yourself a significant favor every day that you’re going to be making decisions about capital allocations and spending, managing a household budget. All of these things require some context and insight. Where are we in this grand continuum? And I think you’ve done a masterful job of creating that.
Edward: Well, thank you. I mean, if one looks back over the last 25 years, it seems to me that in the late ’90s one needed to understand about speculation and understand about valuation and about mean reversion of market valuations. That’s what Andrew Smithers wrote about. In the early 2000s, you need to understand about credit, as Doug Noland will tell you. And then of course, 2009, you needed to know about bear markets. I actually rang up Russell Napier in February 2009 to say that, “Have we reached the bear market trough?” And he said, “Yes.” So you need to know about their markets. But then clearly, in the last decade, one needed to know about interest.
The reason I wrote the book was not just that no one had been thinking about interest for a long time, but you couldn’t really understand the financial world. You couldn’t understand the economy. You couldn’t really understand some of these social upheavals that were taking place without understanding the nature and the role of interest. So for the last decade at least, it struck me as being really the most important thing to understand.
And I still think it’s important to understand because we are in a process of coming out of the very low interest rate, given the supreme importance of interest into valuation and capital allocation. An investor who doesn’t really understand interest is liable to make errors that might possibly have been rectified with a better knowledge. So the nice thing about investment is it’s a multidisciplinary field, and I think an understanding of interest is one of the things that an investor requires, even if they’re just picking stocks or whatever.
David: To play off that theme of this sort of multidisciplinary approach to investing, I think it’s clear there are philosophical assumptions that run through the heart of monetary policy. Adam Smith might promote the wisdom of the marketplace over the wisdom of the academic or technocratic consensus. And I want to come back to a central thread in your book, “Whether a capitalist economy can function properly without market-determined interest?” Where do you land?
Edward: I argue that every type of economy requires interest. You can’t do away with interest. And I even point out that one of the failings of the Soviet system, of the Soviet economy, was they didn’t have market-determined rates of interest, and therefore they didn’t know how to allocate capital. And the problem is even more acute for a capitalist system because the word capital, what we call capital, is really just the net present value of a stream of future income. And if that’s the case, then capital has no meaning or no value if you don’t have a discount rate. Or rather you could say it has an infinite value and it’s not much use if everything has an infinite value.
Again, this was noted in the 17th century. I think it’s Sir William Petty, one of the early English economists, says that if you don’t have a rate of interest or discount rate, then one acre is worth the same as 20,000 acres of lands. Or the other thing about capitalist economy is that it really involves market coordination of current savings and spending and investment with future consumption. So there’s a very complex inter-temporal coordination problem that needs to be unraveled.
And again, I don’t think a committee can do that, and clearly a committee isn’t doing it. A committee is trying to do it in a communist system and making a hash of things. But in our system we’re sort of saying, “Oh, well, this can be done by individuals with their rational expectations about the future and so forth.”
Well, I’m saying if you don’t have the interest to guide your— A market rate of interest that is reflecting genuine savings and genuine demand for those savings, then you’re not going to have this inter-temporal coordination taking place.
Well, one way of thinking about it, which I didn’t put in the book, is that interest is really like a sort of gravitation. It really is to the economy what gravity is to a planetary system. As just gravity holds the planets in place as they move around each other. Then interest coordinates our activities, our savings, and our spending and our investment and our indebtedness.
And one of the things we have seen is a mal-coordination of our financial systems and our economies. And evidence for that, staring you in the face, is extremely, extraordinarily low rates of economic growth. The more we’ve interfered with the rates—the lower interest rates—economic productivity growth has fallen. And then again, as you know, you have these extraordinary persistent imbalances in the financial system, massively inflated asset prices, huge amounts of debt, and an unknowable quantum of financial instability in the system. So yes, I think that we need to get back to market rates. So if you will, market rates or genuine natural rates. I think it probably is impossible to get to an ideal position under our current monetary system.
I think a fiat money system in which central banks are free to create money out of thin air, in which commercial banks can create money through their active lending, that type of system is always going to require a committee of people with PhDs sitting there trying to determine what the market rate would be. You would have to change the monetary system to get to, if you will, a proper market rate of interest. But even under the current system, I think you could do a lot better job. I mean, not least by never having your policy rates below— I mean, I’d say they should never really be below 2%, I would’ve thought.
One of the things I feel quite strongly about is you shouldn’t have the committee of interest rate setters thinking only about inflation and near-term inflation. I think that they should still operate with a much broader remit to look at near-term inflation versus longer-term inflation. To look at the amount of— To look at valuations, to look at credit, to look at the questions that the financial risk building up in the system— This very, very narrow focus on inflation or deflation is I think their problem with the way monetary policy has been set.
David: Edward, the PhD system that we have—as Jim Grant has called it, the PhD standard instead of the gold standard—it’s supposed to be smarter, it’s supposed to be more ideal, it’s supposed to provide less wage and employment volatility. But without a monetary anchor like gold, it’s clear that credit expansion runs to excess, and that may give birth to millionaires, it may give birth to billionaires, but where does the forgotten man fit into that?
Edward: Well, he doesn’t. He’s forgotten. And as I point out in the book, the central bankers and monetary policymakers, they don’t tend to consider the distributional consequences of their actions. And it’s pretty clear that if you take interest rates down to very low levels, you will boost asset prices, which benefits those who already own assets, and you will make it harder for people who don’t have assets to acquire them, to save. And if you lower the returns on savings, it would take longer to acquire wealth. If you throw into the mix the fact, as I argue, that the very low interest rates distort the allocation of capital, lower productivity growth, and therefore lower income growth, you can see that the ultra-low rates were very damaging to the less well-off.
And in fact, in other points, if you remember that central banks justified their low, ultra-low rates, the zero rates, the negative rates on the grounds that they were fighting deflation. But actually deflation, or falling prices, benefits the working family, and actually it’s not so good for corporations. So the battle against deflation really could be seen as a battle against working people in favor of corporations.
And so again, it doesn’t come as a huge surprise that this last decade was one of very low income growth, but very bloated profits. Now, none of this is comprehended by central bankers because their model doesn’t— It has a representative investor. It has a single investor to account for an entire society, so there are no distributional consequences to the model.
And the central bankers get very shirty when asked about this. They always reply, “Oh, well, these are issues for the politicians to deal with, not for us.” So they’d like to take credit when things go well. If inflation is low, if the economy’s recovering, if the financial crisis comes to an end, you pat your central bankers on the head and say, “What a good boy you’ve been.” And if things go badly, the central bankers say, “Well, don’t blame us. These are political issues to be discussed, to be dealt with by your politicians.” So they have their cake and eat it.
David: Going back to 1999, you wrote a book which included the technology bubble. And then in 2005 you did more writing and talked about the mortgage finance bubble. In this year, 2022 book, you cover what really could be argued is a government finance bubble. Is it fair to say that this bubble is one of the greatest of all time, not just a single country, but sort of a global phenomenon where we’ve had zero rates, proliferation of debt, and what are the implications?
Edward: The government finance bubble I think is Doug Noland’s phrase, and to me that’s part of the story. Clearly, you look at, say, Britain and the United States, their national debt relative to GDP has doubled since the financial crisis. In the US, the public debt’s back to levels it was at the end of Second World War. The British had more debt at the end of Second World War, so we haven’t quite got back to that level.
However, it’s very clear that when the cost of borrowing and public borrowing was extremely low, and quantitative easing, as you know, involved, in effect, governments being financed at overnight rates. So you look back to— I know the UK, for instance, Bank of England during the pandemic period was in effect buying up debt roughly equivalent to the amount of UK public sector deficit, around 15% of GDP. And was only charging the government at the time 10 basis points for that borrowing. Now, trouble is that, in effect, much of the UK government debt is charged off overnight rates, and the UK government is spending I think roughly 12% of its total budget on interest service costs.
See, what happened after 2008 was very low rates encouraged an extraordinary government profligacy. I don’t think that the lockdowns would have happened—this, where the government tells the entire population to stay at home for a disease that was really dangerous only to people who were elderly and had other medical health problems. This incredible extravagance of the lockdowns, I can’t think that it would have happened except at a period of ultra low rates, which as you know, then they pushed things too far and that fed through to the inflation that brought the ultra low rate era to an end. So in the end, the system, that low rate period, it contained within it the seeds of its own destruction.
David: When I think about the vast quantities of debt, this is the new issue. We had 18 trillion in debt instruments trading at negative rates just a few years ago. That has been adjusting. We still have something of a maturity wall, certainly here in the US, that we hit over the next 24 to 36 months, which takes our interest costs from a trillion out of the 5 trillion in tax revenue that we have— That’s a significant issue. And it’s going higher. But all this debt has been pushed into the system and has helped finance.
Edward: It’s financed— Capital has been thrown away.
David: Yeah.
Edward: I’ve become quite keen on John Cochrane’s Fiscal Theory of the Price Level, which I’m sure you’re aware of. It’s a sort of alternative view of inflation to the monetarist view, the Friedmanite view, where Cochrane says that given that countries that print their own currency don’t default, that the more debt they have, the more likely they are to inflate away their debt at some stage in the future.
So if you take interest rates very low, the government has an incentive to push up debt very high. Once debt is very high and interest rates return to a more normal level, the debt becomes unsupportable. And instead of defaulting, you go through the process of inflating the debt away, or what’s called financial oppression. If you envisage that process, you can see that one imbalance leads to another imbalance that then finally resolves itself with an instability in the monetary system. This is the sort of stuff that Doug has been writing about for 25 years. I’ve read his stuff over the years. And I think that’s the end game. As you know, it is a loss of monetary stability.
David: If there’s a desire to control that process, then perhaps you run inflation a little hot. You keep your interest rates as low as you possibly can. We talked about the nature of money earlier. In the book, you’ve talked about money as an instrument of freedom. When we think about financial repression, let’s just talk briefly about central bank digital currencies. Because I can’t help but think, you’ve got China’s Red Capitalism, digital currency as a tool of financial repression, and maybe in some instances, particularly across the pond, an expression of sort of panoptic control.
Edward: Yes, I blow hot and cold about the idea of a central bank digital currency. I can see that a badly designed one would really be dystopian. One in which all your transactions were recorded by the state and in which your ability to access your money and spend it could be in effect controlled by the state. Your accounts could be frozen for non-conformist behavior. And having, if you will, a form of money that’s outside the control of the state is attractive under those conditions.
However, you could design a central bank digital currency, if you want to call it that, or a state-endorsed digital currency that could contain anonymity of transactions, that could run in parallel with a paper currency so not everyone would be shoehorned into the digital currency, and that would have some of the at attributes of gold. In other words, you could constitutionally limit the amount of the new currency that was issued every year.
But this is not really my idea. I have a friend called Thomas Meyer, who’s a former chief economist at Deutsche Bank and now runs an economic think tank in Germany called the Flossbach von Storch Institute. It’s Thomas who played around with the idea of a well-designed central bank digital currency. What it would mean is it would bring to an end commercial banking as we know it because you wouldn’t really need to have your money in deposits anymore. But it may be that it’s in the nature of the state to not be able to resist control. So it may be that Thomas’s idea of a well-designed digital currency is utopian.
My own view, I have thought a bit about Hayek’s idea of denationalization of money, competing private monies. I’m a big fan of Hayek. But what I don’t think Hayek took on board in his analysis of private monies is that under his system you would probably get a dominant monetary issuer, but there would be some network effects, and that dominant monetary issuer would then accrue to itself certain monopoly powers and probably abuse those monopoly powers. Really, it’s a thorny problem, how to design a proper monetary system. And the attraction of the gold was that— There were set problems of gold, obviously. You had to go around to the other side of the world and dig a hole deep in the ground, and then, as Keynes complained, then you refine it and you—
David: Put it back in a hole in a bank.
Edward: —create your bullion, and then you bury it in another hole in the vault of a bank. It sounds crazy, but it gives you an absolute restriction on the growth of monetary base, which has certain attraction to it.
David: I know we’re running out of time, but I think about China and the example that they are of easy money policies. Like so many times, and you chart this through your book, this is now an example of a triple bubble: real estate, credit growth, investment. How do you resolve this outside of those twin hammers of inflation and financial repression? They’re just one microcosm of a global issue, where it seems that those are the two hammers that investors and savers have to come to terms with, whether it is red capitalism or some sort of new neo-Keynesian experiment.
Edward: With regard to China, when I thought about China—I haven’t thought a lot about China—you look at Chinese history. The Chinese were, as you know, the first invent paper money, but they were also the first to seek control for the state to control money and to control interest. The great vice of centralization of the mandarinate in China, that it seeks to control, and through controlling it stifles and represses Chinese economic development—Chinese people, if you want. What was interesting when I was writing the chapter on China is, you could see that the Chinese went back to their old ways of controlling money and interest, but on a much grander scale. This was causing huge imbalances in China, as you mentioned: the real estate bubble, the investment bubble, the credit boom.
And now, China is in a difficult position. It looks to me that China’s real estate bubble is much greater, much more significant than the Japanese real estate bubble of the late ’80s, both in terms of valuation and in terms of new building, and in terms of the amount of debt that’s taken on, and in terms of the dominance of construction in an economy. You’ve got a system, an economic system that probably needs to recalibrate, to change, and yet will have all these liabilities that it has to either default on or inflate away, and it also has a currency that is quasi-pegged towards the dollar.
At the moment, the Chinese probably have to face a choice between resolving their domestic issues by inflating them away, in which case the currency is vulnerable, or if they deflate them away, I think they’re going to have as severe, if not more severe problems than Japan faced with its two last decades.
I was very early in my bearish prognostications in China. I always felt that what China was doing was following the so-called Asian development model of just putting more and more inputs into the system to drive growth. And the Asian development model always ends in crisis and always ends with a period of lost economic growth, of which Japan experienced two so-called lost decades.
In that sense, I suppose that’s where I thought China was heading for, but we’ll have to wait and see.
David: Just one last question. You spent a number of years working with Jeremy Grantham at GMO and research writing. I’m just curious, with your exposure to the financial markets, with your interest in the history of financial markets, how would you allocate assets during a period of financial instability?
Edward: As you can tell from the tenor of our conversation, I have a bit of residual gold buggery to me. I like gold. The more unstable the economic system or the prospective economy or financial or political system appears to me, the more I’m attracted to gold, so I tend to run with a much higher level of gold in my portfolios than most people would recommend.
We talked about the prospect of inflation, and we’ve talked about there being too much government debt. My view would be that the debt that’s most at risk is the nominal debt, the fixed-income securities. And I’m happy to own inflation-protected bonds, TIPS and so on, that now have much more decent yields than they had a couple of years ago.
And then, frankly, I think one can own equities, providing they’re relatively cheap and relatively diversified. I think one has to be quite diversified in this current environment. And I also think that investment is very difficult in this current environment. I don’t know about you, but I felt that evading the problems of the dot-com bubble was not particularly difficult. You could buy TIPS yielding 4, 5% in ’99, 2000. Hard to believe. And actually, evading the worst of financial crisis wasn’t that difficult.
I think it’s getting harder. And what’s interesting for me is that the investment firms that I know who were anticipating problems from the ultra-low rate period have not, frankly, done very well over the last two or three years. Normally, if you can foresee the problems, you are able to steer around the rocks, but everyone in their own way seems to have hit a rock or two in the last couple of years. It is difficult. I hate to say it, but I think one should lower one’s expectations of prospective returns.
I share that chart, which I’m sure you’re familiar with, in the book of the Fed data on household net worth, and you see how elevated it is, I think roughly about 150 points of GDP above its long-term value. I think there’s a huge amount of what I call virtual wealth out there. And I think over the coming years that virtual wealth will diminish. A lot of it has diminished already. But then, I would count cryptos as virtual wealth and look how— They seem to be doing just fine as we speak.
I braced myself, at least seven or eight years ago, to expect that it was quite reasonable that one might not get any positive return in real terms on your portfolio, that you might be doing well just to preserve your wealth over the coming years. That’s very disheartening and perhaps too bleak. There are pockets of very cheap assets out there and shares. And I certainly have a decent allocation. I think one should invest without an absolute view that one is correct, but diversify so that you might survive in different states of the world. That’s the way how I allocate assets.
David: I resonate with that. There is a need for diversification. It is truly difficult to find value, but there are pockets of value. If you’re hoping that the market is going to be generous and kind, probably reviewing Smithers’ Valuing Wall Street would be of benefit. Tobin’s Q is about two standard deviations above its mean, which would suggest that you’ve got a zero to 2% rate of return each year over the next decade, so your lowering expectations are quite reasonable.
Edward: Yeah. Lowering expectations, given the high value of the US market, is reasonable. Andrew Smithers, if he’s listening to this, won’t like me saying so, but I don’t think that Tobin’s Q is that good a measure in a world where the great bulk of stock market value is in technology companies with no net assets, that have no replacement costs, and at the moment at least, can’t be competed away. These goliaths may be felled for other reasons, but it’s probably not for competition. I don’t think Tobin’s Q, the replacement cost valuation, is particularly useful.
But yes, I think that the US market, the Schiller PE, the cyclically adjusted PE, is probably a better measure. And the cyclically adjusted PE, I haven’t looked at recently, but it’s—
David: 33.
Edward: —I think, probably over 30 times. What is it?
David: 33.
Edward: 33, yeah. So, 33 times. And long run average of what?
David: 15, 16.
Edward: We’re back where we were in ’99, 2000.
David: Exactly.
Edward: And then you’ve got this little AI bubble going on, so I would be wary in particular of the US market because of the AI bubble and the extreme valuation. If you go to other parts of the world, Japan and the UK, for what it’s worth, you can get cheap valuations there. I own those stocks and I don’t suppose I’m going to lose a huge amount of money on them going forward, but who knows.
If we’ve been living through the era of virtual wealth, as I maintain, then as that unravels, what I expect is you have what the Germans in the hyperinflation called the die Flucht in die Sachwerte, the flight into things of real worth. I’m not ultra convinced by the so-called energy transition. I actually quite like energy stocks. And actually, I don’t even mind the commodity stocks, notwithstanding China’s overhang. I think that you move from an era of financial wealth to, if you will, things of real value. And that does push one more towards commodities, towards gold, towards hydrocarbon energy.
David: I sung the praise of your book earlier in the program and put it on a par with other books that have brought great perspective. But one thing that I’ll say as we close is that I’ve got a list of 28 books on order that come from all the research that you’ve put together. I’m incredibly grateful for a thousand rabbit holes you’ve just sent me into. I look forward to learning, and appreciate all that you’ve done to condense what some would consider a very uninteresting topic. Which is not at all, I think it’s one of the most fascinating topics on the planet. It may be a neglected topic.
Edward: When I was writing the book and I told them what I was writing about, nine out of 10 people would look as if I must be embarked on the most boring project they could imagine.
David: It may be a neglected topic, but we’ve tried to give it a little bit of light today.
Edward: Good. I’ve enjoyed our conversation.
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You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany and our guest today, Edward Chancellor. You can find us at mcalvany.com, and you can call us at (800) 525-9556.
This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.
