The folks at Gresham's
Law just published a nifty interactive chart of real (i.e., inflation-adjusted)
interest rates since the 1960s that explains a lot about today's world.
To make sense of this, let's start with a a little background: Interest rates
are the rental cost of money, but to figure out the true cost you have to adjust
the nominal (or numerical) interest rate for inflation, which is the rate at
which the currency being borrowed is falling in value.
If the nominal interest rate is higher than inflation, then the real interest
rate is positive. If the real rate is both positive and high, that's a signal
that money is expensive and that one is better off being a lender (to reap
those high returns) than a borrower (who has to pay the high true cost of money).
The opposite is true for negative real rates, where the nominal cost of money
is lower than the rate at which the currency is being depreciated. In this
case a borrower actually gets paid to borrow because the true cost of the loan
falls as the currency loses value. So negative real rates tell market participants
to borrow as much as possible.
Given these incentives one might expect the following:
1) Slightly positive real rates should be the norm in a properly-functioning
economy, since that's the way a healthy market works for most other things,
where sellers reap a reasonable real profit and buyers pay a manageable price.
2) Periods of very high real rates should cause borrowing to plummet and economic
growth to slow.
3) Periods of sharply negative real rates should produce a burst of borrowing
that leads to destabilizing booms, either in hot asset classes or across the
board. As Automatic
Earth's Raúl Ilargi Meijer put it just this morning:
The simple truth about ultra low interest rates is so simple it's embarrassing,
at least for those who claim they benefit society. That is, ultra low rates
make borrowing accessible to the wrong people, and to the right people for
the wrong reasons. The former are people who shouldn't be able to borrow
a dime, because they have no credit credibility, the latter borrow only for
unproductive or counter-productive reasons.
The above chart bears all this out. Back in the 1960s when growth was relatively
steady and the dollar was still linked to gold, real interest rates fluctuated
between one and three percent. But after the US broke the link between the
dollar and gold in 1971 and embarked on its epic debt binge, real interest
rates started to gyrate. They plunged to -5% in 1975, leading to an inflation
spike and dollar crisis a few years later. They then jumped to 8%, producing
the severe recession of 1982. They fell to zero in 1994, setting off the tech
stock bubble, and turned negative in 2004, inflating the housing bubble. Then
they spiked, producing the Great Recession.
Since the 2008 crisis the real rate of interest has been mostly negative,
which accounts for the global boom in real assets. For someone with access
to borrowed money it now makes sense to use it to buy fine art, trophy real
estate, farmland, and other things that governments can't create more of. All
of these things are in raging bull markets, implying that the smart money is
responding to negative interest rates exactly as you'd expect.
So what now? History as depicted here says the borrowing binge/asset bubble
continues until real rates spike, either because nominal rates soar or inflation
plummets. It also implies that the phase change, when it comes, will be sudden.
Looking at 1975, 1980 and the volatility since 2007, it's clear that a financial
system based on fiat currencies is inherently unstable -- i.e., incapable of
finding a stable price for money. So the least likely scenario is a return
to a nice, placid world of "normal" interest rates.
