Understanding Interest and Why We Might Need It — The Price of Time #booknotes
I guess it’s started with a simple question that I often asked as a kid, why do bank increase their rates? The question might resonates again in the past few months where we can see most banks, including central banks, increasing interest rates. One of the reason is to fight inflation. And in most cases, interest have been presented as an antagonistic entity. As a tool to leech people.
The curiosity led me to the book titled The Price of Time: The Real Story of Interest, written by Edward Chancellor, a financial historian and journalist. Chancellor advises in the introduction that the reader deserves a warning because interest is an extremely complex subject. Here’s some of interesting parts of the book that strikes me the most.
Chancellor brought the reader through history first. Based on the written history, the Mesopotamians actually charged interest on loads before they discovered how to put wheels on carts. Interest is much older than coined money, which only originated in the eight century BC. In the records of Mesopotamian clay tablets, credit transactions were commonplace in Ancient Near East during the third and second millennia BC.
Interest was generally paid in the same commodity as the load, commonly silver of barley. It might also be paid in kind, with another commodity (dates, firewood, etc.) or labour services.
Looking to the past, interest has always been with us because resources have always been scarce and must be rationed somehow, because wealth is unequally distributed between creditors and borrowers.
In the following chapters, Chancellor wrote that:
interest is a charge for the use of money over a certain period of time.
The next interesting story is the example of the important of interest from Italian merchants Francesco Datini (1335–1410). In his lifetime, it took more than three and a half years from the first order to the sale of the finished wool cloth in Valencia. The materials are imported from England and went through long process requiring a different set of specialized workers along the way. Yet all the effort rendered a profit of less than 9 per cent. No wonder Italian merchants viewed time as an element of cost.
The idea that time has value resurfaces when the Englishman Thomas Wilson wrote Discourse Upon Usury (1572). He said interest is the price of time. Chancellor argued there is no better definition. The story continued with a simple analogy by French statesman, Anne Robert Jacques Turgot (1727–1781), about a bird in the hand. It’s also actually an important story that I still try to learn throughout investing journey.
- While the borrower’s potential profit might justify charging for a commercial loan, this doesn’t explain the existence of interest on consumption loans. Such loans are by their nature unproductive. Turgot had an answer. A bird in the hand is worth two in the bush, he said. This is the earliest known reference to what economists call ‘time preference’, namely our propensity to place a higher value on immediate pleasures. For Turgot, a sum of money delivered immediately and the promise of the same amount of money at some future date could not possibly have the same value.
- Time preference explains why Aristotle was wrong. Interest is the difference in monetary values across time, the rate at which present consumption is exchanged for future consumption. Interest represents the time value of money.
It was John Rae, a little-known early nineteenth-century Scottish economist, who first mooted a connection between investment and time preference (for which he was later credited by Böhm-Bawerk and Fisher). The formation of capital, said Rae, ‘implies the sacrifice of some smaller present good, for the production of some greater future good’.
An act of investment — say the construction of a new manufacturing plant with factory buildings, machinery and all the necessary infrastructure — requires that investors forgo current consumption. Any eventual profits will take time to emerge. In theory, investment should only be made if the rate of return is at least equal to the investors’ time preference. Rae claimed that a society’s decision to make capital investments was determined ‘by the length of the period, to which the inclination of its members yield up a present good, for the purpose of producing the double of it at the expiration of that period’. Put simply:
how long will people wait, forgoing the consumption of a single marshmallow, in order to enjoy two marshmallows in future?
From the basic thought about time value of money, Chancellor continues with the history and various implication of low interest. The closest we have seen mostly in 2020 as the impact of the pandemic. Further away will be 2008 financial crisis. In fact, about half of the book concerning on how low rates begot lower rates. In Chapter 10: Unnatural Selection, Chancellor wrote:
- Low rates induced investors to opt for ‘growth’, taking stakes in companies whose profits lay somewhere in the remote future. Low interest rates inured them to years of losses. Low interest rates justified the unicorns’ fabulous valuation.
Easy money was dumb money. Rather than carefully scrutinize the pitches and books of start-ups, venture capitalists invested on a ‘spray and pray’ basis. As venture capitalists raised ever larger funds, they invested in ever more dubious concepts.
Fascinating part of the book for me is in the allegory for the bubble economy. The allegory is actually inspired by the movie The Truman Show (go watch it if you haven’t).
- As in The Truman Show, we have come to live in a controlled environment, with its fake money, fake interest rates, fake economy, fake jobs and fake politicians. Our bubble world is sustained by a combination of passive acquiescence and powerful vested interests. It’s a 24/7 show with a global audience. Since risk is controlled, we have nothing to fear. Any departure from the bubble threatens a crisis. Extreme measures are adopted: negative interest rates, limitless amounts of quantitative easing and, in response to British’s voters’ wishes to leave the European Union, even a ‘Project Fear’. Too much is at stake to let the bubble burst.
Yet unwelcome reality occasionally intrudes in the form of financial crises (of the Dotcom, subprime and Eurozone variety), ‘flash crashes’ and abnormal economic outcomes — plunging productivity, rising inequality and extreme profitability. The conventional explanations that are provided — secular stagnation, demographic headwinds and technological change — are unconvincing. Like Truman, we feel that things are not right. In an unscripted moment in the show, Truman falls in love with a girl who tries to warn him that everything is fake. She wears a badge with the words,
‘How will it end?’
Nobody knows.
The postscript is titled The World Turned Upside Down to dig a little bit more on the pandemic situation and the transition moving forward. I guess we can see (and hopefully learn) a lot throughout 2020–2021.
Warren Buffett agreed that ultra-high valuations were supported by ultra-low interest rates. ‘Interest rates,’ said the Sage of Omaha, ‘basically are to the value of assets what gravity is to matter.’ Once this gravitational force was removed, Dogecoins, NFTs, meme stocks and other speculative assets were free to float into the stratosphere.
And I guess in not so distant past, we’ve also seen the hype, the boom, and then the bust.
I liked that this book kind of reminding me to understand more about the world. And about something that is actually close to us, such as interest. And how it is highly related to time and risk. It’s probably no more surprise that the interest rate will move to the normal realms. Whatever normal means. And hopefully, we can be prepared for the implications. And also to be aware if in the near future the rates drop again.
This book is a fascinating read on history, and also a kind reminder that we can’t be disconnected with the reality for too long.
