‘Interest, the great guide of commerce, is not a blind one. It is very well able to find its own way; and its necessities are its best laws.’

Edmund Burke, speech to the House of Commons, February 1780

The complex operation of how goods come into existence in a modern market economy is famously described in Leonard Read’s 1958 essay ‘I, Pencil’. Read points out that the manufacture of a seemingly simple product, a child’s pencil, involves the input of materials gathered from various parts of the world – cedar wood from California, graphite from Mississippi, rapeseed oil from Indonesia, candelilla wax from Mexico and copper, zinc and black nickel from sundry places – together with many pieces of capital equipment, including loggers’ saws, trucks, a timber mill, kilns to dry the wood, and, of course, the pencil factory. On top of this, all the workers involved in the process also must be housed, fed and transported to work.

Not a single person on earth, says Read, knows how to make a pencil. The most astounding fact about this whole process is ‘the absence of a master mind, of anyone dictating or forcibly directing these countless actions’. The pencil’s appearance is nothing short of a miracle; the miracle of Adam Smith’s Invisible Hand, in which countless individuals pursuing their own interests are driven to produce pencils and millions of other goods and services; a miracle of coordination in which market prices determine what is made and in what quantity, and which resources are used in production. The lesson to be drawn from this parable, according to Read, is that all that’s needed to satisfy mankind’s material needs is to ‘leave all creative energies uninhibited… Have faith that free men and women will respond to the Invisible Hand. This faith will be confirmed’.

A couple of decades before the appearance of ‘I, Pencil’, the Cambridge economist Dennis Robertson, a colleague of John Maynard Keynes, pondered the role of interest rates in a market economy. ‘Something is needed’, Robertson wrote, ‘to ensure the equality between the amount of tea which sellers are willing to put on to the market and the amount which buyers are willing to take off it; and that something is a certain price of tea. Similarly, something is needed to ensure equality between the amount of money which lenders are willing to put on the market for loans and the amount of money which borrowers are willing to take off it; and that something is a certain rate of interest.’

Robertson makes an important point. However, he gives the misleading impression that interest serves a relatively simple function – namely, coordinating the activities of borrowers and lenders – and that the discovery of its price, a ‘certain rate of interest’, is a straightforward matter. In fact, interest performs a huge variety of roles that are essential to the operation of a market economy or indeed any type of economic organisation. Furthermore, throughout history the determination of interest rates has rarely been left to market forces.

Whereas the production of pencils is still governed by the Invisible Hand, central planners nowadays get to decide on something of far greater consequence: the level of interest rates. After the global financial crisis, monetary policymakers pushed interest rates to zero and even negative levels in Europe and Japan. Never before in history had interest rates been taken so low. We must now reckon with the consequences of this rash monetary experiment.

When considering the topic of interest, the first thing to note is its great antiquity. We have evidence of interest being charged on loans going back more than 5,000 years. Prehistoric peoples probably charged interest on loans of corn and livestock. Across the ancient world the etymologies of interest derive from the offspring of livestock: the Sumerian word for interest, mas, signifies a kid goat (or lamb); the Ancient Egyptian equivalent – ms – means to give birth. In Ancient Greek, interest is tokos, a calf, and in Latin, foenus, signifying fertility or increase.

Why does interest exist? It’s not just because capital – in its earliest forms of livestock and corn – is fertile or productive. Borrowers require compensation to part willingly with their property. It exists because property is unequally distributed – the borrower requires the temporary use of somebody else’s capital (although borrowers are often much wealthier than lenders). Aristotle criticised the charging of interest or usury on the grounds that ‘money was intended to be used in exchange, but not to increase at interest’. Yet this comment ignores the factor of time. Loans are made over a period of time. All economic and financial transactions take place over time.

Time is valuable. We value time because our nature is impatient; we place a higher value on our present over future enjoyments. We are mortal – time is running out. The Yale economic historian Bill Goetzmann describes the appearance of interest as the most important invention in the history of finance because it enables people to transact across time. An English medieval scholar, Thomas of Cobham, rectified Aristotle’s error. Cobham said that usurers were ‘selling time’, but maintained it was still unjust because time belonged to God. A few centuries later, another Englishman, Thomas Wilson, also described the usurer as a seller of time. Wilson went on to provide a new definition of interest: ‘Usurye is also saide to be the price of tyme, or of the delaying or forbearing of moneye.’

The view of interest as the price of time was articulated by the 18th-century French economist, Anne-Robert-Jacques Turgot, who argued that a bird in the hand was worth two in the bush. By this reckoning, a sum of money today and the same sum in the future couldn’t possibly have the same value. For Turgot, interest is ‘the price given for the use of a certain quantity of value during a certain time’. Put another way, interest is the difference in value between current and future money. Modern economists implicitly accept Turgot’s notions when they talk about the time value of money. The great American economist, Irving Fisher defined interest as ‘crystallized impatience’ or what is more commonly called time preference.

Borrowing enables us to bring consumption from the future into the present. Savings allow us to push consumption into the future. When we make productive investments, we consume less today in order to be able to spend more at some future date. Just as market prices perform the miracle of coordination of productive forces that goes into the making of a pencil, so interest coordinates activities that take place over time. The world of finance can be seen as a bridge that connects our present and future economic activities: interest is the toll charged for crossing this bridge when bringing consumption from the future into the present, and a payment received by those moving in the opposite direction.

Every economic activity is influenced, directly or indirectly, by the time value of money. Interest is, therefore, the single most important price in a market economy. The financial historian James Grant calls it the ‘universal price’. Earlier generations of economists understood its importance. The 19th-century Austrian economist Eugen von Böhm-Bawerk described interest as an ‘organic necessity’; Irving Fisher deemed it ‘too omnipresent a phenomenon to be eradicated’. Joseph Schumpeter stated that ‘interest permeates, as it were, the whole economic system’. Even Karl Marx, an avowed enemy of interest, agreed with Schumpeter, the arch-apologist of capital. In a phrase evocative of the ancient world in which lending at interest was first recorded, Marx wrote that ‘usury lives in the pores of production, as it were, just as the gods of Epicurus lived in the spaces between worlds’.

In the ancient Near East, interest was charged on consumption and investment loans – farmers borrowed barley at interest to use as seed corn, others borrowed barley to feed their families. Loans of silver were supplied to merchants to finance their domestic and overseas trading ventures and to entrepreneurs who set up their own businesses, brewing ale or engaging in domestic crafts, such as weaving and jewellery making. Loans at interest were used to finance the purchase of real estate. In other words, interest in the ancient world performed much the same functions as it does today.

Now let us consider how the time value of money shapes our world.

Interest, in the form of a discount or capitalisation rate, is the essential input into every act of valuation. What we call capital is really a future stream of income that is discounted (using a discount or capitalisation rate) to arrive at a present value. Without a discount rate, an apple in a hundred years’ time would be worth the same as an apple today. An obvious absurdity.

Discounting future cash flows is not a novel practice. As John Law, the Scottish-born gambler, economist, and projector, wrote in the early 18th century, ‘anticipation is always at a discount. £100 to be paid now is of more value than £1,000 to be paid £10 a year for 100 years’. Law later founded France’s first national bank while at the same time putting together a vast business enterprise, known to posterity as the Mississippi Company. He also conducted the modern world’s first monetary experiment, substituting paper money for gold and silver, and issuing new bank notes. His plan was to bring interest rates down. As rates fell to two per cent, the price of the Mississippi stock soared. Alas, Law’s scheme failed. His money-printing fuelled inflation, confidence in his system was lost, the bubble burst and Law’s paper money was withdrawn.

As it turns out, every great speculative bubble has occurred during periods of ‘easy money’, from the tulipmania of the 1630s through to more recent times. In 2020/21, when interest rates were stuck at zero or below and central banks were printing trillions of dollars to buy securities, the so-called ‘Everything Bubble’ – bubbles in stocks, real estate around the world, and a variety of other assets (from contemporary art to vintage cars) – entered its last phase.

The level of interest is reflected in the ‘payback period’ or ‘hurdle rate’ required for new investments. When interest rates are high, investors demand a quick payback, and when low a longer payback. Since the Middle Ages, ports have levied a ‘demurrage charge’ for ships that remain at port for longer than an agreed period. Interest is a general demurrage charge on every economic activity. It encourages us to economise scarce resources, spurring efficiency gains and profits.

The 19th-century American economist Arthur Hadley linked interest to the survival of the fittest. Interest, he said, ‘helps the natural selection of the most competent employers and the best processes, and the elimination of the less competent employers and worse processes’. The ultra-low interest rates of recent years thwarted Schumpeter’s process of creative destruction and slowed the tempo of production. With interest rates stuck at zero for many years, we witnessed the appearance of so-called zombie companies – inefficient businesses kept alive on the drip of easy money. Low interest rates also stimulated investment in businesses with long-distant cash flows, notably venture capital and real estate. When rates were stuck at zero, capital flowed indiscriminately into Silicon Valley, which financed ever more preposterous businesses – autonomous cars, space tourism and dubious crypto ventures.

Interest was described by Ferdinando Galiani, the 18th-century philosophe, as the ‘price of anxiety’ or what we would call the price of risk. Galiani reasoned that lending produces anxiety on the part of lenders, which must be compensated. Put another way, interest can be seen as an insurance premium received by the creditor against the risk of loss.

What we find is that extremely low rates offered an inadequate protection against loss. Easy money encourages ‘yield-chasing’ by investors who take on more risk in order to maintain a given level of investment income. Yield-chasing also takes place across borders. When interest rates are low in the global financial centres – New York, and to a lesser extent, London, Frankfurt and Tokyo – cross-border lending picks up as credit flows to countries with higher yields. When the international carry trade suffers a ‘sudden stop’, as it did in 2007–8, debt crises tend to erupt in countries that have rapidly increased their international borrowing.

Interest is also the cost of leverage. As the interest rates fell, governments and companies took on more debt. Government debt levels around the world have soared since 2008. Ultra-low rates spurred companies to use debt to enhance returns whether buying back shares (rather than investing in productive assets) or acquiring other companies. Financial engineering proliferated as evidenced by record levels of leveraged buyouts and mergers. As a result, global debt levels are much higher than at the time of the global financial crisis.

Interest has been described as a ‘reward of abstinence’ – an inducement to save. Interest compounds savings, boosting retirement savings. Ultra-low rates punished savers – what the former German finance minister Wolfgang Schäuble called ‘Strafzinsen’. Without an inducement to save, saving rates in Britain and the United States declined far below their historic averages. Ultra-low rates also contributed to the ongoing pensions crisis. Pension providers that were contracted to provide a fixed benefit on retirement found their liabilities – whose present value was inflated by the low prevailing bond yields – spiralling out of control.

As a result, many defined pension benefit plans were terminated. In Britain, pension providers sought to reduce their exposure to ever-falling bond yields by acquiring long-dated bonds. In practice, the pensions’ liability-driven investment (LDI) involved leveraged exposure to gilt-edged securities in the derivatives market. In September 2022, their LDI strategies blew up as interest rates rose unexpectedly and pension plans faced large cash calls on their derivatives’ positions. The UK gilts market crashed. A severe financial crisis was averted by the rapid intervention of the Bank of England.

Monetary policymakers appear to ignore many of these functions of interest. Instead, they primarily view interest rates as a lever to control inflation. Under the gold standard, interest rates didn’t directly serve this purpose. Back then, the prime duty of a central bank, such as the Bank of England, was to ensure that there was sufficient bullion in its vaults to maintain the convertibility of its paper notes into gold.

When the bullion level was low relative to the note issuance, the bank would raise interest rates in order to attract inflows of gold from abroad. A secondary consequence of this action was a contraction of credit, generally accompanied by a sharp, brief bout of deflation. It was only after the classical gold standard was suspended at the outbreak of the First World War that central bankers started to consider their prime role as setting rates to maintain a stable level of consumer prices – what we would now call inflation-targeting.

Active monetary policy started in the mid-1920s, which was soon followed by the Great Depression. From the perspective of maintaining the purchasing power of money, it has been an unmitigated disaster. Over the last nine decades, the US dollar and sterling have lost around 99 per cent of their value relative to gold. It is true that in recent decades, monetary policy has served to alleviate recessions, as it did after the global financial crisis. However, that has come at the cost of ever greater financial imbalances, as evidenced by rising debt levels, financial engineering, depressed savings and declining productivity growth.

Monetary policy, suggests Harvard economist Jeremy Stein, a former governor of the Federal Reserve, ‘gets into all the cracks’. There’s the rub. Extreme monetary policies induce financial imbalances whose resolution requires even more extreme policies. Hence why zero interest rates were followed in Europe and Japan by negative rates, and hundreds of billions of central bank securities purchases were followed by trillions of dollars of quantitative easing. In the process, central banks expanded their remit far beyond their traditional mandate to control inflation and unemployment into corporate governance (Japan), private credit (Europe) and green investment (United Kingdom).

Time will tell whether the central banks, which started raising interest rates in 2022 in response to rising inflation, will succeed in normalising rates without triggering either another financial crisis and steep recession and without having to resort to yet more extreme monetary policy measures. We will also have to wait to see whether they can maintain financial stability while avoiding yet more inflation. At the time of writing, the markets are betting on a soft landing. From a historical perspective, this would be a rarity. Bubbles and periods of rising debt are normally the harbingers of bad economic outcomes.

If the central bankers fail, then it will be an opportune moment to consider profound changes to the conduct of monetary policy. What’s required is to remove the setting of interest rates from the hands of central planners who, however well-intentioned, will never be able to process all the information required to arrive at the correct answer; and, however constitutionally independent, must always be exposed, to some degree, to political pressures.

Let market forces decide the correct level of interest rates, just as the market enables pencils to be produced and delivered at prices that are acceptable to the buyers of pencils and profitable to their makers. Such a change would require an end to the fiat money system, in which money is conjured out of thin air by central and commercial bankers, and central bankers set interest rates. This current system has only been in operation since the collapse of Bretton Woods in 1971 and its history has been accompanied by a litany of financial crises and speculative bubbles and occasional outbreaks of inflation. Of course, the forces to reject change and maintain the status quo are powerful. But it’s not clear to the present author, at least, that a market-based economic system can prosper or even survive in a world of continuously manipulated interest rates.