... because it performs so many roles. For a start, it constitutes the capitalisation or discount rate without which valuation is impossible.
Infflation is back, and along with it a widespread obsession about the future direction of interest rates. This is hardly surprising. In the past, a dose of tight money has brought prices under control. However, interest’s role in ensuring price stability is just one of its many functions. Our neglect of those other functions explains why the financial markets are in such a jumpy state today.
James Grant, the founder of Grant’s Interest Rate Observer, calls interest the “universal price” because it performs so many roles. For a start, it constitutes the capitalisation or discount rate without which valuation is impossible. As every business student learns, a company’s present value is calculated by discounting future cash flows.
“Anticipation is always at a discount”, said the Scotsman John Law in the early 18th century. The Austrian economist Ludwig von Mises observed that if humans did not value consumption in the present over the future then an apple in a hundred years’ time would be worth the same as an apple today: an evident absurdity.
We have witnessed much such absurdity in financial markets in recent years. After the global financial crisis of 2008 central bankers reduced short-term interest rates to zero, and even lower in Europe and Japan. Longer-term rates declined too.
The collapse in discount rates justified a great inflation in asset prices. The valuations of companies whose cash flows lay in the distant future benefitted most. Easy money pushed up property prices in many cities around the world.
Very low borrowing costs can help keep chronically unprofitable enterprises alive. So-called zombie companies were first observed in Japan in the late 1990s around the time when the country’s central bank reduced its policy rate to zero
American companies have availed themselves of low-cost credit to spend trillions of dollars buying back shares.
Investors may now regret having lent to over-leveraged companies and governments. Over the past decade, however, they had little choice. The era of ultralow interest rates induced a desperate scramble for yield.
Now interest rates are rising and asset prices are coming down.
Edward Chancellor Reuters 30 June 2022
Edward Chancellor’s “The Price of Time: The Real Story of Interest” will be published by Penguin on July 7.
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Edward Chancellor examines the similarities between Japan’s current economic situation and that of the 1930s
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