Panic! The Historical Consequence of Low Interest Rates

Sep.25, 2019
David McAlvany

The following excerpt is from David McAlvany's interview of Jim Grant on the McAlvany Weekly Commentary, July 23, 2019; Episode Title: Cycles Begin and End in Excess

James Grant founded Grant's Interest Rate Observer in 1983 following a stint at Barron's, where he originated the "Current Yield" column.

His books include works of financial history, finance, and biography. They are: Bernard M. Baruch: The Adventures of a Wall Street Legend (Simon & Schuster, 1983); Money of the Mind: Borrowing and Lending from the Civil War to Michael Milken (Farrar, Straus & Giroux, 1992); Minding Mr. Market (Farrar, Straus & Giroux, 1993); The Trouble with Prosperity (Times Books, 1996); John Adams: Party of One (Farrar, Straus & Giroux, 2005); Mr. Market Miscalculates (Axios Press, 2008); and Mr. Speaker! The Life and Times of Thomas B. Reed, the Man Who Broke the Filibuster (Simon & Schuster, 2011). His latest book, Bagehot: The Life and Times of the Greatest Victorian, is the subject of this interview. (Bagehot is pronounced Badget.)

David: I have to begin by asking, what is left to observe in the world of interest rates these days?

Jim: There is very little to see, the rates being so low. It is hard to make out negative rates. They simply don't show up on the horizon. But what interest rates lack in visibility they certainly make up for in drama and in possibility. In 4,000 years of recorded interest rate history we have never before seen substantially negative bond yields. By nominal, I mean not adjusted for inflation, just plain old below zero yields on securities longer than, say, a 90-day treasury bill. So we are living in, really, for better or worse, very interesting times in the credit markets.

David: As a financial market historian, you have the opportunity to observe cycles and common elements from one timeframe to another, and you have said that in the physical sciences, progress is cumulative, and we stand on the shoulders of giants. In economics, you have said that the most ostensibly rigorous of these social sciences, progress, and error, too, are cyclical. We keep stepping on the same rakes. Why Walter Bagehot? And why now?

Jim: Well, Bagehot is an appealing figure for me because he did what I do. He did it very differently, and, I dare say, much better, but he was in the financial journalism trades. He ran the Economist. I should tell people, to anchor this in history, he was born in 1826 and he died in 1877, only 51 years old. He edited the Economist, having married the founder's daughter, but he would have gotten that job on pure merit, so fine a journalist and author was he.

He wrote something called Lombard Street, which is a kind of handbook of central banking practice and dogma that is still, at least, cited. I'm not sure how widely it is read, but it is still discussed and cited to this day. Bern Bernanke, in his own memoir of the great recession, cited Bagehot more frequently than any other living economist. So Bagehot is with us.

When I was just getting starting at Barron's I had come to New York for the Baltimore Sun. I was getting started in financial journalism in a serious way. I would go to the New York public library and sit down on Saturday and call up the then-still-available bound, dusty volumes of the Economist in the physical hard copy form and read them. You could always tell Bagehot's work because of how his style just scintillated and just sparkled, so I've been a fan for years, indeed decades, and I thought it was just high time. I wasn't getting any younger.

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David: We look back at the 19th century, and financial market panics are not uncommon. The common element between them, then and now, perhaps through all time, has been the expansion of credit. Bagehot was in a household that was keenly aware of the history of problems, panics – financial market panics, and what it took to operate in the context of a financial market like that. 1825 was a little early for Walter, as you mentioned, 1826 is when he was born.

But his professional career spanned 1839, 1847, 1857, and 1866, years in the 19th century where he got some experience, both as a banker and as the writer/editor of the Economist. Can you set the stage for his life by taking us back a little further? 1797 – Bank of England suspends gold convertibility. What did that set in motion that would end up influencing his role in the British financial system?

Jim: 1797 was the year, as you say, David, in which the paper pound came to supplant the gold pound. You could up until then exchange your pounds for gold at the fixed and statutory rate – I have forgotten now what it exactly was, but it was inviolable. And all at once, with a threat, perhaps an overblown threat, but still with a threat of a French invasion, the government of Pitt the Younger suspended gold convertibility. So the paper pound was born, and with that birth came also the beginning of a monetary controversy that lasted, certainly, until the restoration of convertibility in the early 1820s.

But in a fundamental way, it is still with us today. What is the nature of money? What is money? And who says so? Those great questions came to the fore during this long suspension of gold convertibility. So in 1797, if you didn't like the paper pound, you could not present yourself at the Bank of England with notes and get the equivalent in gold. You had to make do with the paper, and you had to depend on the management of the bank to maintain the purchasing power of those paper pounds. There were intermittent demands for the restoration of convertibility throughout that 20-odd year period. It was supposed to have been temporary, and it lasted, instead, a full generation.

And when the time came, finally, to revert to a monetary system of convertibility, there was a great debate as to what rate of conversion the British authorities should adopt. Should they go back to the one that was in force in 1997 just before the inflation that necessarily followed the suspension? Or should they set the conversion rate at a somewhat arduous and easier, or cheaper, level to give a break to the people who had borrowed money and inflated paper pounds? I'm probably getting a little bit too deep in the weeds here, but the controversy between lenders and borrowers, between the advocates of inflation and hard money – these debates have recurred at intervals over 200+ years and there seems no end to them even today.

David: So we have a change in the monetary system, perhaps something that was similar to the 1968-1971 period here in the United States in terms of suspension of convertibility. Let's go back to the 1820s. In the modern era, today, we have a response to falling rates, we have a bull market in everything. Is it a stretch to connect the declining rates of the 1820s and the speculation that followed in unusual assets, leading up to the crisis in 1825, almost a similar echo, 1840s, and the panic that followed later in that decade? Can we surmise anything from falling rates, bull markets that then ensue, and corrections that almost seem to be the next domino?

Jim: One of Bagehot's many aphorisms is especially relevant today. He said, alluding to the national symbol of Britain, that John Bull can stand many things, but he can't stand 2% – he meant positive 2%. But what he meant was that very low rates tempt people to reach for yield, to take risks they would not ordinarily think prudent. And the accumulation of those choices, of that risk-taking, leads to – now I'm kind of putting into my words what I think Bagehot would have meant by the process – the persistence of very low rates leads to greater and greater attempts to capture yields through reaching for credit risk.

And lo and behold, one day somebody forgets to bid, and somebody wants cash, and that little flicker of flame is enough to light the fuse that finally ends up in a great big explosion we call a panic. But very low rates have, since the dawn of modern financial capitalism, been the prelude to, and perhaps the cause of, financial difficulties that take the form of panics and bank runs, and generally, a sudden demand for the thing that seemed in such abundance, namely cash.

You can listen to or read the interview in its entirety here.

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