Thanksgiving and the Long-Term Pilgrimage of Interest Rates

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As Thanksgiving approaches, we are reminded of our history. Financial planners are the voice of the financial industry for many of our clients. Here’s a bit about the history of interest rates in this wonderful country of ours as well as globally.

The very long term

Interest rates have been with mankind for a very long time (it is mentioned in Exodus, the second book of the Bible). Homer and Sylla (1996), in their seminal work A History of Interest Rates, estimated rates back to biblical times. Figure 1 graphs their estimates (note that the time line along the horizontal axis has breaks where no data is available). Ancient rates were also estimated by Marc van de Meiroof in The Origins of Value, a compilation edited by Goetzmann and Rouwenhorst (2005).

Interest rates were inferred from clay tablets used by Sumerians to record debts. Scratchings on these tablets typically indicated the parties involved and the terms. Often repayments were based on payments in kind: “10 bushels of barley corn loaned, 12 bushels to be repaid after harvest.” Interestingly, this infers a 20% interest rate and includes inflation protection. If the price of barley corn is higher next year, the 12 bushels will reflect it – the TIPS of old.

Figure 1

: Bank of England, Global Financial Data, Homer and Sylla "A History of Interest Rates."

One thing to observe in Figure 1 is that interest rates have always been positive. There are a number of explanations, including inflation, government policies and the expectation of rising standards of living. But theoreticians believe there are also deeper “root” causes that stem from our nature as human beings and from the dynamic nature of time.

The first root cause is compensation for deferred gratification. The theory is that we all have “positive time preferences,” meaning we want what we want when we want it – now, not later. The default preference is for immediate gratification, but we will wait if there is some reward for doing so. Young children prefer to eat dessert first, so they have to be disciplined to wait until they get some nutrition. By the same token, we will pay interest on a credit card to buy things to enjoy now to avoid the pain of waiting.

The second root cause for interest rates being positive has to do with risk. Positive time preference isn’t just the result of childish impatience. It is a rational response to what physicists call the “dynamic irreversibility of time” and the risk it creates. Once a dollar leaves my direct control, there is always some probability that I won’t ever enjoy the gratification it could have provided me. The investment may go bad, the record of the deposit may be lost or something may happen to me (I die in an automobile accident before getting repaid). In such cases, my gratification wasn’t deferred, it was lost forever. I therefore must be compensated for taking that risk. I want more than my dollar if and when it comes back – I want interest.

These root causes are so fundamental to the reality we live with today – as they have always been. It is doubtful they will ever disappear. If so, positive interest rates will never disappear.