Reckless – Chapter 1: The History Of Interest Rates

Chapter 1 of the book Reckless: The Story Of Cryptocurrency Interest Rates is published below. The full book is available on Amazon. The book was written before the bankruptcy of FTX and therefore does not include coverage of this event. However, the book does provide useful commentary in the run up to the failure of FTX, which provides context for the eventual calamity.

Ancient Times

Contrary to popular misconceptions, credit and debt are thought to pre-date coinage and money, perhaps by thousands of years. The first records of interest being charged are from Mesopotamia in around 3200 BC, long before coins existed. The written record of interest rate regulation appears to have started in around 1800 BC. Hammurabi, a king of the first dynasty of ancient Babylonia, capped the annual interest rate at 33.3% for grain and 20% for silver. If these limits were found to have been breached, the debt was cancelled. 

Ancient Egypt was a largely centralised economy and there are limited records of interest rates in this period. However, a papyrus scroll from 900 BC contains a note that a man received five debens of silver and promises to pay back ten debens in twelve months time, an annual interest rate of 100%. While a tablet from 664 BC records a grain loan at a rate of 75%. In around AD 100, while Egypt was wealthy, interest rates were capped at 12%, while compound interest was banned. Compound interest is when the interest rate not only applies to the principal, but also on accumulated interest charges from previous periods. In Rome in 443 BC, interest rates were capped at 8.33%. This was reduced to 4.17% by 347 BC. Byzantine legal interest rate limits were around 12% in AD 400, before declining to around the 6% to 8% range by AD 700. These limits then appeared to remain stable for several hundred years.

The existence of these limits and regulations indicates that perhaps interest rates and “incorrect” interest rates were already significant enough in scale to cause social, political or economic problems, even thousands of years ago. Therefore regulation may have been demanded as a potential solution. Interest rates seemed to have a cap, perhaps to prevent lenders from exploiting borrowers.

If interest bearing loans were already widespread in ancient Babylonia, perhaps it follows that loans and interest have a long history well before the written record started some 5,000 years ago. Anthropologists and historians tend to believe that interest originated when people lent each other animals or seeds. Animals and seeds are productive assets. Seeds can be used to grow produce, while animals can have offspring. It therefore could make sense that the lender should obtain a share of this growth. We may never know for sure, but this appears to be a reasonable explanation for the origin of interest rates. Therefore, it can be assumed that early interest rates were linked to the growth and the productivity of assets. However, how to determine an appropriate natural interest rate in an economy, remains one of the most controversial and challenging issues in economics and finance, to this day.

Tulip Mania

Often regarded as the first reported financial mania, is the so-called Dutch tulip mania, of the 1630s. This seems particularly appropriate to discuss in this book, given it is about Bitcoin and cryptocurrency and many crypto sceptics often compare the tulip mania to Bitcoin, as a form of criticism. Indeed, the former president of the Dutch Central Bank, Nout Wellink said of Bitcoin:

This is worse than the tulip mania, at least then you got a tulip [at the end], now you get nothing.

The tulip mania is described in Charles Mackay’s 1841 book “Extraordinary Popular Delusions and the Madness of Crowds”:

The rage for possessing them soon caught the middle classes of society, and merchants and shopkeepers, even of moderate means, began to vie with each other in the rarity of these flowers and the preposterous prices they paid for them. A trader at Harlaem was known to pay one-half of his fortune for a single root. So anxious were the speculators to obtain them that one person offered the free-simple of twelve acres of building ground for the Harlaem tulip.

The book only contains seven pages of coverage on the tulip mania, without significant detail. The book may have elevated the tulip mania as a classic example of a financial bubble, perhaps to that of the most famous financial bubble ever. However there is limited evidence as to the scale or economic impact of the tulip bubble. It is possible that the tulip mania of 1634 is mostly legend and myth. At least, in Mackay’s book, its scale is likely to be somewhat exaggerated.

Dutch interest rates during the period are said to have started at around 8% in 1600, before declining to 6.25% by 1620, they then continued their decline to 5% in the 1640s and 4% in the 1650s. Prior to this, from around 1200 to 1500, Dutch rates appear to have been stable for 300 years at around 8%. Dutch interest rates were also considerably lower than in England and other European countries such as France. Rates in England were in the 8% to 10% range in the early 1600s, while French rates were 8%. It is possible these relatively low rates in the Netherlands encouraged an early carry trade, borrowing in the Netherlands and investing in England. The only country to have rates as low as the Dutch was Italy, where rates were in the 4% to 6% range from 1300 to 1800. The declining interest rates in the Netherlands could therefore have contributed to the tulip mania, although it is probably fair to say there is insufficient evidence to support this claim, if the tulip mania was even real at all.

Mississippi Scheme

The first chapter in the “Extraordinary Popular Delusions and the Madness of Crowds” covers the Mississippi bubble of 1719. Unlike the tulip mania, it is clear that this bubble, a  French one, was real and economically significant. It is also fair to say that artificially low interest rates may have been this bubble’s primary cause.

The Mississippi Company was founded in 1684 and held business monopoly trading rights and land claims in the French colonies in North America and the West Indies. The land claims cover approximately 50% of the current United States of America by area. The Mississippi river network can be considered extremely valuable and is probably the largest, most interconnected and powerful river trading transport infrastructure in the world. Shares in the Mississippi Company were made available to the public and in 1719 the stock appreciated in value by 1,900%. 

The world “millionaire” is said to have originated to describe the new class of people who benefited from the bubble. These types of widespread, extraordinary and phenomenally fast gains were not seen again for perhaps another 300 years, in the great cryptocurrency bubbles of 2017 and 2021. Except by 2021, it was billionaires, rather than millionaires, which were created.

The unlikely protagonist in the story of this early bubble was a Scottish man, called John Law. In 1694 Law fought a duel in London, over the affections of a woman called Elizabeth Villiers. Law killed his opponent and was arrested and charged with his murder. He was then found guilty and sentenced to death. With the help of his brother, he managed to get his sentence reduced to a fine before somehow escaping prison and fleeing the country. Despite this dubious past, Law managed to climb the social ladder in France. Louis XIV of France died in 1715 and France’s economy was in poor shape, with high debt, shortages of precious metals, deflation and a stagnant economy. This change in administration and the dire economic circumstances provided an opportunity for Law.

Law had a solution to France’s economic woes, which was eventually accepted by the new administration in 1716 and Law was appointed the Controller General of Finances, essentially the finance minister. Law’s plan was not too dissimilar to the response of central bankers after the global financial crisis in 2008, he was to lower the interest rate and flood the system with new cheap money. This is also said to be the first institutional use of unbacked fiat paper money. The central bank notes were no longer denominated in gold, removing any restriction on the amount of paper that could be issued. Law was free to manipulate the currency in whichever way he saw fit. Free to engage in his plan, Law lowered interest rates to 2% and the money printing machines were operational round the clock, printing larger and larger denominations of paper notes.

Law also took over the Mississippi Company and merged it with France’s other trading monopolies in Asia. Then in 1719, the company took over all of France’s national debt. Holders of the debt could convert it into Mississippi Company stock. Within just a couple of years, Law had created an extraordinary global financial powerhouse, the largest company in human history. The stock price of the company skyrocketed, it traded at around 50 times earnings, matching the 2% interest rates on which its lofty valuation depended.

If one wants an example of a several hundred year old speculative and irrational financial mania in Europe to cynically compare the Bitcoin and the cryptocurrency bubble to, the Mississippi scheme is probably much better suited to that than the tulip mania, which occurred 80 years earlier.

Towards the end of 1719, the huge quantity of money started to produce inflation. Confidence in the paper money began to wane and Law banned the possession of precious metals, because they were seen as a viable alternative to paper money. Law then faced a dilemma, just like the central bankers of 2022, he had to decide whether to keep printing money or let the bubble burst. In 1720 the share price of the Mississippi Company started to collapse and Law was forced to go down the deflationary path. The public rebelled and riots broke out. The central bank was raided and Law’s personal property was vandalised. Law resigned as finance minister and then fled the country. This early monetary experiment failed catastrophically, in just a few years. 

The Irish/French economist Richard Cantillon, was an early investor in the Mississippi Company, from which he is said to have acquired great wealth. Around ten years after the collapse, in 1730, he wrote a book entitled “Essay on the Nature of Trade in General”. His experience as an investor in the Mississippi Company is said to have influenced his thinking. In his book, Cantillon hypothesised that the original recipients of new money enjoy higher standards of living at the expense of later recipients. This observation, that expansion in the money supply doesn’t evenly impact everyone at the same time and may actually unfairly increase inequality, is now known as the Cantillon Effect.

Cantillon ended his book with the following paragraph:

It is then certain that a bank, in concert with a minister, is able to increase and support the price of public stock and to lower the state’s rate of interest with the consent of this minister, when these operations are discreetly managed and in this way free the state of its debts. But these refinements, which open the door to making great fortunes, are rarely managed for the sole benefit of the state, and those who operate them are often corrupted. The excessive banknotes that are created and issued on these occasions do not disturb the circulation because, as they are employed for the purchase and sale of capital stock, they are not used for household expenditure and they are not converted into silver. But if some fear or unforeseen accident drove the holders to demand silver at the bank, the bomb would explode, and it would be seen that these are dangerous operations.

Cantillon appears to be indicating that the banks and government can lower interest rates, which can push up the price of financial assets. Many well-connected individuals can then do incredibly well in that environment. The new liquidity is initially trapped in the financial system and not used for “household expenditure”. Consumer price inflation can therefore initially remain mild. However, this policy causes imbalances to build up in the economy, which may later result in consumer price inflation, as the trapped liquidity eventually leaks out.

South Sea Bubble

The second chapter of “Extraordinary Popular Delusions and the Madness of Crowds” covers the South Sea bubble in 1720. The British South Sea Company, was founded in 1711. The company had a monopoly to supply African slaves to South America. Just like the Mississippi Company, the company was used to lower the cost of government debt, by allowing investors to convert debt into equity. English interest rates collapsed in the early 1700s from around 8% to 4% by the early 1720s. In a monumental rally, no doubt driven by a British public who were inspired, captivated and envious of what happened in France, the stock of the company appreciated by nearly 1,000% in the first half of 1720. However, it soon crashed and lost almost all of its gains by the end of the year. As a result, the “Bubble Act” was passed, which banned the formation of public companies, unless approved by royal charter. The law was finally repealed in 1825.

The Great Depression

Perhaps the most significant period, when it comes to influencing the ideologies of the current crop of central bankers and regulators, was the economic crash of 1929 and the great depression which followed it. 

The roaring twenties was a period of economic prosperity in the United States. Throughout the twenties interest rates appeared quite reasonable, between 4% and 5%. However, the annual economic growth rate in the period was around 8%, driven by technological innovation. In this context, an interest rate of around half this, can be considered as somewhat low. While consumer prices were stable throughout most of the 1920s, there were signs of unsustainable credit expansion and significant asset price inflation. Property prices in particular, increased considerably. Around 30 skyscrapers per year were completed in Manhattan alone towards the end of the 1920s, compared to around three per year before this period. The Empire State building was famously completed in 1931.

The Dow Jones Industrial average climbed 284% from the start of 1925 to its peak in late 1929, before the stock market crash on 24 October 1929, so-called Black-Thursday. The aftermath of this crash led to the Great Depression, a period of low economic growth from 1929 to 1939.

Much of the investment in these securities, driving up prices in the bubble period, were credit financed. However, it was not until late 1927 when the market started to lose its link with reality. Prior to this, the rally was matched by strong growth in corporate earnings, driven by new industries such as oil, automotive and electric. In 1927, the Federal Reserve lowered interest rates and increased the purchasing of government securities, following the infamous Long Island meeting. After this, stocks continued to rally even more aggressively, losing the relationship with corporate earnings. This break from reality is an uncomfortable comparison to the everything bubble of 2021. It is easy to say with the benefit of hindsight, however the stock market boom of the late 1920s looked just like another mania. The US president at the time did not seem to agree though. In 1929, when president Calvin Coolidge left office, he said that stocks were “cheap at current levels”.

British Economist, John Maynard Keynes, who later became famous for his analysis and diagnosis of the Great Depression, did not appear to spot the bubble early either. In 1928 he said that there was “nothing that can be called inflation yet in sight” and he circulated a note to his friends stating that “stocks would not slump severely.” Keynes is said to have lost more than 75% of his net worth in 1929, due to his position in stocks and his portfolio was forced into liquidation. Keynes’ fortune of almost £50,000 is said to have been lost. What Keynes failed to see was the scramble for gold in 1929, which forced central banks to tighten policy in order to retain their gold. Keynes famously referred to gold as a “barbarous relic” and believed that without the gold anchor restricting the flexibility of central bank policy, the crash could have been avoided. The Federal Reserve did lower rates to just 1.5% in 1931 as a result of the crash, however Keynes argued it should have done more and that the action it did take was not sufficient.

While there were only limited signs of consumer price inflation in the 1920s, which could have justified the Federal Reserve tightening, there were signs of excessive credit expansion. Had the Federal Reserve been more focused on these financial conditions, they may not have loosened policy in 1927 and the crisis may have been averted.

The American economist Irving Fisher also lived through the Great Depression. His view, formulated in 1933, was that the cause of the depression was Debt Deflation. This situation arises when there is too much debt in the system. Once the debt begins to be paid off, this causes a contraction in the money supply, which leads to deflation. The outstanding debt then becomes more expensive in real terms, which leads to pessimism and hoarding and a continuing downwards spiral. Fisher considered Debt Deflation to be a solvable problem and his solution to the problem was reflation and the stabilisation of the price level. Deflation was considered as a calamitous outcome and something that should be prevented at all costs. Due to the severity of the depression, this mantra became conventional wisdom in modern monetary thinking. 

Nobody seemed to agree with Fisher’s explanation more than the now Nobel laureate, Ben Bernanke (if you consider economics a “real” Nobel prize that is). Ben Bernanke was the chairman of the Federal Reserve in a key period from 2006 to 2014 and he considered himself somewhat of an expert on the great depression. He even wrote a book on it. The lesson Bernanke took from this was that the Federal Reserve should have been more aggressive in expanding the money supply following the 1929 crash. Indeed, he energetically implemented this idea in the wake of the 2008 crash.

However, like Keynes, Fisher had failed to predict the crash, famously declaring in 1929 that “stock prices had reached what looks like a permanently high plateau”. 

There is an alternative view on the Great Depression, articulated by members of the Austrian school of economics. Friedrich Hayek, who also lived through the great depression, did not believe all deflation was bad. He distinguished between “good deflation”, brought about by technological innovation and “bad deflation”, the debt deflation Fisher was concerned about. Hayek and those in the Austrian school believed that rather than avoiding the recession, we should let it run its course. Artificially preventing the recession would allow the imbalances in the economy to persist and malinvestment to continue, prolonging the crisis. Allowing a recession would enable a process of creative destruction, a type of cleansing, where capital and labour could be reallocated to more productive industries. Perhaps dying industries, disrupted by new technology, should be allowed to die? Unlike Fisher and Keynes, Hayek is said to have predicted the 1929 crash. On the other hand, there does not appear to be any clear written record of this prediction, but one can argue his record of predicting the crash is better than Keynes and Fisher. This may only be important if one considers the ability to predict the 1929 crash as relevant when evaluating their analysis of the causes of it, after the event.

Regardless of the merits of either side of the debate, the Keynes/Fisher interpretation became conventional wisdom, while the Austrian interpretation was ignored by mainstream economists and politicians. It was considered vital to prevent deflation at all costs and lowering the interest rate was the key tool available to achieve this objective.