The Interest Rate Crisis Has Just Begun

The story of interest is the most important story in finance Edward Chancellor is a financial historian journalist and investment strategist he's written a book called the price of time the real story of Interest he says that in 2008 Central Bankers bought interest rates to the lowest level in 5,000 years so what we had after 2008 was a lowest productivity growth in British history since the industrial Revolution when the debt resets at higher levels bad things will happen I want to start broadly and then dig into you know interest rates and how you look at them

you said in an interview that in 2015 you were sat in a room with a friend in London and you came to the conclusion that you can't understand the world we live in unless you understand what interest rates have done my view is that in each period you're living in there's one minent Financial theme so in fact 12 years before that conversation I was sitting with another fund manager friend of mine who said you couldn't understand the world unless you understood credit okay and then if you'd gone back say six years earlier you couldn't understand

the world unless you unless you understood speculation but in fact interest I think is really as you can tell from my book it it underlies both credit growth and speculation so it the Story of Interest I think is the most important story in finance and in the last um the re the reason I wrote this book was um in just after financial crisis I was working for an investment firm in Boston and we were finding that the that the markets that we were investing in I was in what was called asset allocations investing across the

board bonds equities You Name It We were finding that these markets were pretty distorted and when you try to we also Saw I also saw a lot of bubbles the so-called bubbles in housing in places like the US the UK and and Australia didn't come down they just if you remember high prices remain very inflated and yet we were finding long-dated bonds trading at extraordinary low yields we thought that they were we thought that they were mispriced but we but on the other hand they sort of remained mispriced forever and ever I Mean most notoriously

was this Japanese Government Bond the tenure as they're called jgb and um there was one they used to be known as the Widow Maker because in for instance we in our hedge fund were short jgbs and um we short them year after year after year and you know even and they were through swaps contracts 10 year swaps contracts I think we held one contract ra you know right through to maturity um you pay losing money all the Time so then um yeah so I was thinking so what is going on and what was going on

after you know from 2008 onwards was interest rates were set at zero uh in in the US and UK or close to Z and later in in in um in Europe and and Japan they turn negative and this was unprecedented and I don't think very well understood at the time and I I certainly didn't understand it you you talk about moments in time there but Actually your book shows that interest rates are a constant for almost the whole of human civilization right and this is I didn't realize they had them in ancient Mesopotamia no I

mean I wouldn't I would take away that qualify I wouldn't say almost I'd say say definitely we know that for for all of recorded history we have record of Interest we have record of of Interest being charged before you have two Millennia before you have Coined money because everything in finance takes place across time and that's why um you know an American economic historian called bill gsman has say the invention of interest is the most important invention in the history in the history of finance and as I point out uh the word Capital really what

we call Capital is something that has a stream of income going out into the future and that stream of of income Is discounted using an interest rate or discount rate or what we can also call a capitalization rate if you want and then you're you're you're discounting those future cash flows back to the present and if you don't do that then everything falls to Pieces because if you have an asset with a stream of income going forward to the indefinite future it will and you don't discount that stream of income that income will e Even

an income you know in 200 years time from it will be included today at at at its same nominal value what you'd get is the assets would then become um infinite in value and this put you know put quite simply by one Economist way he says that without a discount rate an apple in a hundred years time would be worth the same as an Apple today which is an obvious absurdity yeah do could you could we simplify all that then and say That basically interest rates are just this function of saying if you borrow resources

off someone you have to give them more back to incentivize them to hand over the resources um that's part of the story um I think if you want to really simplify it you you then have to ask you know why is something in the future why is this apple in a 100 years time worse less than than an Apple today well I mean One giveaway is in is conceivable That we're not going to be here in a 100 years time so we are mortal and if we're mortal uh we are also impatient so it's our

impatience the impatience o of mankind built in through our through our mortality if you will uh that induces us to to charge an interest a discount rate so so and everything else and we can talk about the various functions of interest but they're all joined and linked to our time preference our preference to have something today Rather than the future and as one you know American Economist called iring Fisher said interest is crystallized impatience I I quite like that is that I like that because I was to do the what made me understand it more

is the marshmallow test so that this was a test uh done by a Stanford University academic in 1960s called Walter Mitchell and um what he did is he took these uh American preschoolers as they're called and um he offered them a Choice between taking eating a a marshmallow now and um having two marshmallows after a certain period of time and what they found is that some kids delayed their gratification they in effect what we would call saved and through the delaying of gratification they were rewarded with an extra marshmallow so that was if you will

the sort of marshmallow was the the extra Marshmallow was the return yeah on their savings or um yeah or you could say it was the interest rate you I mentioned earlier this negative interest ratees so when I was back in you middle of the last decade when I was started this work and I was giving a few talks I got this friend of mine who's a documentary maker who had some young kids at the time uh to do a marshmallow test for me um in which it was a marshmallow test on under conditions of negative

they get Half of one interest rate so yeah so the girl so he got his daughter she he did the F conventional marshmallow test one one marshmallow Now 50 minutes l a second one and she passed that she's a good girl and uh then she said you know you can either have one marshmallow now or half a marshmallow in 15 minutes time now this is quite interesting so because she's sort of good obedient girl she's thinking I should wouldn't eat the Marshmallow but some or other I know I'm only going to get half marshmallow in

15 minutes time so it takes her about sort of five minutes to Twig and then she um and then she eats the marshmallow says it tastes so good but on a more complicated scale it took it's maybe taken the world a few years to Twig the impact of negative real rates in an economy in the same same way as a marshmallow you know we've we' played that experiment yeah sorry I Don't think the world has twigged I mean I I think certainly the the policy makers who um instituted this experiment of negative interest rates um

H haven't really to my mind considered what they did they haven't I mean again one of the reasons I wrote the book I I thought this this whole area was under examined um so yeah so so the negative interest rates you know discourage savings they encourage the consumption of capital and That in the long run isn't particularly good for an economy could could so we we've simplified what interest rates are and it's this you know the price of time um but could you talk I think interest rates can often feel quite confusing in the modern

setting because they perform a lot of functions could you maybe list out you did that so well in you know what they do why are interest rates around why are they a good thing well they're not they're Inevitable it's not a question sort of being good or bad they're an inevitable feature as I say given our mortality and and impatience and the first function is the role of and I've already talked about it the role of interest in valuation in in capitalizing an assd uh and that has um and so one way of looking at

that is that there is a relationship between the prevailing interest rate and the valuation say on stocks and and on Property and property actually is is it's fairly easy to understand um you know if you're buying a house you have to save up enough to put down you know as a deposit uh and then you take out of mortgage and then what you you can afford uh is based on how much of your income you can put towards the mortgage which is sort of I think sort of roughly in the range of sort of 30

to 40% is generally average and therefore as Interest rates decline or Mortgage Co rates decline then people will take on uh more they will borrow more they're able to borrow more and in a country like us where the supply of housing is limited that means they will pay more for property and and that's really you know what's happened um as you know over the last you know you know roughly 45 years interest rates went down and down and down and property prices in in the UK went up and up and Up and then people started

talking about you know a housing crisis and they blamed everything on the supply of housing um well may may be an argument there um but what was also true at the time is that the the mortgage affordability became cheaper and cheaper and cheaper as mortgage costs W went down so in that sense people you know the house prices went out people weren't spending more of their Income uh on mortgage costs it's just that they were getting a lot less bang for their for their bucks so that that's a you know very clear case that the

housing affordability crisis was a crisis induced by low rates and and one consequence of that is that and this is you know potentially troubling and it hasn't really fed through yet as far as I can see is that households have much more you know households with Mortgage Debt have much more debt relative to Their income than they used to have I when when rates are up at you know in mortgage rates up in the mid teens as they were in the 19 early 1980s you you can't take a a huge mortgage that mortgage is going

to be limited multiple of your income where it's now I think I read somewh a year or so ago that the amount of Mortgage Debt uh relative income is two and a half times what it was in the early in the90s in the early 1980s I didn't about the '90s yeah the '92 I think it you know people say it hit 15% but the the affordability was say four or five times salary so the the 6% or four five% of today are more painful than the 15% of then because you know the debt is so

much bigger I know and it but and one would expect that fixed rates yeah but one would I mean I think what I we can get on later if you wantest you know how long it takes for this to feed through but as you know people take a threeyear fix on their Mortgage and then it goes to floating so given that interest rates only picked up just over two years ago we haven't yet they haven't completely run off but in general uh periods of high of rising rates tend to bring these you know these speculative

booms or these periods of elevated asset prices gravity to a hand yeah say gravity say this is um Warren Buffet a f famous American investor says that interest the interest rate is to valuation what gravity is to matter and I then I I thought about his um comment about gravity and then I think that um interest is holding a whole whole host of sort of if you will sort of financial phenomen like valuations and we get oned um you know saving things and and and how much people borrow interest is determining them so it's to

me it's almost as if an economy is comprised of all these planets moving through the heavens held in place by an interest rate which is Balancing all our transactions across time all what we call intertemporal transactions it's a beautiful way of describing it are you building a SAS or Venture back business or just trying to grow abroad well if potential customers or investors haven't asked already about iso27001 sock 2 or gdpr compliance they probably will soon achieving compliance can unlock major growth for your company but the process is often you know Intensive and costly this

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what about things like control of control of the economy through the bank of England what's how the how's the interest rate function there the interest rate instead of really form you know being thought of in terms of of Val you know of something that determines valuations or savings or Capital allocation whatever it then Becomes this sort of tool in the hand of a central Banker to first of all to control inflation and then you think well how good a job have they done at that and you know it roughly in the last 100 less than

100 years let say n 90 odd years since Sterling has moved off gold you Sterling has lost more than 99% of its value relative to to um to Gold so you know this been you know the period of paper money of Monetary policy where the putative purpose of monetary policy to control the to control inflation has been pretty much disaster and that's also obviously true you if you go up to last few years where you know we were told that bank of England was independent you didn't want these politicians meddling all they had to do

was to pursue their 2% inflation Target and everyone would be happy and then what we get this you know great you Know the bank of England printed billions and billions hundreds of billions of B and uh fed grow Supply you know low and behold we got inflation so that that's that's one thing interest as as a lever to control inflation and even that and what's what is interesting about this and I haven't actually put this in the book is that the relationship between interest and inflation as a lever to control inflation is not at all

Straightforward um interest is um think of it say you're a landlord and you um own your properties on on with large mortgages and you rent them out and the mortgage rate Rises what are you going to do you're going to put up the rent yeah and rents are included in the inflation measure so actually the interest feeds through to higher rent the higher interest feeds through to higher rents that feed through to higher Inflation from from the perspective of the government once your governments operate with very high levels of debt and as I point out

in the book when you know when the interest when the cost of Leverage the cost of borrowing was you know was was very low close to zero short term you what did the governments do surprise surprise they borrowed a hell of lot of money so now theyve got a lot of money and interest rates start Rising and that means the government finances are constrained because now you know probably I'm saying you know the interest charge in the UK as a share of government spending is prob 15% is it yeah it's probably in the range I

was going to say sort of 12 to 15% something somewhere somewhere yeah somewhere in that range so what do governments do when they when they come under pressure they don't go bus because they can print money so why would you bother to get bus So obviously they have an inducement to print money and that means that you're going to get higher inflation in future so the rise in the interest rate undermines the stability of government financing and the undermining the stability of the of government financing presages more more money which causes inflation everything is and

and funnily enough it also works strangely enough the other way around again this is something that the that the um you know That the policy makers don't seem to understand which is actually that low interest rates are can be deflationary and one way to think of it this way is that you lower with households you lower the rate of interest they take on more debt once they've taken on more debt because they you know they buy themselves a car they go on holiday blah blah blah they brought that consumption from the future into the Present

and then that present it sadly is in the past and that means they've got they've got less consumption poti poal consumption going forward and what happens when you have lower potential consumption going forward well you have a sort of spending drag a deflationary drag when companies take on more debt they have to invest less and so forth and therefore you have a deflationary drag there so actually the low interest the low interest rates Feed deflation not saying in every case but and the high interest rates can feed inflation See the s the way it's conventionally

looked at is is possibly diametrically wrong they call that blunt tool it is a blunt very blunt so you don't think that the interest is can be used as a lever to control inflation because I mean we hear all the time but do you think it's a lot more diluted and not correlated than we think well or there's other Factors see in yeah so in extreme I one has to think how it how does it work the interest and if um I think the mechanism by which it works is um In The End by pushing

up unemployment and inducing financial problems and that's why um you often you know when um when the you you got long bonds when interest short-term interest rates rise and long bond yields stay more or less same PL same in the same place that you you get What we call an inverted uh bond yield or yield curve so that short-term rates are higher than long-term rates and and that stays in and that inverted yield curve so tight short-term money uh normally presses recessions not always we've had a period of a very long period of an inverted

yield cff and we haven't had a recession yet uh but I think the general mechanism is that higher rates kill off inflation uh by um not directly but but Through smashing the economy or financial system and think think back to the global financial crisis I mean I in the US in 2001 2002 took interest rates down to 1% was in the wake of the dotom bubble and then you know they got sort of you know us property bubble forming because you know money cost borrowing was very cheap and then from 2004 onwards interest rates started

to rise and it's hard to believe it now but even in you know 2007 mid 2007 people thought Everything was safe and the central bank still kept money tight and then you know the whole subprime Tob Backle uh came down upon us so there was a case where yeah they'd innocently raised interest rates and they had you know not the foggiest of what was about to to hit them so yeah a blunt tool and not just a blunt tool a tool that works as as as the American Economist Milton Freedman says with long and variable

lacks so it's not just blunt you don't even quite Know when the Hammer's going to hit its victim it could be you know six month months it could be a year it could be two or three years you're swinging a very long dull sword in the dark basically yeah yeah so what do you think the impacts of so again so just to frame this 5,000 years of interest rates and then for a period of time we went let's just bring them down to zero and hold them there you said that interest rates are the most

important invention and you You say that low interest rates are the second most and probably the worst negative I say negative rates sorry negative rates this period that we've been through what do you think that's done specifically to the UK economy that period well so we mentioned some of them you we have a very inflated real estate market um and you one of the we had very low Savings rates and um it's you know much harder oh yes so we they have another thing we have what we haven't talked about is the role that interest

plays in determining what we invest in um I don't mean just you know choosing your stocks sh but from from actually building what we actually build with our say you know with our capital and when interest rates are very low um it's the nature of things that People will invest in in assets whose Returns come over the over the very long term and and actually real estate is is one of those and we would have been Bor building more real estate if the planning regulations weren't so um you know depressingly complex um but we also

one of the things I point out in the book is that when interest rates are very low you um you you get these companies that really should go out of business and um and they're just very Inefficient they they hardly have any profits and the profits can't even cover their interest cost even when interest costs are very are very low and and those are what we call zombie companies I like that and so what was interesting after the the global financial crisis all the you know insolvency experts were sort of rubbing their hats saying you

know God we're going to have a lot of business cuz you know all these firms we we've got the great So-Cal Great Recession and all these terms going out of business but no interest rates were cut very low and what you saw is that business insolvencies were actually relatively low abnormally low after the global financial crisis at least I know that from looking at us and UK data then we have these businesses that would otherwise gone bus become your zombies and the with zombies is that um they sort of hang around you know they Sort

of move slowly like zombies they're the so to speak Living Dead and um they don't invest very much and once you know a sector is sort of covered with surrounded with with zombies no one's really going to start a new business to operate in that area would you say Wilkinson's was a zombie you know wios as soon as the rates came up they died right and they were like a they just clog up the high and it's like what do they sell I think I think That so I think there were there were huge Ms

numbers of zombies you know particularly you know among unlisted companies one wouldn't really have heard of you relatively small companies and one of the things about the they didn't invest very much and as they say no one comes into them into these industries so they they tend to have low productivity growth so you know that there's Le less efficiency there's less um you know what what what the you Know what's called creative destruction which is the you know the driving force of capitalism of taking it's brutal you just you know this guy is failing going

to take his money and give it to these guys who are going to get a higher return but that's the way you know system works at least should work and one of the the upsides of it is that when you get productivity growth you get income growth so what what we had after 2008 Was the lowest productivity growth in British history since the Industrial Revolution I mean an absolutely phenomenal failure I'm not saying you know it's 100% linked to the thwarting of the of this process of of creative destruction it's not it's not 100% linked

to the zombie phenomenon but I think that that plays some some role then now so other fact you know we've already mentioned that households have Too much debt because Interest being the price of Leverage you lower the you lower the price leverage you get more leverage so households have more well they don't in aggregate have more but but but the but the um mortgage owners hold more debt on their houses the government we met I mean you know the government were paying 10 basis points that's one tenth of one% on their borrowing in effect via

this the bank of England's quantitive easing operation so of course they went and spent a lot of money and wasted a great deal of money and my my slightly pical view is that we wouldn't have had such a long and unfocused lockdown During the covid period period where you know everyone was put on fur and you know whatever is you know sunak was giving money to uh you lunch and V people going eat in restaurants whatever and we wouldn't have that that great Splurge of Money which seemed seemed so easy at the time hey you

know what was easy but actually has ended up with a huge amount of of government and all the other ramifications of the lockdown so I'm leaving aside the government de so so I so those are some of the effects of the of the long period of ultra low rates and and as I say and this I think is you know a lingering problem is that if the System requires interest rates positive interest rates Fair interest rates for for uh for want of better work if it requires a fair of interest to operate and that rate

is distorted for a prolonged period of time then system starts to fail then you get younger people you growing up and they're thinking H we have a society which is highly unequal and this something we haven't talked about but when the interest rates Are low the halves people who already own own assets people who own houses people who own the stocks whatever they do well because those prices get inflated but people who don't have any assets suffer they suffer in particular because the less well off you are the more money you're likely to hold in

cash in deposit on the bank in part because well not just cuz you you don't have access to you know venture capital or private Equity or hedge funds whatever and also you need you know if you're going to lose your job it's your emergency fund you need some some precautionary savings those precautionary savings will be or should be in cash and so you what you you you are targeting the negative the the ultr lay rates Target inadvertently the least well-off Savers in an economy and and because the interest rate is the rate at which savings

accumulate Then you're also making it harder to retire harder to buy a house you're if what I'm saying about productivity growth and income growth is true you also mean that the person's not actually going to see such strong real income grou going forward so what are they going to think they're going to think hey I don't like this system I'm going to be a communist or whatever I mean little do they know that actually one of the reasons the commun the Soviet Union Fell is that it didn't have interest to interest rates to determine the

allocation of capital and the allocation of capital was so absolutely appalling in the Soviet Union that it collapsed but you can mean I I completely understand I think why people would be grieved by system is beginning to fail um and I don't think it's generally you know this point I'm making that that this Distortion of the interest rates is is in part responsible fail I don't Think that's generally recognized uh in in part because you know there's always been the main narrative on um in in on interest for five Millennia has been that interest the

charging of interest is unfair and it's exploitative shock is it you know I mean you gave I mean it's it's it's true that that you in in uh the ancient world people um and in the ancient world and in the modern world um you know Particularly in um you know in in in poor rural economies you will get exploitative users who are you know who who are driving people into into debt bondage who are taking their property and so on so for that's ABS you know there and they still do and that's also true of

you know payday lenders and sharks payday Archbishop of cut did his war war and wonger I worked in the debt management industry at the time that the payday loans were Prevalent and I think the bad thing about them was that their business model relied on people defaulting so they didn't want you to pay the loan back and they made it very easy for you to not roll it over for 50 Quid and and if you fail oh it's five times a loan instantly you know it was predatory in that sense like you say yeah you

I mean what we call user and and actually I mean this is another interesting thing if you remember in the I point out in the book Is that these ultralow rates Were Meant to you know after the financial crisis you if you ask you know the Central Bank oh we you know intended to you know reduce you know to reduce un unemployment to you know to as Janet Yellen who was chair of the Federal Reserve now now US Treasury SE says you know we're trying to help Main Street but in fact after the financial crisis

the banks all tighten their lending Standards so you know they subprime was out they gave birth to that industry yeah but also the rates charged yeah very credit card rates didn't come down I think they sort of just chug along at 25% so in that sense they as you say they the ultra load rates fed loone sharking and actually meant if you were poor and had a low credit School you weren't benefit you didn't benefit at all if you if you As I say and I will repeat if you were very rich you could go

and invest in lever make leverage type of Investments and make a huge amount of money in private equity in particular I mean it's property even like for the more normal person they could they could leverage a portfolio quite aggressively whereas you're saying that people with no money were exposed to really high interest rates in a really low rate environment and that that bred more inequality Essentially I that's what I would argue yeah that that that very high rates so these users rates we're talking about Payday Lo that breeds inequality so you've got you know some

bound Scoundrels making a lot of money from these payday loans so that that's what and they're sucking money and capital from the Bor so that's an inequality but there's this other inequality which is relatively new and sign it's the type of inequality that happens in a modern Financialized economy which is the which is you know what we've talked about the you know the the halves having more when interest rates low and and the not having less you you talk about good and bad inequality or we've seen quotes around that do can you explain what you

mean by that um yeah I think so um so good inequality is when people like us we get filthy Rich got beans and toast for the rest of the country what I mean is this is that if you if you do something that adds value and um that value is if if you will sort of beneficial to society um then it you you know it's not just fair that you should get a reward some share of that value uh but also if you get some share of that value perhaps it's an inducement to other people

to you know to also so to speak ad value um and then what is what is your what's Your bad inequality so I think bad inequality comes about when you're when you're not creating value uh when when you haven't really done anything positive to to have you know to have that you know to have great wealth and and and so and those can come in in in various way you know corruption mhm yeah that's you know not Very nice um exploiting your Monopoly power yeah now one of the points I make in the book is

that actually with very low rates it's much easier to sort of bring you know to merge companies together and so we got a much we got a growth in Monopoly power so that that's one form you know o of bad you know a bad inequality this um inequality that is just Created through you know through monetary policy uh in particular i' would say this is you know the financial sector does some useful things but you know after a certain point it actually it consumes more takes more than it than it produces and um if you

Have very low interest rates what we've seen is it tends to feed the growth of the financial sector and that's you know particularly true of of Britain and and the US where you our the US financial sector you know what we sometimes just call Wall Street short used to be around sort of 3 and a half% of US GDP historically and then it sort of grew to sort of 10 or or 11% and and same is roughly true here I mean uh and what and Why is that say well because you know Bankers when you

when well Bankers will lend more when interest rates are low and they'll get you know they will get particularly they get fees on their corporate lending when interest rates low you get incentive for for what I call Financial engineering you know companies go out and borrow and buy back their share and bankers get a a transaction fee on it the bankers get the mergers that you say they get fees On mergers uh then of course you know and then you know the investment world with the asset basically the investment World professional investment World their fees

are are roughly you know a proportion of the assets that they're managing I mean principle they're meant to be about adding value about outperforming markets in reality in aggregate they don't do that so where's their money coming their money is coming from changing overall market Capitalization now if that if the market capitalization is just being driven by low interest rates and they are as a result getting richer and richer well I would call that a bad inequality and in particular if you get a financial sector that becomes sort of horribly bloated and actually attracts people

who might otherwise be doing something of genuine Valu in some other activity so sort of brain drain into Finance and really frankly you know for all my um you know I graduated in ' 86 and and you know Frank since that period it's been a tremendous brain drein into finance and and it sightly feeds off you know we talked about how um you know the lower falling interest rates pushed up house prices and you're living in London you think well how the hell am I ever going to be able to afford a house I better

go into Finance industry rather Than being a doctor I'll be a finance professional because I can earn what a doctor does it's not so much I don't think it's so much do I think it's genuine Engineers I you you actually get Engineers who've done you know degrees and how to build Bridges and put up skyscrapers going off into the sort of nebulous area of of financial engineering it's and politicians as well like a lot of politicians go into Finance because they can make more money Oh well that is another for and this is this gets

back to the bad inequality is um you a bloated Financial system is one also in which you know it's attractive for politicians to to earn money and and and so and so yes you get you know and perhaps it's just coincidental that we live in an era in which you know politicians now monetize their their skills much more than they used to they say putting the ball in the back Of the net is the most difficult thing to do in football so what is the most difficult thing to do in business while the clues in

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description for you for full offer te's and C's and Tides terms visit tide. c/ terms variable rates are correct as of the 7th of November 2024 they one feed into the other do you think that Finance professionals become Politicians and politicians lean on the finance industry for reward you know well Rishi sunak seems to you know have skirted in both worlds quite heavily Jac Rees MOG was very much that that way inclined as well they was taking shots at everyone today no I'm just just recent examples right you you get these former hedge fund managers

that enter into politics or people that have worked in that World um you know have they benefited from low interest rates They've skimmed their fees and then they go let's go create some real influence in the political world sunak was a sort of Junior Analyst at the hedge fund yeah think he was he married well there he's what we tunak was what we call a grunt a grun we so okay we've we've spoken about that's falling over we bit like the economy we we've spoken about the the blow the inflation it creates in asset prices

and the way it distorts the Economy I want to talk about now what you think that will lead into you I think you you you had a way of describing it as it kind of seeps into the the cracks of the economy inflation and now interest rates rise do you think that though that will expand those cracks um yeah that's what I thought I mean the question then is you know am I correct um I was going to ask you that in a minute come back we'll come back to that I put it there it's

good I what can I think so sometimes you we talked about these we talked about this long and monetary policy with long and variable lags and um so far you interest rates started to rise in Britain sort of mid 2022 just a bit earlier roughly when my book was published and in initially we saw huge sell-off in the bond market um and the the the guilts market as we call it these long-dated inflation index bonds linkers they they lost you know they Lost 80% of their value so this is a huge bond market crash that

quite significant um we've seen we talk in finance about something called duration and dur ation is the sensitivity of an acid to a change in interest rates if you have a long dated bond with very low interest rates and interest rates then start to rise that that bond has a lot of duration risk and And that was you know clearly seen in 2022 and I would say that that is sort of feeding through into all sorts of assets that that are not Bonds but have a similar sensitivity to to interest rates similar duration risk and

yeah I know you one that's comes to mind we we have um you may have noticed you know for all this talk of you energy transition and so forth the um the you know the The Operators of of wind farms Of wind turbines that stock prices completely collapsed and when I last looked you know the the the index of of alternative energy producers were it was down about 60% and I think that that that's because if you build a wind turbine all your costs are up front and your payoff relatively low operational cost your payoff

comes over the 20 30e span now think what I was saying earlier about this discount rate well obviously if you have very low cost Of financing and a stream of income over 30 years you're going to be worth more or you'll be economically viable when interest rates are low and when interest rates rise you're become less vable and and I I mean okay here's a sort of you know a troubling thought which is that this whole this accelerated move towards net zero with huge upfront Capital costs in whether it was in electric vehicles again more

Expensive than conventional Vehicles because the battery is a you know a capital cost that pays off over the 15 20 year life vehicle that perhaps that whole move to Net Zero was accelerated because interest rates were outra L because Capital seemed more affordable so you think we're seeing these cracks now one push back would be why haven't we seen the consequences you know go on yeah I mean uh we friend of the show Martin wolf um very sharp sharp mind he he disagrees with you and he's not often wrong so um he made some valid

valid arguments so has it has anything made you change your mind or change your views or do you still believe that a recession is loading and um so yeah so Martin wol who writes the ft and he gave my book a sort of bad review in the F which is fair enough I mean he he because Martin Wolf's journalism over the last you know 50 15 Years have been very supportive of these policies so um I if you know it would be a big deal for him to shift position and change uh his argument in

a nutshell is that we would have had much higher inflation a much higher unemployment after the global financial crisis and this you know these extreme monetary policies mitigated the the um the unemployment and lowered the recession and there must be other the causes for all this you know for the inequality all The low productivity whatever um it is I I debated Martin wolf last year and yeah I know you know they didn't properly count to the end of the debate you know hands up but it was sort of Fairly tightly um it was fairly evenly

balanced I like to think I won but I didn't kind say he told us he won yeah did no it's a bit like it's a bit like Donald Trump versus Cala like both both sides think they won so so um and I think it is I I So to be fair if the world stopped now and we had no new information and and and this was it there was never a Great Recession and and the economies started going back to their not you know to their old level of growth and and that then I would

say I would say that if you will the critical or pical aspects of my book uh were egged I don't think I still Think the book's interesting just for what it says about the nature of interests in know what I don't think that sort of if you will the sort of criticism of the lower rates are you know the 100% of the import of the book um however I'm still sticking to my guts and there is this um there's this this fellow called American political scientist called Philip tetlock who wrote a book I didn't even

come across it called expert Political judgment and I'm actually it's actually amusing B because it points out something of course we all know which is that experts are constantly wrong about everything and um what he says is that they have these sort of reflex defenses when they're pointed out that they're wrong and among those reflex defenses are it hasn't happened yet another 10 minutes my brother-in-law says my brother-in-law says I'm a stopped clock and So I'm suggesting that the way I put this is is that the ultra low interest rates were the determining factor in

you know in finance and the economies of you know the 15 years after the global financial crisis and the move towards normalized interest rates will be the determining factor of what happens in um over the coming years my I still think that Because in you know because we we mentioned earlier that some quite a lot of borrowing in the modern world is fixed for short periods of time UK mortgages fixed for 3 years American mortgages you know fixed right for 30 years corporates borrow uh they might borrow floating rate but they can get uh they

can use derivatives or uh interest rate swaps to swap their floating obligation into fix and those tend to last about 3 years and three years ago You could you could ensure in effect1 million do of borrowing against any rise in interest rates in other words fix your rate for $556,000 so that's you know pretty small charge so you so one and I haven't seen the date on it but what I would have thought is that when the debt resets at higher levels and in particular if inflation is not under control and Interest rates as we

say not a very clear relationship between uh in inflation interest rates however you can be pretty sure that the authorities will move to raise interest rates when inflation takes off if it takes off if inflation takes off at the time when uh these fixed rate interest you know loans start become floating or loans have to be uh re reissued then um then I'm yeah I'm pretty sure that that you know bad things will happen what what I mean when I think when I say bad things will happen is probably some you what we call a

sort of stagflationary bust um again as we saw in the 1970s and that would be characterized by um a recession by by higher interest rates creating both a um financial problems for the banking system and also in the property market so that that would you know a period of sharp a crisis another crisis and I suppose my view has always Been that the consequences of the last crisis were uh postponed the Day of Reckoning pushed off by these ultr rates and I never believed that you could do that artificially that I was you know something

biblical in me said that that some or other there would be a payback day at some stage and I I suppose I still believe that it I mean it makes sense doesn't it like you know I think you and Martin obviously there's a Disagreement but you're you're similar in a lot of ways we sat here and talked to him about inequality and he I'm taller than M yes that's I'm I'm the DAV shut up us two guys got to stick together T typical that if you if you're not sure you want the debate you just

bring it down to physical qualities do you think do you do you think there's a a way that we could navigate out of it you know just outside of your own argument you could There I mean for instance you know where it you know affects in particular your listeners um one of the things is to look for is is are our nominal incomes growing faster than the rise in mortgage cost or borrowing cost so we've had relatively strong nominal a brief period of yeah brief period so if if you keep up that that's also staves

off problems yeah so yes you know you're paying more on your loan but your income is risen uh slightly faster then actually the in in Terms of affordability you're actually more AFF real wage growth to to improve no nominal wage go yeah that's see I me that's another I perhaps didn't make this point strong enough in the book people you distinguish between nominal which is you know what we deal with you know on paper on paper and and real which is after inflation but the re the idea of real is itself a artificial construct what

we pay is that no one you your bank doesn't say oh well I was Going to charge you 10% but you know inflation was 5% so now going to charge you 15% no you pay nominal you don't pay real uh real is unreal and what it it matters is nominal strong nominal wage growth could um and and and strong corporate profits would you know would keep things and have been keeping things going I know you say real is not real but it it is a good measure of say spending power over time right so you

know we can see That from 2008 that in real terms wages did not have thought sunk or they've gone backwards and and I do think that that's an important measure for people because otherwise you get a situation where people have been handed teners and they they've got more money and they can buy less stuff yeah no know I understand as a measure of spending overtime it's just people think that you that when we're talking about transactions and in loans this and that that they they talk In in they sometimes talk in in real terms when

actually it's the nominal matters think back to you know when inflation is very high and interest rates are very high think interest rates well nominal rates very high they may actually be negative or flat but that doesn't mean that you know if you if does doesn't mean that they don't hurt so you know a zero real interest rate and a normal interest rate of 15% on your house you may force you to sell Your house and will actually also bring down the value of the house so in that sense I I just you know it's

very it's all very theoretical I can agree with you there the nominal price does have a place and people do get a bit obsessed with the real but like you say that's the money that's enter in your life right yeah can we can we talk about individuals to to wrap this up a bit just because I think you know talk about the economy I want to know what what our Audience should be doing to navigate this period of changing rates and changing returns landscape and I'd like to look at investing in the M stock market

and maybe how we View Property if if you don't mind think you know the trouble is that if you're get you know the most sensible thing to do is to to get a sort of global Index Fund but the trouble is that the US is very inflated it's now more than I didn't know where it is yeah you see I was going to say 58% it depends on which way you're looking yeah um the currency sh in the currency um the yeah it's large and so you and then what you're buying um given that Nvidia

was around 6% so but when you buy a global index you actually putting 3% into in know AI chipmaker and5 pound goes into Microsoft I think every time and so it's very very so the US market is very expensive um and hasn't come down I mean it came down a bit in it came down bare Market 22 and then bounced back with this sort of AI bubble and you said that very AI bubble invol I want we're not going to talk about it at L um and then um and and it look you know we

measure the valuation stock market by looking at its you know price to earnings ratio but we averaged earnings over 10 years to get a sort of more reliable uh data and it looks exp you know us markets more expensive than 1929 they've looked expensive for a long time now it has looked and it's part because of you know super profitability of the likes of Google and Microsoft and so forth and this never seen before so is it expensive then if they're backing it up with the the revenue or the cash flows if there you know

people are like oh it's expensive the PE blah blah blah but actually these guys are making again this is you know this is a longer conversation there are A number of things uh the big Tech is now having to spend Splurge lot of money on AI so whether it typically you know doing bubbles that you know even if the even if the bubble is in a technology that eventually Works typically the spending during the bubble phase is uh is loss making those companies are also under pressure from monopolies for monopol break I think you get

to a certain point where monopolies um become sort of onerous to The public and you say hang say why should you why you why is likes of Google and Facebook and so on allowed to buy up I mean you've got I mean with Facebook you've got you know you've got schools Banning uh social media you've got Google being threatened uh to with a breakup in the US you've got you've got um Apple being you know under the Kos with the EU see I you people are are quite complacent about the sort of big Tech given

that it's had such good Run um and but then you know also you've got higher rates and that higher rates should feed through make them you know any day now when the bubble bursts their stocks will come down yeah I mean but there's always been these high periods of concentration within within the the indexes no no no I mean they they again I mean say make it clear to to listen what we mean by concentration Concent High concentration means that more and more of the stock market is in a limited number of names like 50

names for instance we used had something called a nifty50 bubble in 19723 then was 50 stocks that dominate my then um in the late 1990s during the tech bubble uh that was again limited I I don't know let's say a around it wasn't quite as strong as a nifty50 Bubble very very concentrated market so you see as the bubble as the stock prices go higher and higher the concentration of the market becomes more and more extreme and then this year uh we had you know the so-called magnificent 7 uh you know seven stocks large capitalization

stocks more and more conc we so if you go down to sort of concentration Market in five stocks it's it's far more concentrated than ever Before and that that that is that is um undoubtedly risky I me what you can do to mitigate that is instead of buying a market cap weight equally weighted you could buy an equally weighted one so you you get sort of instead of putting you know three or 6% of your money in into Nvidia you're just getting a small and and that picks up the value um compon equally weighted in

indexes are weighted towards value but you then you're you're not back in the win the runners right Like you know you would have if you'd have done that over I don't know what the returns are to be fair I think we looked at look so the trouble with whatever works in investment is most likely to be what hasn't worked over the last 10 or 20 years the the winners are always shifting and that's what actually makes investment quite interesting so just buy the index and forget about it well no I'm not saying I'm saying I

actually think that the you know I think the index you know a broad market cap weighted index is a riskier proposition than it was 10 or 15 years ago do you think there was other periods say where they were concentrated they were risky and and when you talk risk you mean potentially a bubble bursting imminently valuation of loss value no I'm think of it just I mean more prosaically just of of low expected returns going lower Expected Returns what people you what people don't always get their head around is that the higher valuation of an

assd everything else being equal the lower return you're going to get from that asset uh and I mean that's clearly true say on you know with a bond yeah it's not necessarily so true these tech companies with not you know with fast growth and Monopoly positions but but by and large it holds true and um I I I Think my preference perhaps you know I'm a bit more sophisticated in sense having worked in investment world and so on that I prefer to sort of buy pockets of the market that I think particularly cheap I like

I think that the Emerging Markets ex China is relatively cheap I think the Japanese smaller companies are relatively cheap I think that UK smaller companies value companies are relatively cheap I think value is relatively cheap to So-Cal Growth stocks and I think the US Stock Market um uh index is probably going to have you know very low returns over the next 10 years have have you beaten the market in the last 10 to 15 years that was a good question no see I so I run you know I'm very so two things I'm very conservative

see yes or no in it it's not it's not because the thing is that one one runs a portfolio according to your own so You're saying and I you know I do my feeling is this is that when I've earned income um and PID tax on it I really hate losing that money okay and so and I run relativ and I'm actually most and most and because because I'm probably overly cautious with my own money I um I I give most of my own money to um to other people to manage um what what I

find in in I look after um some family money which not mine and I'm and I'm not say risk ver That yeah I don't care in that and actually and there I have yeah I think it doesn't sound like a great thing there I have actually sort of compounded over 15 years at roughly the index return which sounds like yeah like huge M here's a guy retive M retive and he's just equal the index but actually I again I'd say I've done it with much low risk so had the world fallen to pieces I know

that because I've sort of navigated through Global financial crisis through the covid crash and I haven't lost money in those periods so I've and so I think to run yeah I think and I yes I think I'm reasonably not a great force I love your honesty it's like it's brilliant and the audience will love that as well Martin wolf out performed the market did he I have no idea got he did 1% better yeah I mean one has to understand that the in the time when interest rates Were falling and bond I mean it's a

bit technical but bonds and and and equities were negatively correlated so one when loss on one were offset by profits on another and the stock market was Rising higher and higher higher that then you know the Benchmark passive uh portfolio of 6040 was very powerful but but you know in 2022 it blew up and it's recovered a bit since then Although the bonds never not recovered um but it probably is still vulnerable so so so you shouldn't be going for 6040 on I'm not saying look I'm not I'm not first not investing no no first

of all but I'm not even saying because you know you can it it's probably better than nothing yeah I mean if your money if your alternative is to keep your money in cash then that's probably better but but in the 1970s you a period of inflation um you had you know bonds being marked down and you had equities marked down and the so you know the so called you the safe uh Benchmark Port asset allocation portfolio of 60% equities 40% Bond lost half its value in real terms in terms in terms of spending say so

yeah you whereas if you'd had your money in gold or Commodities this and that you know you could have Probably done a lot better I'm not saying that one would necessarily do a lot better but I I think that that that in to go back the we have been through a period in which passive investment has done extraordinary wealth so you've I you've not got long left and I want to let you go and get your flight to Amsterdam um just want to finish on property because the the problem with the UK is we have

we have an obsession with bricks And morar and I think there's a large part of our audience understand investing there's a large part who just think the best thing I could possibly do is buy a home do you think that narrative is going to change now or how do you think people should think about buying owning and investing in in housing what we seen in London uh is that house prices normal have remain relatively flat whereas in real terms I mustn't mention This real real terms they have actually declined by about 35% so actually the

houses are they've got cheaper and it's conceivable that you know when you have period of of inflation the sort of best outcome again you know we were talking about sort of best outcomes you know best outcome is you don't have a housing crash in nominal terms this what we had in the early 199s but slowly inflation like a Silent crash a silent crash and that's what we've had you know I mean people would be up in arms you know they bought a house for a million and a half you know 5 years ago and it

was worth a million today but in fact that's in effect what's happening in given that inflation is a rad of value um I I think I mean the trouble with housing in Britany is you've got you know these these these other variables you've got you know now now there sort of War on The landlords uh whether it's going to come in the form of more tax on landlords or some type of rent control or some type of stronger um protections for tenants well all those will feed through to lower supply of rental housing so we'll

push up rents as well as I mentioned higher higher interest cost so so in that sense you you can't you know you can't go just you know sleep in Queen Park can you so you've got to have a Roof over your head and so the rental supply rental houses is I think going be constrained um and then there's talks of you know of of increasing the supply of new housing but we'll see what comes they they promise that every time don't they and it never and then you've got sort of indeterminate immigration and how much

that impacts on our aggri supply I mean one of the things I found and I actually started off as a sort of housing analyst in the city of London is That what really crashes the housing market is a combination of higher interest costs and new Supply massive new Supply and that that's actually what we saw in the US up to 2008 and and what then what we haven't seen in the UK since the early 1990s you know big crash in the early 199 in part induced by the fact that the home builders in those days

actually used to build homes believe it or not you need the motivated Sellers as well right don't you that They've got to come to the market because it feels like at the minute transactions have probably slowed a lot but people just AR they're just sat waiting they're not like I don't need to sell so the market just sits like this doesn't it yeah and I think that I mean it's also true in um commercial real estate I think that the these are Market you know it's it's like is Martin wolf right full CLE and the

market is it's like it's balanced on this full doesn't quite no but it hasn't cleared it hasn't cleared yet yeah and um and we'll see let's revisit this in say like two three years and then like you know we we can definitively say you know who's taller I was right we'll give like a little trophy to whoever was right be so good we have a little fight that' be good we we set that get the Saudis involved and get a big ticket fight get a live Audience and yeah it'll be look I know I think

Martin W's probably pretty Scrappy got a lot of Bal getting under my reach thank you so much I really enjoyed that yeah thanks no worries excellent that was a loaded episode if you want a summary click the link below to check out our newsletter and if you enjoyed this episode then watch this one next with Marin Somerset web I think you'll really like it