What is possibly the world’s most popular savings product, has four legs, produces milk and, as every child knows, says “moo”?
In many rural areas those without much access to formal banking use cattle to preserve their surplus funds. Like a savings account, cows provide a regular income, although in the form of milk (or dung for fuel) rather than interest payments. While you might not be able to withdraw your money from a cow, you can always sell or eat it.
This is nothing new. What is probably humanity’s oldest economic model was based on cows. A roughly 4,000-year-old Sumerian tablet discovered at Drehem in modern-day Iraq describes the growth of an idealized herd over 10 years. Like many models, it relies on unrealistic assumptions: no cows ever die and each pair always has a calf.
Nevertheless, the Sumerian accountants likely used this tablet to forecast the value (in terms of silver) of the milk and cheese produced by such a herd over 10 years. Archaeologists believe the Drehem tablet was probably an investment plan. The initial number of cows increases exponentially in the same way as adding interest to savings compounds the value over time.
Why should this matter to a modern investor? One who faces not a choice of whether to eat or keep their cows but choosing between stocks, bonds, cash or even just spending their nest egg? Well, it helps illuminate how central bankers see the world.
Critical to their decisions is the economic theory of the “natural interest” rate – the principle that, even in a world without money, our savings should still produce a return. Indeed, the idea of a herd of livestock naturally growing in number may be where the Sumerians got the idea to charge each other interest.
If a farmer lends a neighbor his herd, not only would he expect to get back what he lent – the principal – but also the income produced by the assets, in this case calves. The Sumerian word for interest is mashwhich also means “calves”.
The English word “capital” has a similar origin. In medieval Europe, livestock was an economic keystone and it was counted by heads of cattle. The Latin for head, capita, then gradually started to refer to wealth more generally and, eventually, to funds of money used by merchants.
These days, economists draw a distinction between capital goods and financial capital. Actual things – a business’s premises, software and equipment – are all capital goods. They are commodities used to produce other commodities – an oil rig gives you oil; a cow gives you milk. This physical capital can be lent to a business, just as money is.
Following the lead of the 19th century Swedish economist Knut Wicksell – a birth control-advocating iconoclast who was imprisoned for blasphemy – central bankers think the natural interest rate matches the supply and demand for investment funds.
Wicksell knew that the commercial banks – not the central banks – created the vast majority of modern money and he wanted to know where the limits were to this process. His answer was that when the interest rate on money – the cost of borrowing – matched the return on “real” assets, the natural interest rate, there would be some sort of stability as the costs and benefits of creating new debt were equal. Otherwise, prices would surge out of control, leading to hyperinflation, or, if rates were set too low, a deflationary spiral.
This theory is why central bankers often do not believe they really set interest rates. The long-term natural rate of interest ought to be independent of the short-term rates at which a central bank lends – changes in the money supply will not make cows breed faster or any other investment more productive. So, as central bankers target a particular rate of inflation, they will have to adjust their policy rate.
So what does this mean for monetary tightening? Central banks are now engaged in a program of withdrawing their pandemic support: the Bank of England raised interest rates at its February meeting, in only the second consecutive rise in base rate since 1997.
But where will rates end up? Before the pandemic, central bankers argued that lower productivity growth – akin to cows breeding more slowly – would mean that rates would need to be lower for longer. The returns on offer from investing in real assets were lower so more needed to be done to push investors out of cash.
It now seems clear that the pandemic has shaken something loose in the global economy: the emergency low interest rates adopted after the 2008 financial crisis seem, after years of not doing very much, to be finally generating inflation.
Yet almost two years into the experiment of mass working from home, it also seems hard to believe that the pandemic will, on its own, unleash more than marginal productivity improvements. Indeed, a 2020 economics paper argues that the historical record shows that pandemics typically lead to a 1.5 percentage point fall – not rise – in the natural interest rate. Possibly, the authors argue, this is because there was less need for investment as the death toll meant fewer surviving laborers for each unit of capital.
That would be an argument for inflation to fade swiftly as the central bank’s short-term interest rates increase: monetary policy will soon become disinflationary rather than stimulative. Interest rates will rise a bit and then stop.
There is another half to this mainstream theory of interest rates, however. The natural rate is not determined only by how productive investment is but also society’s willingness to save and that includes governments and companies. This time things may be different: unlike during historic pandemics the government has been willing to spend to protect jobs.
Pressure to keep spending, for better or worse, looks unlikely to fade any time soon, whether that is in the drive to reduce carbon emissions, repairing supply chains, or just satisfying largesse-loving voters.
On the other hand, it may be that there is nothing “natural” about the natural interest rate. The mid-20th century British economist John Maynard Keynesfor instance, argued that it was a misleading idea as “interest” had to be a purely financial phenomenon, one that depended not on the return on capital but the desire to hold money and, therefore, our uncertainty about the future.
Vaccines may have removed many of the darkest clouds on the horizon – since the central banks began the latest iteration of extraordinary policies – but many investors would be forgiven for thinking that there is still too much to worry about to abandon cash just yet.
Gavin Jackson’s book Money In One Lesson was published by PanMacmillan on January 22. RRP: £ 18.99.