The Price of Time

Ancient Tablet

In 2022 interest rates increased dramatically. The yield on the 2-year Treasury went from 0.73 to 4.32%. That’s almost a 500% increase! One could say that interest rates have increase more and at a faster clip this year than at any other time in human history (and that’s not hyperbole). Accounting records go back pretty far and many of the earliest writings we have are documentation on loans and interest. Some known artifacts date back to as early as 1760 BC and show text containing regulations limiting the maximum rate of interest (usury) and prescribing conditions for loan forgiveness.

Today the term usury is used to exclusively refer to extremely high interest rates. Each state in the US has its own usury laws about how high these rates should be. But thousands of years ago certain cultures referred to any borrowing at interest as usury. The nascent Catholic Church for example outlawed it. St. Augustine (354-430 AD) once said that it was better to steal from the rich than to slay the poor by usury. Pope Innocent II in 1139 condemned the “insatiable rapacity of usurers”. And Thomas Aquinas once wrote in his Summa Theologica (1485) that “the usurer violates the law of the just price by taking back more than he originally handed over.”

Overtime, as trade and exploration picked up, the demand for loans increased significantly and eventually a more modern approach to usury or interest was adopted. Around the turn of the 18th century philosophers began thinking of interest as we do today, as the price of time. What is more valuable to you? $1,000 today or $1,000 one year from now? By answering today, we admit that time has value. So, what exactly is the value of $1,000 one year from now? Traditionally this is done by “discounting” the payment by the prevailing rate of interest. Let’s assume that the prevailing rate is 5%. $1,000 divided by 1.05 is $952.38. As the years go out, we raise the discount rate to the respective power. So, if we are waiting 5 years to receive our $1,000 we would divide by 1.05 raised to the 5th power giving us a value of $783.52.

As we can see, as the rate increases the future value of our cash flows diminishes. This creates a sense of urgency in finance and economics. If interest rates are at zero, then it doesn’t matter whether I receive my $1,000 now or later. It is often said that low interest rates encourage growth because it encourages borrowing. If you’re a business owner, you are more likely to take out a loan to expand production if the interest rate is low. But too low of a rate of interest can have the opposite effect. This is because there is no sense of urgency. Think of the rate of interest like a shot-clock in basketball. When rates are at zero it’s like the shot-clock has been turned off. The players on the court take forever to shoot the ball and the game turns out to be very low scoring and not that interesting to watch.

Over the last decade central banks around the world have actively suppressed interest rates, even pushing them into negative territory in some parts of the world. While this has increased asset prices around the world (think stocks, bonds, and real estate) it has not done what policy makers have hoped it would for the real economy (think productivity growth, real wages, and job creation).

The other notorious problem with low interest rates is the formation of bubbles. Because the shot-clock has been turned off the economy has no time preference and investments that could take decades to pay off don’t seem that bad. Take cryptocurrencies and decentralized finance for example. For some, it has been difficult to see the use cases for these ideas. Now, with the shot-clock back on and a sense of urgency injected into the economy, more and more people will likely have time preferences that do not match the investment time horizon for some of the more speculative investments.

In his book The Price of Time: The Real Story of Interest, Edward Chancellor shows how unprecedented and unnatural the past 10 years have been with interest rates near zero and even negative. In the five thousand years in which there are records of interest rates, it wasn’t until the 20th century that rates touched zero. While the rate increases in 2022 have been painful in the short run, I believe that higher, more normal rates are better for our economy and society. In my opinion, a shot-clock should always be preferred.