A History Lesson on Interest Rates

There is a 19th century saying attributed to Walter Bagehot, an early journalist for The Economist: "John Bull can stand many things, but he can't stand 2%."

In order to understand this, rewind the clock, and think back to the 19th century when the British were bankers to the world. On a gold standard, there was no meaningful inflation so nominal interest rates were the same as real interest rates.

Interest rates are determined by the credit-worthiness of the borrower. In other words, they incorporate the risk that the counter-party will default on the debt. It goes without saying that when you had a longish period of prosperity, and no forward looking prospect of war, famine or distress, people gazed on the future with infinite complacency and interest rates dropped.

Whenever rates plunged down to below 2%, a speculative frenzy would break out because people relied on the income produced by their investments to fund their lifestyle.

Time after time, people rushed into speculative investments which promised the illusion of larger returns, and each time they were burnt, and the episode ended badly in a brutal deflation.

Please note very clearly that this has nothing to do with the gold standard as long as we think in real rates not nominal ones. The only thing a gold standard does is exarcebate a deflation.

Also note carefully that the "central banks" in a fiat currency world cannot really "mop up" after the fact because all they are doing is screwing the lender in favor of the borrower, or vice versa -- this is never ever going to change the basic economic fact that the speculative object was never worth the price paid for it. (Once again, you don't need a gold standard as long as you think in real terms not nominal terms.)

Most importantly, if the speculative money has flown into multiple channels, there's no mechanism to preserve every single one of those prices in nominal terms. You can at best favor some over others, and while this is totally arbitrary, they must all collapse in real terms (as pointed out above because they were never truly worth what people paid for them.)

It should be obvious to any student of history what happened when the Federal Reserve slashed the rate down to 1% in 2003, effectively driving the real rate into negative territory.