Most developed markets are at zero effective interest rates. Japan has been under 1% since the 90s, the EU since 2009, and the US from 2009 to 2017 and since the 2020 pandemic. Zero-interest rates disrupt the economy’s traditional transmission mechanisms, eliminating the time value of money. Consumers can now get a 0% interest rate mortgage in Denmark. Last time it happened was in the 1930s during the Great Depression and WWII (see Ray Dalio chart). I will explore two potential explanations: (1) another cycle that repeats the 1930s and (2) a new era in which Capital is plentiful and loses value to Knowledge, the new limiting factor of production.
“Stock prices have reached what looks like a permanently high plateau.”
Irving Fisher, 1929
In this explanation, the zero interest rate phase would be part of a broader cycle. This cycle is driven by a combination of technological change, inequality, global power transition, political upheaval, and/or other factors. These pressures drive governments to lower interest rates to the minimum to keep the system going without taking painful decisions. Lowering interest rates requires rapid monetary base expansion. At some point, conflicts come to a head as inflation starts to get out of control and decisive interest rate action resumes.
Taking the 1930s as a reference, this could include populist takeovers of governments, wars, asset bubbles, currencies going to zero, and much more. There are undoubtedly uncanny parallels between the 1930s and our current situation. First, we are at a time of extreme inequality between countries and within countries that COVID has exacerbated. Inequality creates social conflict and is triggering populism as the attack on the US Capitol showed. Second, growing geopolitical competition between the US and China has led to trade and technology wars. Third, western governments and Japan are engaged in unprecedented monetary base expansion with debt is growing to previously unseen levels. Fourth, technological change is ready to redefine our social and economic structure.
On top of this, we face climate change and the COVID epidemic, which increases pressure and uncertainty. While at the same time, binds countries together, as neither can be addressed individually.
At the end of the cycle, we can expect “hard” disruptions over the next years to reconfigure our technological, economic, social and geopolitical balance. The consequences can range from minor to tragic. Whatever system comes out of catharsis would again have higher interest rates, allowing us to keep most of our financial mechanisms intact.
A new era
“I can state flatly that heavier than air flying machines are impossible.”
Lord Kelvin, 1895
In this explanation, interest rates have gone to zero as part of a secular trend of increased capital availability. Increased availability has removed it as a limiting resource in developed countries. Knowledge is the new factor of production that is limited and highly rewarded. As Capital superseded Land, Knowledge has superseded Capital. As wealthy landowners lost the central stage to industrialists, banks and asset managers have lost to tech innovators and private equity.
Of course, Capital is not free everywhere—many people, companies, and states have substantial risk profiles and have to pay for that risk. However, supposedly “riskless” assets like the German state, Apple or Danish homeowners don’t pay any interest rates, at least while they behave responsibly.
Knowledge takes many forms. It can be codified in software assets, it can be a business system or business processes, it can be proprietary information, or it can be in the knower’s head. Capital was less tangible than Land, and Knowledge is less tangible than Capital. Making it difficult to evaluate and audit, as balance sheets with exploding intangible assets show. Knowledge is also much more domain-specific and has a higher risk of obsolescence. This makes it difficult to distinguish between “good and bad” Knowledge.
Entrepreneurs with an advantage in the Knowledge factor of production like technology and biotech startups and scale-ups have almost limitless access to funding. They can choose from many potential capital providers that bid up their asset values to the future cash-flows Knowledge will supposedly generate. Big Techs have managed to create a virtuous cycle of Knowledge creating access to data, which they convert into further Knowledge which differentiates them. Customers are paying for Big Tech services which are “free” from a monetary/Capital perspective in terms of data/Knowledge.
Investors with an advantage in the Knowledge factor of production like Private Equities, Venture Capitals or Hedge Funds also have unlimited access to Capital. They are limited only by their capacity to apply Knowledge to the Capital they raise. So they look for ways to gradually expand their scope of activity to maximize the leverage of that Knowledge. This can be seen in exploding assets under management in the largest PE funds like Blackstone, Carlyle and Apollo.
In the new era, interest rates for Capital are permanently lower. Abundant Capital competes for scarce Knowledge, driving prices down. This dynamic can generate a winner-take-all situation driving inequality and reducing opportunity for many. It requires rethinking and rebuilding our economic, financial and social systems.
Only time will tell where we end. My opinion is that a combination of both phenomenons is at work. On the one side, we are in the middle of an asset bubble. The “permanently higher plateau” of SPACs, priced for perfection equities and artificially low-interest rates will at some point collapse and force a reckoning. On the other hand, there is much more Capital available, and financial innovation has made Capital more liquid and flexible, and thus less scarce and less rewarded. We should use this abundance of Capital to tackle our time’s challenges, like climate change or inequality. Those that can convince capital holders of differential Knowledge will continue to access Capital with increasing ease and be rewarded for it.
How can we square both conclusions? It is about the difficulty of evaluating Knowledge in a bull run. The long monetary-induced bull market has made critically evaluating Knowledge difficult. Knowledge in companies is swamped by infinite Capital that can be used to fake results (e.g. WeWork). Knowledge in investing is obscured by a market where most investors are getting phenomenal returns just by showing up. Paraphrasing Warren Buffet, once the tide of valuations recedes, we will see who was swimming with relevant Knowledge, and who was taking advantage of the bull market.