The years since the 2008 financial crisis have been among the strangest in the history of monetary policy. Interest rates have been lower than at any time since the Industrial Revolution. Governments have been issuing debt in unprecedented quantities, and central banks have been buying the debt back. But this era seems to be coming to an end. Interest rates around the world are rising. Markets talk not of quantitative easing but of quantitative tightening.
What has been going on? Edward Chancellor’s new book offers a very long-term perspective, beginning in Babylon and ending with Covid. The book combines historical scholarship with a deep understanding of modern financial markets. The first known legal code—that of the Babylonian king Hammurabi—was, Chancellor explains, mainly concerned with financial regulation. Still, he observes, “drawing up financial regulations is one thing but getting people to follow the spirit of the law is another matter”. Almost 5,000 years after Hammurabi, some things have not changed.
Chancellor has already provided a history of speculative bubbles—from Dutch tulips through to the South Sea bubble and Mississippi Company, to railway mania and the Wall Street crash—in his excellent Devil Take the Hindmost. In the present book, these episodes are recounted with an emphasis on the monetary policy environment that contributed to them.
But the meat of the book is in its critique of the monetary policies of the last two decades. Chancellor’s heroes are William White and Claudio Borio of the Basel-based Bank for International Settlements. Together with Raghuram Rajan, one-time chief economist of the International Monetary Fund and governor of the Reserve Bank of India, they were among the few to warn of the dangers of sustained low interest rates—and the difficulties of escaping from these policies. Low rates beget low rates, they claimed. Which is to say: low rates discourage investment, inhibiting the potential for longer-term growth in demand, thus necessitating future rate cuts in future.
And in the end, the lesson from both historical and recent experience is a simple one. Low interest rates have always been associated with episodes of financial speculation, and episodes of financial speculation have invariably ended in tears. At the start of 2023, with rising interest rates, rapid inflation and the end of the “everything bubble”, there are many tears.
How did we get here? In 2008, central banks around the world responded to the emerging crisis in financial markets by cutting interest rates—eventually to more or less zero—and flooding the system with liquidity. That flood of liquidity continued with “quantitative easing”: buying long-term bonds issued by the governments that oversaw the central banks. Eventually, the authorities would accept the securities of practically any credible issuer.
The 19th-century banker and economist Walter Bagehot described how central banks function as the “lender of last resort”: in a liquidity crisis, banks are unable to access credit and so the central bank ought to lend to those banks that are solvent at penal rates. The knowledge that central banks will ultimately provide liquidity to banks if they are unable to meet withdrawal demands removes the incentive to remove your deposit before someone else does, thereby preventing bank runs. But the 2008 crisis was not like that. Banks ran out of liquidity because they were insolvent—or, more precisely, because no one, least of all the banks themselves, knew whether they were solvent. The low interest rates prevailing since the end of the dotcom bubble in 2000 had paved the way for foolish lending, aggravated by an “originate to distribute” model in which loans were traded on, packaged into securities whose arcane structures gained approval from rating agencies but defied analysis. That complexity allowed their value to be marked up to the market value or to the value determined by the application of a mathematical model. This provided bonuses for those who traded them, with these inflated prices disguising their true value.
Policymakers in 2008 had absorbed few of the historic lessons described in Chancellor’s account. And in their struggle to answer a fundamental question—“what the hell is going on here?”—they had little help from economists. In the words of then European Central Bank chair Jean-Claude Trichet, “as a policymaker during the crisis, I found the available models of limited help. I would go further: in the face of the crisis, we felt abandoned by conventional tools.”
Academic work in macroeconomics took a new turn in the 1970s, as the Keynesian-influenced policies that had prevailed since the Second World War seemed to have failed in that troubled decade. The argument made at that time was that all models needed microeconomic foundations—after all, what happened in the economy was necessarily the product of the decisions of individual households and businesses. Government policies were relevant primarily to the extent that they influenced these decisions. And the expectations of individual households and firms were crucial, too. Hence the idea that if independent central banks were committed to an inflation target, expectations would become aligned with that target, and the target would be achievable. Central bank independence and inflation-targeting have become the principal policy prescriptions of modern monetary economics.
These prescriptions have put central banks in the spotlight. But their response to every development since 2008 has been to flood the system with yet more liquidity. The “taper tantrum” of 2013, when markets feared quantitative easing might be withdrawn… the Eurozone troubles… jitters in the repo market… the pandemic… “give them the money” has been the strategy. Even in the last days of the Truss interlude, rising gilt yields necessitated intervention to provide liquidity to struggling pension funds. Low interest rates begat low interest rates.
Economists must share the responsibility. Half a century later, the idea of building macroeconomic models from microeconomic foundations—an idea that I found appealing as a young graduate student—appears today to be a failed project. The central problem is that such analyses require so many simplifying assumptions that the resulting models have little policy relevance or predictive value. Asked to explain the rationale of quantitative easing, Ben Bernanke, the academic economist turned Federal Reserve Board chairman, used the old quip that “the problem… is it works in practice, but it doesn’t work in theory.”
The nadir of modern macroeconomics was perhaps achieved in 2011. Princeton University held a press conference to mark the award of Nobel memorial prizes in economics to Thomas Sargent and Christopher Sims “for their empirical research on cause and effect in the macroeconomy”. As the event was thrown open to the floor, the first question posed to the two laureates was obvious and predictable—indeed, the interlocutor noted that it is the question everyone is asking. “What does your work tell us about how we can support the economy, create jobs?” A lengthy silence followed, broken only when the audience dissolved in laughter. Pressed to respond, Sims asserted that his work shows that answers to that question require careful thinking and a lot of data analysis, and he cannot be expected to make comments “off the top of his head”. Sargent meandered and said he would rather be talking about something else.
With academic economists having effectively vacated the field of helpful policy advice, cranks rushed in where professors feared to tread. This is not new. Chancellor recounts many historical instances of eccentric theories of money and the colourful characters who advocated them. Figures such as John Law, the Scotsman who avoided hanging by escaping from an English prison, but in exile became finance minister to a 17th-century regent of France, Philippe d’Orléans. As promoter of the Mississippi bubble (a French scheme contemporaneous with the South Sea bubble and one with a similar outcome), he is somewhat improbably lauded by Chancellor as a precursor of Milton Friedman. William Jennings Bryan tramped the prairies, campaigning for the US presidency with the slogan: “You shall not crucify mankind upon a cross of gold”. Major Douglas, a retired army officer, propagated social credit theories that became the economic policies of some Canadian provincial governments.
So it is no surprise that the 2008 crisis produced new wheezes and much watering of the Magic Money Tree. Proponents of “modern monetary theory” assert that sovereign governments do not have to worry about debt levels because they can always print currency to repay those debts. And advocates of cryptocurrencies believe that the blockchain can displace central banks as the arbiters of the world’s money and allow a decentralised financial system, along with a democratic, libertarian utopia.
An environment in which strength of conviction, rather than empirical evidence, is the principal test of the validity of an economic theory opens the way to the 44-day hegemony of Liz Truss and her economic policies. Chancellor cites a contemporary of John Law who wrote, “He had never seen a man more stubborn than him about his cursed system, and in such a way that it is probable that from the start of its operations he really believed his projects to be infallible.” The description might be widely applied today, and not just to Truss.
Easy money, excess liquidity, boundless self-confidence and an absence of economic theory with policy relevance and empirical support formed the background to the “everything bubble”. Bitcoin was the first cryptocurrency, the creation of the still-pseudonymous Satoshi Nakamoto, and it remains the most widely traded. Trading cryptocurrencies, of course, means buying and selling a speculative asset, not using these “currencies” in place of familiar moneys in the exchange of goods and services. At its peak in 2021, the total market value of the 10,000 or so cryptocurrencies was estimated at $3 trillion. This is slightly more than the value of the world’s most valuable company (Apple) or of all the London Stock Exchange companies.
The crypto boom demonstrated how willing speculators were, in the easy money environment, to trade assets of no fundamental value. That naturally stimulated the supply of assets of no fundamental value. Not just the 10,000 more crypto tokens that followed Bitcoin, but other instruments such as non-fungible tokens (NFTs). In 2021, the digital artist Beeple (the pseudonym of Mike Winkelmann) sold an NFT of a collage at Christie’s for $69m, although the image you can download is effectively identical to the one available to the buyer (himself a crypto millionaire).
The mania extended to more mainstream markets. The Robinhood app offered speculative stock trading from your mobile. Many users of that service also subscribed to r/wallstreetbets, a subforum on Reddit, where traders exchange ideas about “meme stocks”, generating market activity that bears no relation to any events or news about the company. It seems likely that the pandemic, which trapped many relatively affluent young people at home with their social media, further boosted this silliness.
So it continues. Until the music stops. And perhaps in November 2022 it did stop—or at least the musicians took a break. The pace of the party had been decelerating since early 2021, as tech stocks fell from their dizzy heights. Companies such as Apple and Amazon were still great businesses, but their share prices came to reflect slightly more realistic assessments of the returns they could generate. Elizabeth Holmes, once the darling of Silicon Valley with her non-existent blood-testing product, was jailed for fraud. FTX, a crypto exchange whose founder Sam Bankman-Fried was the publicity-conscious face of the cryptocurrency world, filed for bankruptcy. Wearing shorts, the 30-year-old Bankman-Fried had lectured the world from his Bahamas office on his achievements, the markets, regulatory frameworks—and the duty to make money in order to give it away, as per the “effective altruism” expounded by Oxford philosopher William MacAskill. Both Holmes and Bankman-Fried had attracted an A-list of credulous grandees as supporters of or investors in their ventures.
There will be many histories of the everything bubble, and it is too soon to assess what of value will be left when the partygoers have dispersed. But Chancellor’s historical perspective is a reminder that while at first sight every bubble appears distinct—“this time it’s different!”—the explosive mixture of easy money and greed is essentially always the same.