The price of money has been falling for 700 years: True or False?

A study unveiled by Paul Schmelzing, carried out for the Bank of England, suggests that one asset has been on a steady downward trend for 700 years. That asset is the price of money, in other words, real interest rates. A journey into the past.

As a preamble, let's make a distinction. Nominal interest rates, those we see when we borrow or lend money, have recently risen sharply. However, once inflation is subtracted, real interest rates remain negative.

7 centuries of data compiled

Schmelzing's study, which covers the years 1311 to 2018, required a colossal amount of research work to gather data over 7 centuries, from a wide variety of sources. The researcher has compiled evidence of loans from individuals, countries, cities and statesmen: for example, there is evidence of a loan from the Dutchman Van Halen to King Edward III of England at 35% per annum in 1340, or loans from the Rothschild family to the Pope in 1832 at a rate of 6%. He notes a clear downward trend in real interest rates over this period: from 1 to 2 basis points per annum, i.e. between 0.01 and 0.02% per annum (although sometimes, over long periods, rates break away from this trend).

Schmelzing therefore suggests that today's near-zero or negative real interest rates are not an anomaly. In fact, they are in line with what we would expect if we followed the trend observed over the last 700 years.

The McNamara effect and risk mitigation

Other research has attempted to find reasons for this steady decline in interest rates. Several hypotheses were tested, such as economic growth, demographics or the arrival of central banks. However, no significant reason was found to categorically explain the trend. The study seems to have fallen victim to the McNamara effect, which consists in using certain indicators because they are readily available.

In reality, improvements in economic conditions, transportation, regulation and money storage conditions could explain much of the fall in interest rates. Let's take an example: lending to the King of England in the 14th century already meant lending "physical" gold, transporting it by ship and then by carriage (an already costly undertaking!), and therefore running the risk of theft or shipwreck. It also meant risking non-repayment, in the absence of international regulations, in the event of armed conflict, state bankruptcy, loss of territory or change of sovereign.

The introduction of strong national and international laws and banking institutions, the dematerialization of currencies, and improvements in transport and economic conditions have all contributed to mitigating risk and, consequently, to lowering interest rates. Finally, in the EU, the changeover to the euro has also facilitated cross-border capital flows.