The Interesting History of Interest Rates

An Interest Rate (noun) is described by modern dictionaries as the percentage of a sum of money charged for its use.

Interest rates once upon a time…

While the concept and practise of ‘interest rates’ has been around for nearly 4,000 years when Babylon merchants recorded bills and promissory notes on clay tablets, it’s use and function has changed significantly over time.  One such tablet on display at the Louve in Paris illustrates how long it will take a sum of money to double at an interest rate of 20%.

Many financial historians point to the European Renaissance as the beginning of the modern day use of interest rates. Although the Renaissance is known for its many intellectual and artistic pursuits, it was a period of time where capitalism movements created markets and trade to support advancing explorations and economic endeavours. At one point Venice became the leading trading centre to the east and specialised in lending gold against the sale of intellectual ideas from Asian countries.

In 1929, the United States began its descent into the Great Depression and by 1931 many banks were going out of business because depositors were withdrawing their savings in droves fearing the banks would not be able to collect the loans the banks issued with their deposits. The activity significantly decreased the amount of available money in the country. In one of the purest examples of supply and demand; interest rates in the country soared with surviving banks doing anything they could to raise deposits to lend at very high interest levels.

During this time home building in the United States dropped 80%. While the causes of the great depression are still highly debated to this day, one contributing factor was that there was no meaningful legislation protecting depositors from how much of their money the banks lent out.

During her tenure as Prime Minister of the United Kingdom, Margaret Thatcher made a controversial decision to not allow the Bank of England to reduce interest rates to help the economy during some difficult periods during the 1980’s. Many credit the stable growth of the UK during this time to this decision, however there were many other factors such as privatisation and tax increases which directed the economy during her time in office.

How does it work in Australia today?

Today, interest rates are functional elements to nearly every financial instrument and product. You’re paid interest rates on your savings deposits by your banks, you pay interest rates to the bank on your home loan, and the Reserve Bank of Australia meet eleven times a year to determine the overnight cash rate for lending in Australia.

Australian banks and lenders are highly regulated and held to internal standards developed by the Basil Committee on Banking Supervision. The standards have been developed to protect deposit holders by ensuring banks remain within certain leverage levels and that the bank has enough capacity to immediately pay out the deposits to clients. The Australian Government has been known to step in and guarantee deposits Australians had in Authorised Deposit Institutions (ADI’s). In 2008, at the beginning of the financial crisis, the Rudd Government announced it would protect deposits to help ease the worries of Australians when many overseas banks were failing.

For countries like Australia who have floating exchange interest, the RBA cash rate sets the short-term interest rates that businesses lend and are leant money. The amount rates go up or down depends on if the RBA see’s the need to increase or decrease economic indicators such as consumption, imports or the exchange rate.

How do other countries do it? 

In other countries such as Hong Kong, who has pegged their cash rate to the exchange rate to the American currency, they have simply adopted a system which means they are importing their interest rate from America. With no control of its monitory policy Hong Kong has recently seen unprecedented levels of domestic inflation, particularly in real estate. The reason for this is that Hong Kong residents are taking advantage of the historic low interest rates in the United States and and then exchanging that borrowed money into Hong Kong dollars knowing that they can exchange that money back at any time at a fixed price.

Because the American interest rate is set to stimulate the American economy, it is providing an interest that is much too low for the booming Hong Kong economy. This low interest rate has caused a rapid inflation of many sectors of the economy including property. With such a rapid rise of property prices, the Hong Kong government has attempted to control the inflation by adding new laws and taxes to the sales of properties.

For the latest information about interest rates in Australia you can visit the RBA’s website. If you’re interested in the interest rates banks are offering for home loans, your Loan Market broker will be happy to send you some.