Real Interest Rate Is What Counts

How quickly we forget. Economic policy discussions rage about the trade deficit and the federal budget deficit. But the level of interest rates is rarely, if ever, debated. Instead, interest rates are treated as if they are incontrovertibly handed down from the gods above through their oracles at the Federal Reserve Board. Who would ever dare argue with such authorities?

But monetary policy should and must be debated as a central focus of economic policy. Real interest rates are too high. They should decline significantly--and soon. Our failure to push for lower real interest rates tacitly tolerates some crippling lead weights on U.S. economic performance.

One source of the neglect, of course, is the frequent failure to distinguish between the actual (nominal) level of interest rates and their real levels (adjusted for inflation). What matters for the economy are real interest rates--since the effective value or cost of the money we earn or owe on principal will depend not only on the interest rates we earn or pay but also on the rate at which price increases are inflating the costs of what we want to purchase or reducing the value of the earnings with which we can support debt service payments.

If the actual interest rate is 6%, for example, but inflation is expanding the value of our earnings at an annual rate of 3% a year, then the real cost to us of borrowing money--after taking into account the rising inflationary tide--is only 3%, or the level of the nominal interest rate minus the rate of inflation.

For many, despite the need for this correction, it has appeared as if interest rates are much lower now than they were in the early 1980s because their nominal levels have declined dramatically. The three-month Treasury bill rate hit an annual peak of 14% in 1981, for example, and then declined to only 5.8% in 1987, a drop of more than eight percentage points.

But the decline in real interest rates over that period has been much more modest (because the rate of inflation has declined dramatically as well). After taking into account the rate of inflation, the real three-month Treasury bill rate declined from 4.3% in 1981 to 2.8% in 1987, a drop of only 1.5 percentage points. (For the rest of this discussion, unless otherwise noted, data for “real interest rates” will be for the three-month Treasury bill rate adjusted for an estimate of the expected rate of inflation.)

Even with that decline, moreover, real interest rates remain very high by historical standards. During the period of the long postwar boom from 1948 to 1966, for example, average annual real interest rates were 0.0%; nominal levels and inflation rates, in other words, were equal. During the 1966-73 business cycle, when growth pressures began to generate some friction in credit markets, real interest rates still averaged only 0.8%. During 1973-79, with slackening growth and rising inflation, real interest rates were actually negative, falling to an annual average of minus 0.1%.

After October, 1979, however, real interest rates soared. For the entire recent business cycle from 1979 to 1987, real interest rates have averaged 3.9%. Even after the more recent decline in nominal rates, they are still much higher than at any other time in the postwar period before 1979: In 1986-87, for example, real interest rates averaged 2.5%, three times higher than the highest previous cycle, with its credit-market fiction, in 1966-73.

These persistent high real interest rates weigh heavily on the economy. The steep cost of borrowing tends to stifle corporate investment. The lofty price of household credit--at a time when many households have been forced to borrow to make up for stagnant earnings--slices into consumers’ standards of living at a time when belts are already tight enough.

The rising burden of interest payments results in a regressive transfer of income from borrowers to creditors--from the least to the most affluent. This regressive shift is by no means of trivial proportions: from 1979 to 1987, for example, income from interest payments as a share of total personal income rose by more than a quarter, from 10.9% to 13.8%.

Even when we do pay attention to this interest-rate burden, however, we’re told there’s nothing we can do about such restrictive monetary policy. We need to keep interest rates high in order to attract foreign capital, we’re told, and we desperately need foreign capital in order to make up for the huge burden of federal government borrowing. And so, the pundits continually insist, we can’t do anything about interest rates until and after the federal deficit is reduced.

But there are two counter-arguments to this fatalistic approach.

First of all, even if one accepts the logic of this justification for persisting high real interest rates, our policy understanding should be that interest rates will and must come down at the same time as the federal budget deficit is reduced, not afterwards. If and when the federal budget deficit is reduced, the economy will contract--because the federal government will be pumping in less money than before. Unless interest rates come down at the same time, economic growth will be further dampened and a recession would be very likely.

Calculations included in the recent “Budget Plan & Economic Program” released by the Rev. Jesse Jackson’s campaign for the Democratic presidential nomination illustrate the importance of this concern. If the federal budget deficit were reduced by as much as the Jackson budget plan proposes in 1989 and 1990, for example, it is estimated that a reduction in real interest rates of 1.5 percentage points would be necessary in order to keep the economy growing at the same rate as before; any less reduction and the rate of economic growth would suffer.

Second, our subjection to the caprices of foreign capital is sometimes exaggerated. While we have become more and more dependent on the inflow of money from abroad, it’s not as if we have no leverage over the terms on which capital flows back and forth.

Suppose interest rates in the United States declined, for example. The value of the dollar would decline further. This would substantially reduce the export surpluses of Japan and West Germany, considerably contracting their already sluggish economies. This would create considerable pressure, in turn, on the Japanese and West German central banks to reduce their interest rates in order to facilitate exchange rate readjustments and restore some export boost to their economies.

It’s like a game of chicken. Each government hopes the other will lower interest rates first, while at the same time daring it to try. And so far, over the past two or three years, our central bankers have continually caved in to pressure from central banks abroad rather than throwing some pressure back at them. We have much more leverage and much more room for maneuver, in short, than is often suggested.

But behind all that bluff and bluster, another game has been playing backstage. William Greider writes in “Secrets of the Temple”: “One interest group, almost alone, understood its place in the debate--the bondholders, the commercial bankers, the 400,000 financial professionals of Wall Street and their customers, the investors. They were like an ever-present chorus, scolding the Fed or applauding it, demanding that their interests (in higher interest rates) be served by the government before all others. . . . The gross distortion of influence would endure so long as neither political party had the presence or courage to challenge it.”