Monday, April 27, 2009

Negative Interest Rates: Yep, Pretty Goofy

Robert Murphy explains here why even a careful thinker like Greg Mankiw shouldn't be left alone to think too long all by himself. John Maynard Keynes warned about that.

The Fed has been giving us negative real interest rates whenever it wants to for a long time. When the rate of inflation is higher than the market rate of interest, the real rate of interest is negative. That's easy to see with a little example.

Suppose you lend me $100 for a year and we both agree that I will pay you 5% interest. At the end of the year, I give you back your original $100 plus $5 interest. Did you really earn 5% interest? Not if the rate of inflation was 10% during the year.

With an average inflation rate of 10%, the purchasing power of $105 is less than the purchasing power of your original $100 a year ago. So, you actually paid me to borrow your money. Thanks.

Have we ever had a 10% rate of inflation in the United States. You bet. From 1974 through 2004, the average annual rate of inflation came in at about 10.5% per year. Did lenders actually earn a negative rate of interest during that time. You bet. Market rates of interest were definitely below 10.5% for a good part of that period. Why would lenders do that? Because they didn't know the Fed was going to jack up inflation; they were fooled.

If you'd like someone to thank, you know who to look to. That's right; our old buddy the Fed. When will Mankiw, Bernanke, Geithner, and all the rest of the really, really smart economists figure out that interest rates are prices and that meddling with prices has consequences?

Some of us dumber economists already know that.

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