Negative Real Interest Rates

Let me begin with a brief warning to my readers.  I woke up in the middle of the night coughing my head off and it took quite a while to get that calmed down.  So I am sleep deprived and crabby as a result, the perfect time to write about the dismal science.

I was taught in grad school that the real interest rate was determined by the difference between the nominal interest rate and the rate of inflation.  So, for example, on my current mortgage, which has a fixed rate of 3.125%, if the inflation rate is now 1.6% then the real rate 1.525%.  So the folks lending me the funds are getting a positive return, though not a very big one.  In contrast, on my so-called interest bearing checking account, where the nominal rate is something like .0025%  (I made that figure up but I saw the real figure in the fall and this is the right order of magnitude), the real rate is negative.  Put a different way, the typical term structure curve has interest rates increasing with the term.  Nowadays, short rates are negative while long rates are still positive.

I needed to get that textbook stuff out of the way first, so I can talk about what this post is really about.  A different way to reckon the real interest rate is that it should move directly with the growth rate of the economy.  I want to argue that in a sensible way of thinking about things, the economy is shrinking.  Published statistics about GDP growth say it has been growing, albeit slowly.  Again you have to net out the inflation rate, and if you do that, then the growth has been minimal, but the published statistics wouldn't support a hypothesis of shrinkage, in and of themselves. 

To get to where I'm headed we need to talk about imputations.  Back in grad school, we talked about imputations mainly due to non-market activity that was productive but not counted in GDP. This was primarily child care and housework, but really any non-market work fits here.  There are also capital gains and losses on non-market traded assets, such as public roads, public infrastructure, and public lands.  I'll get back to this one in a bit. 

At the time we didn't talk about imputations for market transactions for security, or maintenance of private capital, or the investment of public capital that itself doesn't produce economic benefits, each of which arises because the society is getting less healthy.  Before I get to examples, the argument is that if these expenditures grow no faster than the economy overall then it is no big deal, but if they grow faster than GDP, then the rest of GDP, which is what provides a benefit, is growing slower than the measured statistics indicate. 

Now for the examples.  On the security front, consider that most every college campus around the country now has an early warning security system, the purchase of which was triggered by the horrible shooting at Virgina Tech some years ago.  There may have been other reasons to get such a system which is productive, accidents do happen and warning people when there are accidents that create a public hazard is a productive thing to do.  But these systems were not procured for that reason.  They were obtained to reduce the consequence if and when gun violence hits a campus.  They make sense as a purchase if there is a rational perception that gun violence is possible and/or that it is on the rise.  Gun violence is clearly a big negative.   Economic activity aimed at reducing its consequence, while rational, clearly doesn't make us any better off as compared to the case where there is no gun violence to begin with.  In this sense, the possibility of gun violence is an economic shrinking factor. 

The next example, regarding the maintenance of private capital, has to do with my current fixation - potholes.  It doesn't take a genius to forecast that there will be many more wheel alignments performed this spring as cars are brought in for regular maintenance and the car service guys inform the car owners that their vehicles would benefit from wheel alignment work as well.  From a GDP measurement point of view, this additional service work for wheel alignment will boost measured GDP, but of course there is no increase in welfare as compared to the case where the roads are in decent repair so no wheel alignment work is necessary.  Potholes are in this sense an economic shrinking factor.  But now there is a second effect - the roads themselves are capital assets, held by the public, and there has been a substantial capital loss.  That adds to the shrinking. 

Let me get to the last example.  I had originally thought about border security investments to deter illegal immigration, but that one is politically charged, so I thought I'd make the point on something far less polarizing - public investments to prevent flood control, such as the new levee system in New Orleans, and whatever public investments emerge in the NYC-New Jersey shore area in the wake of Hurricane Sandy, to lessen the impact of flooding from future storms.  The perceived greater likelihood of future storms is a shrinking factor. 

If you are a Keynesian, as I am, you might argue that in our current macro economy where aggregate demand remains weak, what I've referred to here as shrinking factors actual serve as fiscal stimulus, because they do generate current economic activity.  To me the issue of stimulus or shrinking factor gets resolved by understanding how they are financed.  If they are financed by current savers, who continue to spend as before but save less as a consequence, the fiscal stimulus argument would be right.  If they are financed by those who save little, then they crowd out other spending on consumption, ergo shrinking. 

I leave it to the reader to figure out which of these makes the most sense as interpretation.  My opinion is that the average Joe is being made worse off.