I have to admit that I derive some pleasure in taking on hoary old myths. For example, some economists assert that the interest rate you see on the Treasury bond is not real. You see, it’s only nominal. To calculate the real rate, they say you must adjust the nominal rate by inflation.
Real Interest Rate = Nominal Interest – Inflation
It seems to make sense. Suppose you have enough cash to feed your family for 2,000 days. Then the general price level increases by 15%. You still have the same dollars, but now you can only buy groceries for 1,700 days. You’ve been robbed, some of your purchasing power stolen. Therefore you want to earn enough interest to overcome this loss.
This view is flawed.
Normally, you don’t spend your savings, only the income on it. In ancient times, people had to hoard a commodity like salt when they worked. In retirement, they sold it to buy food. Modern economies evolved beyond that, with the development of interest. Retirees should not have to liquidate their life savings.
Now, let’s examine this idea of correcting the interest rate using the Consumer Price Index, or CPI. We’ll skip over the problems in trying to measure prices, and avoid the controversy over whether CPI does a good job. We’ll just compare two retirees from two different eras.
Clarence was retired way back in 1979. Suppose he had $100,000 saved up. According to the St. Louis Fed, the CPI was 68.5 on January 1, 1979 and it rose to 78.0 one year later. This means prices rose by about 14%—what most people call inflation. Also according to the St. Louis Fed, a 3-month certificate of deposit offered 11.23%. There are many interest rates, but let’s use this one for simplicity.
The popular view focuses on his lost purchasing power. He begins the year with $100,000. That amount could buy some meat and potatoes. Clarence ends the year with $111,230 in principal + interest. Liquidating that larger amount buys less hamburger and fewer fries at the higher prices at the end of the year. Therefore Clarence had a loss, and the loss is interest – CPI, or 2.77% of $100,000, which $2,770.
I suggest another view. The interest afforded Clarence $11,230 worth of food. According to the U.S. Census Bureau, the median income in 1979 was $16,841. Clarence made 2/3 of his former income. That’s about right for a retiree without a mortgage or commuting expenses. He could eat pretty well. Although the falling dollar did erode his wealth, we’re focusing on how Clarence experiences interest in the real world.
Now, consider Larry, a recent retiree. Larry has $1,000,000 in savings. CPI actually fell over the past year. Interest on a 3-month CD is negligible—0.03%. Again, we’re not focused on whether CPI is accurate. Just grant for the sake of argument, that some prices dropped and this was matched by a rise in others.
In the standard view Larry appears to be better off than ol’ Clarence. Larry lost no purchasing power, unlike Clarence’s loss of almost 3%. This is deceptive and misleading.
The stark reality is that Larry earns a scant $300 in interest. He can’t afford groceries on this paltry sum, so he is spending down his savings. The median income was $52,250 in 2013 (the latest year available). To earn 2/3 of that—and match Clarence—poor Larry would need over $116 million.
The notion of nominal interest paints a misleading picture of Clarence losing purchasing power and Larry keeping even. If you look at what they can buy with the interest on their savings—Yield purchasing power—you see that Clarence was living well while Larry is quickly spending down his life’s savings.
This article is from Keith Weiner’s weekly column, called The Gold Standard, at the Swiss National Bank and Swiss Franc Blog SNBCHF.com.
This is basically the same argument that I have been putting out for years.
But I go further and use a simpler example.
Here is an extract from my new Home Page at http://macro-economic-design.blogspot.com
ALL IN HARMONY
Without going into too much detail at this stage, as NAE [National Average Earnings] rises, so all prices should tend to rise including investments, company turnover, costs, profits, dividends, share prices, rentals etc. To keep a sustainable balance (something which has never been achieved but which nations strive to achieve by manipulation of interest rates), interest should add to savings and loans at a rate which keeps that balance. They should add 1% to the money value of accounts for every 1% rise in NAE. It is not possible to make National Average Earnings (NAE) rise at a constant Average Earnings Growth, (AEG% p.a.), Rate – [the rate at which NAE rises]. Therefore, in a sustainable and well balanced economy, the AEG% p.a. rate should be a guide as to how interest rates should change; and, given freedom to do so, that will happen. [But that freedom is denied as the website explains]. If all prices, costs, and values can be free to adjust, spending patterns will not change. Employment patterns will remain the same.
Edward Ingram likes to give this example: Imagine this: a fund valued at 20 National Average Earnings, 20 NAE, (around half a life-time’s earnings for an average person), was invested by your grandpa to keep pace with a prices index. A century later, when you were expecting to inherit this fortune, and to be able to spend half a lifetime spending it all, you are told that it might be worth just one year’s National Average Earnings, 1 NAE. That is a 95% loss of NAE over the century. You are shocked. It will be worth, not a half life-time’s earnings as intended, (the original 20 NAE), but closer to 1 NAE – just a single year’s average earnings. Other people got the main benefit, not you.
That is because it is usual for earnings to rise faster than prices. Here, the difference in the rate of increase between rising earnings and rising prices was assumed to have averaged 3% p.a. for 100 years. That is, about 3% p.a. real economic growth, which broadly, is accepted to mean the difference between the rate of average earnings growth (AEG% p.a.), and the rate of prices growth, (inflation). As earnings rise faster than prices we all, savers included, should become better off.
CONCLUSION
AEG% p.a. is the growth rate (or interest rate) needed by a pension fund in order to offer a pension which reflects the amount of NAE paid into the fund. If a total of 6 NAE is paid in during the course of say, 30 years, then there needs to be around 6 NAE in the fund at the end of the 30 year contract – when the fund is needed to provide a pension. So the fund must earn AEG% p.a. just in order to preserve those NAE. Any more NAE earned is a profit. Any less is a loss. AEG% p.a. is a neutral rate of interest.
Here is a table showing how much a small variation in the marginal interest rate relative to AEG% p.a. can affect the cost of borrowing and the return on lending.
To read more go to the website. There is a lot to learn.