The folks at Gresham’s Law just published a nifty interactive chart of real (i.e., inflation-adjusted) interest rates since the 1960s that explains a lot about today’s world.
Gresham’s Law
To make sense of this, let’s start with a a little background: Interest rates are the rental cost of money, but to figure out the true cost you have to adjust the nominal (or numerical) interest rate for inflation, which is the rate at which the currency being borrowed is falling in value.
If the nominal interest rate is higher than inflation, then the real interest rate is positive. If the real rate is both positive and high, that’s a signal that money is expensive and that one is better off being a lender (to reap those high returns) than a borrower (who has to pay the high true cost of money). The opposite is true for negative real rates, where the nominal cost of money is lower than the rate at which the currency is being depreciated. In this case a borrower actually gets paid to borrow because the true cost of the loan falls as the currency loses value. So negative real rates tell market participants to borrow as much as possible.
Given these incentives one might expect the following:
1) Slightly positive real rates should be the norm in a properly-functioning economy, since that’s the way a healthy market works for most other things, where sellers reap a reasonable real profit and buyers pay a manageable price.
2) Periods of very high real rates should cause borrowing to plummet and economic growth to slow.
3) Periods of sharply negative real rates should produce a burst of borrowing that leads to destabilizing booms, either in hot asset classes or across the board. As Automatic Earth’s Raúl Ilargi Meijer put it this morning:
The simple truth about ultra low interest rates is so simple it’s embarrassing, at least for those who claim they benefit society. That is, ultra low rates make borrowing accessible to the wrong people, and to the right people for the wrong reasons. The former are people who shouldn’t be able to borrow a dime, because they have no credit credibility, the latter borrow only for unproductive or counter-productive reasons.
