Why Negative Real Interest Rates Are Not Optimal

In the past, the Fed has pursued low interest rate policy multiple times.Perhaps you’ve heard the expression time = money?

Although it is likely intended more as an insight into the economic concept of opportunity cost, I believe it also applies to real interest rates.

The “real” interest rate is the rate one gets paid for supplying capital, over and above the rate of inflation.  In other words, the real interest rate + inflation = the nominal interest rate one is theoretically paid for providing capital as opposed to consuming it.

Economics is the study of how to allocate scarce (i.e. not infinite) resources optimally.  “Capital” is meant to encapsulate the totality of those limited resources.

As a brief aside, I believe there is enough capital for all folks to thrive.  Human innovation will continue leading to increased productivity to allow for more efficient usage of capital so humans can continue to prosper for lifetimes to come.

The evolutionary process demands that humans continue to become more efficient with the limited capital resources in order to increase their standard of living.

Incenting capital holders by providing them with a positive real interest rate leads to a movement of capital from holders who will not use it as efficiently in the short-run to individuals who will use it more efficiently.  In return, the former earns the real interest rate, and the latter earns a real return for their labor.

I understand some folks might be frustrated with this issue regarding labor, because they may feel wages do not keep up with inflation, and that is a justifiable frustration, but it is a separate issue requiring a different analysis.

So how does this discussion of the definition of real interest rates coincide with the aside about capital and evolution?

Essentially, a desire for negative real interest rates implies that capital is beyond infinite.  A real interest rate approaches the theoretical limit of zero when capital approaches infinity.

One goal of a society might be to maximize efficiency in order to ensure maximum resources for all and, in doing so, would push the real interest rate for capital holders towards zero.

But, a negative real interest rate is a problem.  It shows a lack of value for capital holders, because it signals to capital holders that their savings are less than worthless.

And so (finally), I get back to the original equation.  Negative real interest rates imply a desire to reverse time.  In addition to that desire being theoretically impossible (at least I think so, perhaps I’ll need to consult with a physicist!), it is not optimal.

Yes, I have discussed before that inflation is not necessarily as low as some may think because consumer price ‘flation should be evaluated differently than asset price ‘flation.  In doing so, I commented that while technology costs may be going down, one can’t eat an iPad.  But that doesn’t mean I want to go back in time to when I didn’t have one…

And periods of low interest rate policy often come with bubbles.

 

Related Reading:

Negative Interest Rates: Deposit Rates and Sovereign Bonds

Negative Nominal Debt Yields: How Low Can Yields Go?

2 thoughts on “Why Negative Real Interest Rates Are Not Optimal

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