§5. Real Interest Varies More Than Money Interest

If perfect foresight existed, continuously rising prices would be associated not with a continuously rising rate of interest but with a continuing high rate of interest, and falling prices would be associated not with a continuously Edition: current; Page: [412] falling rate of interest but with a continuing low rate of interest, and a constant price level would be associated with a constant rate of interest—assuming, in each case, that other influences than price change remained the same.

This perfect theoretical relationship of interest rates to price levels, assuming perfect foresight, is shown in Chart 43, showing high (not rising) interest rates while prices are rising, and low (not falling) interest rates while prices are falling. The real rate would remain constant at, say, 5 per cent under the ideal conditions here assumed.

In this chart, i stands for interest rate and P' for price change, but the upper line indicates the price level. When Edition: current; Page: [413] in the first period the price level rises, the price change (P') is assumed to be at the rate of 5 per cent per annum. In the next period, the price level remains constant so that price change is zero, and so on as indicated. The lower curve shows the theoretical effects on the rate of interest. In the first period, it would be 5 per cent above normal; in the second period, normal; and so on.

One obvious result of such an ideally prompt and perfect adjustment would undoubtedly be that money interest would be far more variable than it really is and that when it was translated into real interest this real interest would be comparatively steady. What we actually find, however, is the reverse—a great unsteadiness in real interest when compared with money interest.

Real interest, however, as shown by the dotted lines on Chart 42, changed in the opposite way to money interest, due to the lack of foresight and adjustment. Attention is called to the period 1852-1857 in London, during which prices rose very fast (that is, money depreciated) simultaneously with, and mainly because of, the great gold production. The market rate of interest averaged 4.7 per cent, which was higher than in any subsequent or in any previous period. Yet during this period of apparently highest interest rates, lenders were receiving, in real interest, less than nothing for their savings. Also in the inflation period 1914-1920, bank rates reached their highest peak, 5.2 per cent, while average market rates, at 4.4 per cent, were but little lower than in 1852-1857. Yet in terms of real commodities those who saved and deposited or invested at the bank rates or market rates of interest were mulcted 9 to 10 per cent for their abstinence and sacrifices. In the following period, 1920-1927, however, the savers and lenders got back more Edition: current; Page: [414] than all they, or their predecessors, lost in the previous period. The tremendous fall in prices in 1920 and 1921 boosted the real interest rate above 15 per cent. Thus the computed real rate is exceedingly erratic during a serious inflation or deflation.

Chart 44 represents in a different way the same theoretical relationship between price change and the rate of interest as that depicted on Chart 43. In Chart 44, price change (P') is represented not by the slope of a line, but by distance measured above or below the zero line. Thus when the price level is rising at the rate of 5 per cent per annum, P' is represented by a horizontal line 5 per cent above zero. When prices are stationary, P' drops to zero, and so on. If men had perfect foresight, they would adjust the money interest rate so as exactly to counterbalance Edition: current; Page: [415] or offset the effect of changes in the price level, thus causing the real interest rate to remain unchanged at the normal rate.

The following table shows that the standard deviation from the mean is far greater for the computed real rate of interest than for the actual rate of interest.

This table shows that the real rate of interest in terms of commodities is from seven to thirteen times as variable as the market rate of interest expressed in terms of money. This means that men are unable or unwilling to adjust at all accurately and promptly the money interest rates to changed price levels. Negative real interest could scarcely occur if contracts were made in a composite commodity standard. The erratic behavior of real interest is evidently a trick played on the money market by the "money illusion" when contracts are made in unstable money. The computed real rate of interest was minus 7.4 per cent in New York in the period 1860-1865 and was still lower during 1915-1920. The rate was nearly minus 100 per cent in Germany during the period of most rapid inflation.

Another symptom of the same imperfection of adjustment Edition: current; Page: [416] is the fact that the adjustment is very slow. When prices begin to rise, money interest is scarcely affected. It requires the cumulative effect of a long rise, or of a marked rise in prices, to produce a definite advance in the interest rate. If there were no "money illusion" and if adjustments of interest were perfect, unhindered by any failure to foresee future changes in the purchasing power of money or by custom or law or any other impediment, we should have found a very different set of facts.