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Real Interest Rates and Investment and Borrowing Strategy.

By Peter S. Spiro, New York: Quorum Books, 1989. Pp238, $42.95.

MR. SPIRO'S book addresses a problem in economic theory that has attracted attention mostly in the past decade. Historically, the assumption was normally made that real interest rates were constant. This constant real interest rate was one of Kaldor's "stylized facts" that were drummed into graduate students during the 1960s and 1970s. In the 1980s, however, this assumption became more difficult to sustain. Real interest rates were consistently high, and in spite of discussion about errors in price expectations, the persistence of strongly positive real interest rates was difficult to reconcile with the assumption that real interest rates never changed.

Neoclassical growth theory gives some justification for changing real interest rates. In the original Solow article, the real interest rate is equal in equilibrium to the rate of growth of per capita real GNP, and is a function of the saving rate and the technological production function in the country. Because the saving rate in the country was thought to be determined sociologically, the real rate was more or less constant. As a result of the heavy government borrowing in the early 1980s, however, the national saving rate dropped very sharply.

As Mr. Spiro points out, this neoclassical theory applies only in equilibrium, where the economy never is. The theory cannot adequately explain what happened in financial markets in the early 1980s. In his chapter on the impact of government deficits, Mr. Spiro states that the historical relationship between the deficit and the real interest rate is not significant. I think that he glosses over some of the problems with the historical analysis; in particular, he ignores the fact that there was no large government deficit during the postwar period, when most of these studies were conducted. Only in the 1980s was there a significant and sustained full employment deficit. The absence of any correlation before 1980 may well reflect the lack of evidence rather than the lack of importance.

The author contends that the level of debt rather than its change has an impact on interest rates. From the immediate postwar period through the late 1960s, debt as a share of GNP declined as inflation and real growth reduced the importance of the wartime borrowing. When the Vietnam war began to cause government deficits, however, and especially as heavy full-employment deficits began in the 1980s, there was a stabilization and then an upward move in the debt/GNP ratio that shows up in higher interest rates.

The sections on the relationship between inflation and short-term interest rates are perhaps the most useful in the book. This relationship has often been oversimplified in basic economics texts and courses. There has been an implicit assumption that the economy is price neutral. Inflation has often been treated as a neutral factor for real interest rates. Given tax considerations and possibilities of capital gains, however, it is clear that inflation is not necessarily neutral for real interest rates, and may in fact tend to lower them.

The impact on bond yields is perhaps the opposite. In periods of high inflation, the yield curve tends to steepen. This tendency helps create the apparent paradox that bond yields, which should be a long-term interest rate expectation, often respond more rapidly than short-term interest rates to changes in economic policy.

The descriptions of the historical behavior of the yield curve are quite interesting. The yield curve was positively sloped for most of the period since the mid-1920s, but not before. What caused this difference between the pre-World War I and postWorld War I behavior is not entirely clear. The author makes a strong argument, however, that it was predominantly caused by changes in inflationary expectations, themselves caused by the abandonment of the gold standard. This argument is somewhat unconvincing, or at least oversimplified. There were many changes in institutional structure during this period, as well as major changes in the way that the government ran its finances. I think that the general absence of new government debt before World War I makes analysis very tricky.

The discussion of international interest differentials is perhaps the weakest chapter of the book. The openness of the financial markets has been a major shift during the 1980s, and I am not sure that confining the discussion of interest rate differentials to near the end of the book adequately satisfies the needs of modern analysis. A fuller development of foreign exchange determination is needed for the analysis to be really useful.

The analysis of the impact of interest rate change on stock prices - another subsidiary issue - is more successful. This chapter is, however, irrelevant to the essential theme of the book, and, although interesting, does not affect the analysis of real interest rates.

The section on forecasting bond yields was most interesting. I generally agree with his conclusion that economists are more successful in forecasting the long-term movement in interest rates than the short term. In the short run, interest rates are strongly affected by policy shifts, by market expectations and international developments. In the longer run, more fundamental factors tend to dominate. Put another way, economists know much more about long-term equilibrium than they do about the behavior of the economy in disequilibrium. Spiro's conclusion that the short-term forecasts are generally inferior to a naive forecast may be a little too pessimistic, and is heavily influenced by large errors made by economists during the early 1980s. I think forecasters have improved since then.

Overall, the book is an excellent addition to the business economist's bookshelf. The analysis of real, as opposed to nominal, interest rates has been neglected for too long. However, a more complete analysis of interest rates in an open economy still needs to be written.

David Wyss DRI/McGraw-Hill
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Author:Wyss, David
Publication:Business Economics
Article Type:Book Review
Date:Oct 1, 1990
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