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It's easy to throw around numbers and statistics, but they are sometimes misleading if not downright wrong. Most economic numbers reported are adjusted for inflation. For example, when we hear that the Gross Domestic Product rose by 3%, that number is a real figure. If nominal GDP is 6% and the inflation rate is 3%, then the real GDP is 3% and it is reported that way. In all things economic and monetary, a real number is the nominal number less the inflation rate.
Many numbers are not adjusted for inflation. For example, the price of gold got a lot of publicity because it broke its all time high of eight hundred and fifty dollars. It got further publicity when it broke through a thousand. If you just look at the nominal numbers you might conclude that inflation is roaring out of control and that the economy is in serious trouble. But in real terms, once you discount for inflation over the years, gold is half of what it was in 1980. For the price of gold to represent the same degree of inflation and anxiety of 1980 when the dollar was nose diving, inflation and interest rates were soaring, and the economy falling off a cliff, gold would have to be over 2000 dollars an ounce. Conclusion: the price of gold is signaling a trend of increased inflation and anxiety but not near that of 1980.
The dollar is not adjusted for inflation. Most people think that a dollar is a dollar. But the fact is that the dollar is worth about 3 cents in real terms compared to the dollar 100 years ago. If inflation is running at around 4%, prices will more than double every 20 years. A twenty dollar gold piece bought approximately the same amount of goods and services at the end of the 19th century as it did at the beginning. Under the fiat standard the dollar has been devalued to almost zero through the theft of inflation. That is why many advocate returning to a gold standard over the present fiat standard. One monetary system provides real money, the other provides a fiction.
Interest rates are not calculated in real terms. Most people take as a given that a 1% interest rate is low and an 8% interest rate is high. The numbers are meaningless in nominal terms. You have to ask "relative to what"? During the Great Depression we had 1% interest rates for a decade. But when you have a 4 to 10% deflation rate, 1% is very expensive. In the 70's we had 8% interest rates. But we also had a 12% inflation rate which makes the real rate of interest negative, and a bargain at that. It is a paradox that one percent is more expensive than eight percent when you view these figures in real terms.
Negative interest rates encourage inflation, mal-investment, over-consumption, and the mis-allocation of resources. Positive interest rates are penalty rates. They discourage these conditions. It is taken as a given that Alan Greenspan drove interest rates too low when he set the fed funds rate at 1%. 1% sounds artificially low because the nominal number is almost zero. But when you look at the inflation rate of that time you will find that we were running a deflation rate of over 2% at times. So, in real terms the real interest rate was as high as 3%. 3% is normal.
To apply this lesson to current events, consider what the real rate of interest was when the fed funds was at 5.25% one year ago, and the inflation rate was at 2%. Compare that with today's fed funds rate of 2% and an inflation rate of 4%. The fed funds rate has dropped from a positive 2.75% to a negative 2% in a very short time period. Negative interest rates for a prolonged period of time are almost always associated with inflation.
Understanding the value of things in real terms exposes the illusion of nominal numbers.
The next time you hear on the nightly news that gold hit a record high, or that interest rates are too low, or too high, think of them in real terms and you'll be about two steps ahead of the experts that seemed to have forgotten this lesson. Then, make your investment decisions or draw your economic conclusions accordingly. This simple lesson will allow you to avoid mistakes and understand the real nature of economics, the real value of money, and the real world around you.
Paul Nathan
August 2008
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Paul Nathan is a free lance writer who specializes in the field of economics.
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