Robert Samuelson's Confusion on Real Interest Rates

November 15, 2010

Robert Samuelson is beating up on Japan in his column today. While its economy has certainly had troubles in the last two decades, the picture is not quite as bleak as he seems to believe. Its rate of productivity growth (the most important measure of economic dynamism) since 1995 has been almost identical to the average for the OECD and within 0.2 percentage points of the rate in the United States. Furthermore, since depreciation is a large and growing share of U.S. output (primarily because computers become obsolete quickly) it is likely that a net measure of output would show Japan and the United States having virtually the same productivity growth over this period. Net productivity is the measure that is relevant for living standards, since you can’t eat depreciation.

It is also worth noting that Japan’s unemployment rate is just 5.0 percent. It never rose above 6.0 percent over the last two decades.

However Samuelson’s biggest error is that he fails to understand the problem that deflation, or more correctly low inflation, poses for Japan’s economy. While he rightly ridicules the idea that consumers would delay purchases to buy items of like cars to buy them at a price that is 0.5 percent lower the following year, this is not the main way that low inflation harms the economy. 

In an economy operating below capacity, it would be desirably to have very low real interest rates to boost investment. This means that the cost of borrowing is low relative to the return on investment. Because interest rates can’t go negative, it is impossible for real interest rates to fall as much as would be desired given the weakness of Japan’s economy. It would be ideal if it could keep its nominal rates at their current near zero level, while inflation rose to 3.0 or 4.0 percent.

The other reason why inflation would be desirable is that it would allow homeowners to get out from under their debt burdens. If wages rose 3.0-4.0 percent annually in step with inflation, the burden of a fixed mortgage debt would be eroded through time. Also, if house prices rose in step with inflation, consumers would gain equity in their homes.

However, the problem in both of these cases is that the rate of inflation is too low. The fact that it crosses zero and is negative is of no special importance. The problem is low inflation, not deflation.

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