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Home Publications Blogs Beat the Press Are Investors Less Confused About Real and Nominal Interest Rates Than They Were 40 Years Ago?

Are Investors Less Confused About Real and Nominal Interest Rates Than They Were 40 Years Ago?

Monday, 07 April 2014 12:38

Brad DeLong picks up on Paul Krugman's column and questions whether the top one percent of the income distribution (or top 0.01 percent) really have much to fear from higher inflation. Brad concludes that they don't, but that they think they do.  He says:

"The top 0.01% were impoverished by the 1970s as a whole. But they have not been enriched by the post 2008 era. What they have gained via a higher capitalization via low safe interest rates has been offset by what they have lost as a result of depressed profits, depressed by a low level of economic activity, a depression which has not been completely offset by downward pressure on wages. The top 0.01% would not be poorer absolutely (although they would be poorer relatively) in a high-pressure higher-inflation economy."

"But they think they would be…"

I'm not sure about Brad's story here. While weak GDP growth has undoubtedly depressed profits, this has been largely offset by a large increase in profit shares. If I were a 0.01 percenter, I would certainly not be confident that a return to something resembling full employment would not depress profits. In other words, a loss in profit share due to higher wage pressures could certainly offset the gains due to increased output. Also, from the standpoint of the rich, why risk it?

The other factor that could carry much weight in the minds of the super-rich is the impact of inflation on the stock market. Brad notes the plunge in stock valuations in the 1970s as one of the items that reduced the wealth of the rich:

"a steep fall in stock market equities even though the value of corporate debt owed falls, as investors become much more pessimistic and value earnings at a much lower multiple–in part because of the productivity growth slowdown, in part because of confusion between nominal and real discount rates, and for other reasons."

It is remarkable that more than three decades later we don't have a widely accepted explanation for the extraordinarily low price to earnings ratios of the 1970s. The view that investors were confused and wrongly discounted earnings using nominal interest rates rather than real interest rates is one common explanation.

However, if this was true in the 1970s do we have good reason to believe that it would not be true today? After all, these are the same folks that could not see an $8 trillion housing bubble in the last decade and a $10 trillion stock bubble in the prior decade. When do we think the big investors stopped being wrong on fundamental economic issues?


Comments (8)Add Comment
written by skeptonomist, April 07, 2014 6:14
Delong says "But [the 0.1%] have not been enriched by the post 2008 era". Yes they have - Krugman's graph of the wealth of the 0.1% shows the trend of the last 35 years continuing, with just a slight break in the recession. Corporate profits likewise have gone on to new record highs, despite lower GDP level and slower growth - how oblivious do you have to be to call current profits "depressed"?


written by djb, April 07, 2014 6:39
Yes percentagewise we are talking about a redistribution of money supply

Rich benefit in many ways.... richer more productive stabler society....more rapid advancement of technology and technique...and if investment goes in right direction s olving problems of pollution global warming..wars etc etc...is we have expansive economic solutions
what is delong talking about?
written by jim, April 07, 2014 7:57
i still am having difficulty making sense of what point delong is attempting to make. equities ALWAYS discount real rates. inflation destroys stock valuations because it eats away at real returns. buffett laid out why inflation was the enemy of stocks in a brilliant 1977 fortune op-ed. we are still in a time of low interest rates/low inflation/and have higher re-investment rates than historical names due to increased margins, which allow for higher ROEs' than the typical 12 pcnt. stocks should go down if inflation picks as there are only 5 ways a company can increase profits
1. grow margins-tough in inflationary environment
2. increase leverage-during inflation lenders are less likely to lend
3. cheaper leverage- inflation increases cost of capital
4. increase turnover- this will increase in inflationary times but is illusory as it will cost firms more to reinvest capital to maintain the same output.
5. decrease taxes- inflation has no effect
further the increase in the REAL(inflation break-evens are anchored) fed funds futures curve since yellens march 19th presser has caused equities with longer duration to re-rate as their valuations hinge on real cost of capital.

when rates are low and inflation is low stocks merit a premium valuation. taken in conduction with the IMF's world outlook regarding low real rates for longer should further cement such a view. if you could produce a 8% at return with 0 inflation it is worth much more than an 8% at return with 8% inflation. these scales tip further towards stocks when considering bond like alternatives yields, near historic lows today.
written by dax, April 08, 2014 6:46
"But they have not been enriched by the post 2008 era. "

So DeLong can't even read the graph in the Krugman post he links to which shows the enrichment by the rich is the worst of any five-year period since the roaring 20s?

Look, price inflation without wage inflation and with low interest rates is good for stocks. It's wage inflation which is bad for stocks, and the 70s was the era of cost-push inflation.
written by skeptonomist, April 08, 2014 8:35
Krugman and it seems nearly everyone else is still getting it badly wrong about wages during the 70's. Real wages came nowhere close to inflation during that time:


There won't be a rational discussion about inflation until the historical facts are recognized.
Use hourly wage and correct deflators
written by Dean, April 08, 2014 4:32

your weekly wage series overstates the drop in wages for two reasons. There was a big decline in hours as many women entered the workforce and took part-time jobs. The other reason is that series uses a flawed CPI. Virtually all economists would used the CPI-U-RS for years after 1978 https://www.google.com/url?q=http://www.bls.gov/cpi/cpiursai1978_2011.pdf&sa=U&ei=22lEU4_gIeGC2QXY14GYCA&ved=0CAcQFjAB&client=internal-uds-cse&usg=AFQjCNHnkJHrcXZ3DWL0ukWDantNWrzGYQ
And the CPI-UX1 for earlier years. Depending on the exact years chosen, these will leave either a small real wage gain or small loss.
Change What?
written by Larry Signor, April 08, 2014 9:48
Why should the plutocrats change, short of government intervention? They are experiencing the best of times; record earnings, record levels of amassed wealthhttp://frominsidethetincan.blo...jared.html and they own the corridors of power. The plutocrats have amassed enough equity to ensure the only way the bubble bursts is if they lose faith in one another. That does not leave us many choices. Some sort of modest, but accelerating, policy adjustments would be the preferred solution.
cap gains taxes also spiked in
written by jim, April 08, 2014 10:55
late 70s which coincided with bottom of p/e

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.