Every rate this volume has named has been a nominal rate — a figure in money, "five per cent," "ten." But money's own value will not hold still; inflation gnaws it; and so the rate one is quoted is not the rate one truly earns. This plate takes up the distinction, which is Fisher's, between the nominal rate and the real rate — between the number on the loan and the purchasing power it actually returns, once the shrinking of money is reckoned in. It will show that the real rate, not the nominal, is the rate that matters, for one cares what one's money will buy, not how many dollars it counts; that the nominal rate is the real rate plus the inflation the lender expects, by which lenders defend themselves against the erosion to come; that a pervasive money illusion leads people to mistake the one for the other, and so to be fooled by inflation into thinking themselves rewarded when they are merely repaid; and that the volume's question, carried behind the quoted number to the real return it conceals, finds the earned reward in the real rate, and the extraction in the inflation — above all the unexpected inflation — that silently makes the quoted number a lie.
Begin with the distinction. A man lends a hundred dollars for a year at five per cent, and is repaid a hundred and five. Has he gained five per cent? Only if a dollar buys, at the year's end, what it bought at its beginning. But suppose that over the year prices have risen three per cent — that the basket of goods which cost a hundred dollars now costs a hundred and three. Then the hundred and five he is repaid will buy only what a hundred and two would have bought a year before: his true gain, in the only terms that matter, the terms of what money will purchase, is not five per cent but barely two. The five per cent is the nominal rate, the rate in money, the number on the contract. The two per cent is the real rate, the rate in purchasing power, the rate he has truly earned. And it is the real rate, not the nominal, that he ought to care for, since no one consumes dollars; one consumes the bread and the shelter and the leisure that dollars command, and it is the command over those, not the count of the coins, that measures whether the waiting has been rewarded. The nominal rate is what is quoted; the real rate is what is earned; and inflation is the wedge between them.
The relation between the two was set down by Irving Fisher, and bears his name. To a first approximation the real rate is simply the nominal rate less the rate of inflation — the gain in money, minus the loss in money's value, leaving the gain in purchasing power. But Fisher saw the deeper point, which runs the other way. Lenders are not fools; they know that inflation will erode their return, and they defend themselves by demanding a higher nominal rate to make good the loss. So the nominal rate one is quoted is built of two parts: the real rate the lender means to earn, and the inflation he expects, added on to keep himself whole. The nominal rate equals the real rate plus expected inflation — the Fisher equation, read as the lender reads it. And from this follows the Fisher effect: that when expected inflation rises, nominal rates rise with it, more or less one for one, as lenders build the higher anticipated erosion into the price they charge. A country with high interest rates may reward waiting no better than a country with low ones; its nominal rate is merely padded, dollar for dollar, with the inflation that everyone there foresees. The quoted rate already contains a forecast of the inflation to come; and to find the real rate beneath it, one must subtract not the inflation that arrived but the inflation that was expected when the rate was struck.
A country with high interest rates may reward waiting no better than a country with low ones; its nominal rate is merely padded, dollar for dollar, with the inflation everyone foresees.
Yet most people, most of the time, do not make the subtraction. They think in money, not in purchasing power; they feel the nominal number and forget the shrinking of its worth; they suffer, in Fisher's phrase, from money illusion. The worker rejoices at a five per cent rise in his wages though prices have risen six, and feels poorer only obscurely, without knowing why; the saver is pleased by the interest his account pays though inflation devours it whole, and believes himself rewarded when he is merely, and incompletely, repaid. Fisher thought money illusion so important and so pervasive that he gave it a book of its own, and the behavioural economists who came after have confirmed him many times over: the mind clings to the nominal, the face value, the number stamped on the coin, and reckons the erosion of its worth only with effort and reluctance. And money illusion is no harmless quirk, for it is precisely what allows inflation to do its work unseen. A people who reckoned always in real terms could not be fooled by inflation; they would watch their real wealth shrink and demand redress. It is because they reckon in nominal terms — because the illusion holds — that inflation can quietly carry their wealth away while they feel, if anything, the richer for the larger numbers in their accounts. The illusion is the inflation's accomplice.
And now a subtlety that turns the real rate from a simple correction into a genuine uncertainty. The real rate, it emerges, cannot be known when the loan is made. For to find it one must subtract inflation from the nominal rate — but which inflation? The inflation over the loan's life, which has not yet happened, and cannot be known, only guessed. When a man lends at five per cent for ten years, he does not know the real rate he will earn, because he does not know what inflation will average over the decade to come. He knows only his expected real rate — five per cent, less the inflation he forecasts. The real rate he actually earns will be known only at the end, when the realized inflation is in; and if inflation runs higher than he expected, his realized real rate will fall below what he bargained for, and if lower, rise above it. So the lender at a fixed nominal rate bears a hazard the borrower's promise cannot remove: inflation risk, the risk that the money he is repaid in will be worth less than he counted on. This is why the long bond, as the last plate said, carries a premium partly for inflation; why lenders dread inflation above almost all things; and why, in the end, a kind of bond was invented to abolish the risk — the inflation-protected bond, whose payments climb with prices, and which therefore promises a real rate directly, with no guess about inflation required. The gap between the ordinary bond's yield and the protected bond's reveals, as a kind of bonus, the very inflation the market expects: the quoted forecast made visible at last.
Here the volume's question, and the redistribution the natural-rate plate described, return in their sharpest individual form. For the gap between expected and realized inflation is a transfer between lender and borrower, struck at the level of the single loan. When inflation runs higher than was expected, the lender is repaid in money worth less than he and the borrower had reckoned: his realized real rate sinks below the bargain, and the difference passes to the borrower, who discharges his debt in cheaper coin. Unexpected inflation is thus a silent transfer from creditor to debtor — and, since the greatest debtor of all is the state, a silent tax laid by the government upon all who hold its bonds and its money, the famous inflation tax, collected without a vote and paid without a bill. Unexpected deflation runs the transfer the other way, and crueller: it swells the real value of every debt, and the realized real rate leaps above the bargain, enriching the creditor and breaking the debtor. But — and the scruple must be exact here — only the unexpected part transfers. Inflation that is foreseen is built into the nominal rate by the Fisher effect; the lender, having demanded compensation for it, is made whole, and no injustice is done, for the transfer was anticipated and priced. It is the inflation that is sprung, the inflation no one saw coming, that works the silent redistribution — for it alone was never compensated in the rate. The justice of the price of time turns, then, not on whether there is inflation but on whether the inflation was foreseen.
It is not inflation that works the silent transfer, but inflation that is sprung — the rise no one saw coming, and so no one was paid to bear.
What, then, does the real rate say to the volume's question — earned, or extracted? It says, first and most clearly, where to look: that the earned reward of waiting is the real rate, not the nominal. The nominal rate is a compound thing, part genuine reward and part mere compensation for the shrinking of money; and to ask whether interest is earned is to ask of the real rate alone, the part that is a true gain in command over goods. The real rate, where it is positive, is the honest wage of waiting — the increase in what the lender can buy, purchased by his patience; and it is as earned as the foundational plates allowed any interest to be, the clean reward of deferral and productiveness, with the veil of money lifted away. The extraction enters with inflation — but, the scruple again, only with the inflation that is unforeseen. Foreseen inflation is no theft; it is named in the nominal rate and compensated. Unforeseen inflation is the silent transfer, the tax no one votes, the erosion the money-illusioned saver does not even feel; and unforeseen deflation is its mirror, the windfall to the creditor wrung from the broken debtor. So the real rate completes the volume's account of the price of time with a last clarification: that the thing to be judged earned or extracted is the real return, not the nominal; that a positive real rate is the genuine wage of waiting; that expected inflation is a neutral compensation, neither earning nor extracting; and that the extraction proper is the work of inflation sprung by surprise — and of the money illusion that lets it pass unseen.
So the price of time, having been given its level and its shape, is here given its truth — the real rate behind the nominal, the purchasing power behind the count of coins. Every figure the volume has spoken, "the rate," "the curve," "the natural rate," must now be read twice over: once as it is quoted, in money, and once as it is earned, in goods, with inflation the wedge between. The earned reward is the real rate; the nominal rate is that reward plus a compensation for the erosion the lender foresees; and money illusion is the standing temptation to mistake the larger nominal number for the smaller real gain. Where inflation is foreseen, the nominal rate absorbs it and no wrong is done; where it is sprung, it works a silent transfer between debtor and creditor that no one voted and the illusion hides. The volume's question, behind the quoted number, comes to rest upon a simple discipline: judge the real rate, not the nominal, and ask of any inflation whether it was foreseen. What the long moral history made of the price of time — the ancient charge that all interest, real or nominal, was sin — the next plate must take up; and through it, as the table says of every price, the argument remains open.