Christopher Ruddy
Wednesday, Aug. 8, 2001

The package is a hefty compilation of his columns from Newsday, news clippings about Koch himself or correspondence he has had with luminaries. He shares this material with a select group, and I am honored to be on the list.

His correspondences can be fascinating. Koch, out office for more than a decade, continues to be, as he puts it, "relevant."

He remains relevant by remaining engaged. His correspondence shows it, with letters (and responses!) from everyone from Yasser Arafat to the president.

I was wading through a recent set of correspondence when my eyes fell upon an interesting letter by Koch to Alan Greenspan, the Federal Reserve chairman, and Milton Friedman, the Nobel Laureate economist.

Koch had written to Greenspan after being prompted by a caller to his radio talk show on New York's WEVD.

The caller was angered that with all the positive press about interest rate cuts, no one ever talks about the downside to interest rate cuts.

As Koch wrote to Greenspan, "Although interest rates and market fluctuations are constantly discussed, no one ever mentions the negative impact that falling interest rates have on people living on fixed incomes."

So far this year, the Federal Reserve has cut interest rates by almost 3 points. But that has also yielded a devastating loss of income for people who rely on their interest income from a CD, Treasury bill or other interest-paying security.

Koch asked Greenspan if the Fed or the U.S. government considers the impact of these cuts on people on fixed incomes.

In his response, Greenspan wrote to Koch that this was an "important point to the effect that the impact of monetary policy on different households will depend on the composition of their individual households."

Greenspan went on to admit that households invested in bank deposits and the like "will be relatively disadvantaged" compared to households in long-term assets.

Greenspan went on to stress the benefits of interest rate cuts. He concluded by saying, "While it has long been recognized that monetary policy affects every family differently, for the economy as a whole, there is little question that reducing interest rates stimulates activity, while raising interest rates depresses activity."

Then Greenspan covered himself: "This has certainly been the case throughout the modern financial history of the United States, and in the history of a wide-range of foreign countries as well."

Greenspan is well aware that sharp interest rate cuts in Japan during the past 10 years have done little to stimulate the Japanese economy.

Milton Friedman's response was brilliant. He essentially told Koch that people need to forget about interest rates and focus on "the real interest rate" – which is not the quoted Fed Funds rate.

What is the real interest rate?

Friedman says the real rate is "the nominal interest rate minus the rate of price rise." In other words, if the interest rate is 5 percent and inflation is 5 percent a year, then the real interest rate is zero.

The wealth of households is determined by this real interest rate. If inflation is at 5 percent and the bank pays 2 percent on a CD, the CD owner is losing capital at the rate of 3 percent a year in real dollars.

So, here are some points I would raise based on the observations of Greenspan and Friedman, and the current economic situation:

1. If interest rates have been cut to the point that fixed income portfolio and bank deposits pay just 2 percent to 3 percent – while inflation officially hovers at the same rate – then such investors are making nothing, or perhaps even diminishing their real wealth.

2. During much of the '90s, interest rates held between 4 percent and 6 percent, meaning banks paid depositors a relatively high real rate of interest. Meanwhile, inflation was said to have been about 2 percent to 3 percent. This would mean that real wealth increased during the '90s by several percentage points.

3. I believe, however, that there is evidence inflation was actually higher than reported during the '90s. I have written about this before. If that was the case, then many fixed-income investors didn't really gain much during the '90s. Since most capital was parked in equity markets, most people didn't feel the negative effects of this flat or negative real interest rate.

4. But that has changed now. Equities are an orphan. People are moving back to fixed-income securities. As the Fed cuts rates, and still claims that inflation is very low, the stated real interest rate is clearly moving at about zero, or worse.

5. If the government continues, as I believe, to give faulty inflation numbers, the real interest rate could be even worse, and investors are losing significant capital by keeping their money in fixed-income securities or banks.

6. If Greenspan is wrong, and interest rate cuts don't stimulate the economy, I suspect that the economic downturn could be severe. Here's why. Money will continue to pour into fixed-income securities and banks as the equity markets continue to perform poorly. But there won't be much relief for investors. At best, investors may keep their wealth constant. More likely, real wealth will be lost.

The main problem with the U.S. economy is high consumer debt, which has increased threefold since 1992. High debt is crimping disposable income, which allows for discretionary spending, which increases economic activity.

If households are increasingly investing in fixed securities where the real interest rate return is zero or even a minus, households will be less likely to spend and they will have difficulty paying off their debts.

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