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ECB Interest Rates and the PIIGS.

In Investment Returns on April 11, 2011 by CQCA

If I deposit €100 in the bank for one year, and then receive €105 at the end of that year, the nominal interest rate is 5%. However, if the value of those Euros decrease by 6% over that same period, that €105 at the end of the year is not worth the original €100 at the beginning of the year. Even though the nominal interest rate is 5%, the real interest rate, which equals the nominal interest rate minus the inflation rate, is -1%.

Ludwig von Mises wrote:

“The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved. (Human Action, 4th revised edition, Fox & Wilkes, San Francisco, p. 572.)”

This seems to have been the case in the Eurozone. Since 2002, the Eurozone’s real interest rate has been zero for most years. However, the PIIGS’s real inflation rate has been consistently lower that the Eurozone until 2007, when a larger correction happened in the PIIGS than in the Eurozone as a whole. The data supports Professor von Mises’ conclusion that sustained artificially low interest rates will cause booms to occur, followed by busts. In Europe’s case, the lower interest rate countries saw a larger bust.

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