(FORTUNE Magazine) – Rarely have economists been so unanimous, and so wrong. Nearly all of them -- Keynesians, monetarists, supply-siders -- agree that inflation-adjusted interest rates in the U.S. have been unusually high for the past five years or ! so. Some, including Martin Feldstein, president of the National Bureau of Economic Research and former chairman of the Council of Economic Advisers, attribute high real rates (nominal interest rates minus expected inflation) to the federal budget deficit. Some blame excessively tight monetary policy by the Federal Reserve. And a few, including Robert Genetski, chief economist of the Harris Bank in Chicago, blame high tax rates (Other Voices, December 10). But practically all economists, and politicians as well, believe real rates are high. A couple of years ago the perception of high real interest rates was central to one of the worst forecasting bloopers of all time: the ''anemic'' recovery from the 1981-82 recession. Now high rates are said to threaten the economic expansion and they are cited as a principal cause of the strong dollar. European leaders complain that high interest rates in the U.S. are forcing their interest rates up, drawing needed capital out of their countries, and preventing their economies from pulling out of a protracted slump. However, strong evidence suggests that real interest rates are not high, and have in fact been surprisingly low and stable -- around 3% -- for the past few years. If this is true, it calls into question the foundations of both Keynesian and monetarist economics; neither of those theories is compatible with the degree of stability in real interest rates suggested by the evidence. In thinking about real rates, it is important to distinguish between real rates of return (the inflation-adjusted returns that lenders got last month or last year) and real rates of interest. The real rate of interest is the real return borrowers and lenders expect to pay and receive over the next month or the next year. Economists have always made this distinction, but it is a point that tends to get lost in popular discussions of real interest rates. The fact that real rates of return on, say, Treasury bills turned out to be very high last year may be interesting, but it is unimportant in assessing real interest rates. Those rates of return may have been quite different from what people had expected. In fact, realized returns can deviate from expected returns for long periods. They apparently did so throughout most of the 1970s, when inflation often exceeded nominal interest rates. Large deviations are particularly likely when expectations include a discount for the small probability of an extreme outcome, such as runaway inflation. $ If inflation was lower than people expected over the past few years, it means that borrowers ended up paying more than they had planned on in real, inflation-adjusted terms, and lenders reaped larger returns. But those higher- than-expected real returns shouldn't put a drag on the economy, any more than the negative returns in the 1970s should have fueled a boom. The real rates that affect the economy are the expected rates because they are what influence decisions. The evidence of low real interest rates is not all new. Consumer opinion surveys dating back to 1948 have indicated all along that interest rates move up and down in step with inflation fears. But most economists neglect this evidence. They make the mistake of discounting the opinions of ordinary people, and instead consult such expert observers as businessmen, purchasing agents, investment analysts -- and other economists -- to get a fix on inflation expectations. Not surprisingly, such informed opinion correlates closely with the government inflation statistics that experts use. WHO'S RIGHT, the consumer or the expert? We can thank Prime Minister Margaret Thatcher of Britain for providing an answer. In 1982 the Thatcher government began to issue inflation-proof bonds, known in the City of London as index- linked gilts. The bonds promise investors a stream of interest payments and principal whose purchasing power is guaranteed. The promised real returns on the bonds, based on the market prices the bonds sell for in London, provide a direct reading of the real interest rate. For long-term bonds the rate is 3%, give or take a quarter percentage point or so.

Britain is not the U.S., of course, but its example is telling. In both countries interest rates have been much higher than the reported inflation rates. Short-term Treasury securities in Britain yield about 12.5%, while consumer prices have increased only 6% in the last year (though at an accelerating rate). Moreover, the markets for credit and capital are largely unregulated in Britain, the U.S., and most other industrial countries. Since investors are free to move their wealth from one country to another in search of the highest real return, they can easily exploit differences in real interest rates. Arbitrage should produce a single real interest rate throughout the world capital market -- a world rate. The evidence from Britain and from other countries that have indexed bonds suggests that this world rate is uniform and has remained stable. The notion of a stable real interest rate shouldn't be surprising. The stability of real interest rates reflects the stability of the capitalist price system, in which free market competition sets the price of trillions of dollars of credit. A market so large can hardly be within the power of any government to manipulate. But governments do influence the value of money, and the lack of stability in nominal interest rates reflects the destabilizing results of government policies. Why is the belief in high and unstable real interest rates so widespread? First, most people have been using the latest inflation statistics as the measure of the inflation that borrowers and lenders expect in the near future. But, as Milton Friedman has pointed out, inflation expectations can remain high even though inflation has been low. Indeed, inflation fears may be fully justified even if they never are vindicated. Most New Yorkers never get mugged, but few would fault them for being cautious. Second, I think we have been bamboozled into accepting government statistics as authoritative measures of short-term inflation. The press eats, drinks, and breathes the latest readings of the consumer price index and other popular inflation measures. We forget that these measuring instruments are designed to smooth out transient price movements. The CPI contains long built-in delays because the price quotations on which it is based do not fully reflect the continually changing quality of the goods consumers buy. Nor does the Bureau of Labor Statistics collect the price of every item in every city in the sample each month. The CPI can give misleading results over the short term. THE EVIDENCE of low and stable real interest rates suggests that many economists are expecting too much from deficit reduction. If the deficit hasn't caused real interest rates to rise, reducing it won't cause them to fall. There may be good reasons to reduce the deficit, but high real interest rates aren't among them. Perhaps the most remarkable implication of my firm's research into real interest rates concerns the way monetary policy works. Both Keynesians and monetarists believe that a restrictive monetary policy causes real interest rates to rise, at least in the short run. But this apparently isn't so. The record in Britain shows that the yields on longterm indexed bonds have hardly responded at all to several pronounced shifts in monetary policy, while nominal interest rates have gyrated. If a more restrictive monetary policy doesn't cause real interest rates to rise and a less restrictive one doesn't cause real rates to fall, our policymakers are at sea. What we need is nothing less than a new theory of how monetary policy works.