I am trying to make sure I fully understand ABCT. It seems that with easy money during the “boom” phase, there are many bad things that happen:
Industry can be fooled in to thinking that rates will remain low indefinately and so may instigate projects that are viable only if rates remain low. When rates finally rise these investments will fail.
Asset prices will rise at an unsustainable rate fooling people into being overoptimistic about their future wealth. This will cause then to adopt unsustainable spending and saving patterns based on this false optimism which will have to be corrected after the bust.
I had casually thought that ABCT was all about 1&2 equally, but after reading a few articles, it seems that (1) is the only thing that is ever discussed. Am I just looking in the wrong places or is ABCT genuinely all about (1)?
EDIT: I’ll just add that IMHO (2) is a much bigger “malinvestment” than (1).
(1) and (2) are inter-related. Businesses are falsely encouraged both by the artificially low interest rates (1) and by the artificial demand (2) caused by them. The fake capital (“liquidity”) sloshes around the economy affecting both supply and demand at every level.
Sorry, I’m very bad at keeping references. I only keep distilled versions of acquired/understood concepts in my head. Perhaps someone else can help you out with a reference.
You’re focusing too much on the psychological aspect/expecations and entirely ignoring the actual technical issues. ABCT is not about “irrational exhuberance” and the interest rate effect is merely one effect amongst many. I mean, expectations are important, but there are other key variables that are often overlooked/misunderstood. Inflation effects both the demand-side and the supply-side simultaneously.
Here’s a real quick (entirely inadequate) explanation:
Relative price distortions, brought about by monetary expansion, direct capital and labor towards unwarranted productions that cannot be completed on time, at all, or will be completed at the expense of other, more warranted productions. Actors begin investment projects as if there was an adequate supply of real savings while consumption is not curtailed by a sufficient degree (or at all). This creates a temporary disconect between the savings/consumption trade-off and places the economy on an unstable trajectory where it operates off of the PPF. There is tension between investment and consumption in favor of the latter, and continuous inflation/credit expansion is required in order to prevent the necessary correction (realignment of the capital structure). But the correction is both painful and difficult because capital is not a homogenous blob that is simply “reallocated.” It must be liquidated, which means that some resources will be lost forever.
I wish people would just read Prices and Production. It’s not that long.
On your second point: Since inflation is usually relatively high in the boom period and interests rates are low, real interest rates tend to be negative. Therefore people will, to avoid a loss in purchasing power, also tend to invest in assets/commodities which additionally to the inflationary effects of increasing the money supply increases asset prices a lot. It is not “irrational” to invest in hard assets at all as staying in the currency really will decrease your purchasing power. But as the boom gets replaced by the bust and the expanded credit contracts, the reasons for staying in hard assets not only vanish, but turn into reasons to switch into the currency (growth of purchasing power through deflationary effects) and therefore prices in hard assets/commodities will have to come down again even in real terms (and especially so in nominal terms as the price is pushed even further down by the currency getting additional purchasing power).
Esuric wrote: “You’re focusing too much on the psychological aspect/expecations and entirely ignoring the actual technical issues. ABCT is not about “irrational exhuberance” and the interest rate effect is merely one effect amongst many. I mean, expectations are important, but there are other key variables that are often overlooked/misunderstood. Inflation effects both the demand-side and the supply-side simultaneously.”
Are you denying that (2) occurs? or are you just saying that (1) is the more important effect?
“I’m saying that (1) may not happen at all, that you’re entirely ignoring effects 3,4,5,6,7,8,9,10…n.”
Maybe I am… I won’t even try and deny it… but I’m still curious to know whether you think (2) occurs at all and is it part of (albeit a small part of) ABCT?
(2) is really describing two different phenomena. The second part will happen, and it’s called “forced savings,” but the first part may or may not happen. Again, the first part of (2) is more psychological and isn’t a necessary condition of ABC’s.
One more thing: consumption levels may remain constant, but investment will grow beyond the actually supply of real savings. In such a condition, you still have over-consumption and over-investment.
The heart of an ABCT is lots of newly printed money. The people who get the money are the govt and the banks. In Mises’ day, nobody in his right mind lent to ordinary people [except for mortgages on very strict terms], because how were they going to be able to pay back. So the bulk of the moolah was lent to businesses, and since there was so much of it, they got the money at very low rates, causing (1).
In other times and places, like nowadays, when for various reasons there is nobody to lend to but fools, it gets lent to fools who use it for (2).
Yes, this is in disagreement with Esuric, but I’ll live.
There’s a nice Peter Schiff video lecturing as a guest of the Mises organization, called Why the Meltdown Should have Surprised No One". He explains (2) very nicely, both the dot.com and the housing bubble. Very funny too. Keep your ears peeled for the word “malinvestment”, it’s in there one time I think.
The interest rates were relatively low (relative to the natural rate) because the supply of loanable funds exceeded the demand for loanable funds at the equilibrium rate.
“In other times and places, like nowadays, when for various reasons there is nobody to lend to but fools, it gets lent to fools who use it for (2).”
Very interesting… I think that if ABCT was described to non-austrians in terms of lots of (2) going on, or at least with (2) being the main example of a malinvestment, it will ring more true. You will probably get more converts.
If you watch that Schiff video, he goes on and on about foolishnesses. There’s a thread started by rational economist where he quotes current AE people saying similar things, though some of the posters here disagreed with that interpretation of their words.
(2) is really describing two different phenomena. The second part will happen, and it’s called “forced savings,” but the first part may or may not happen. Again, the first part of (2) is more psychological and isn’t a necessary condition of ABC’s.
From all of the books I’ve read describing actual bubbles, I think 2 is caused by ABC. Look at what happens to the prices of higher order capital (and possibly higher order consumer goods, like houses, that are normally “consumed” over very long periods of time) goods when interest rates drop. They go up.
I can’t explain why, but think it is quite possibly a part of most people’s nature to respond to these raising prices (and in a real bubble they raise from a good bit to a crazy amount) by thinking they will keep going up, and using a larger portion of money available to buy into the bubble. Of course most of the money pouring in comes from the expanding money supply, but even people who see their incomes stay the same are much more likely to buy in.
If you look at what happens during a bubble, there are always psychological changes going on. What would it take to prove beyond normal doubt that (2) is necessarily caused by the ABCT?
I accept this as a challenge. I will refrain from posting comments regarding my favorite subject, ABCT, until I have read this book. I am going to start reading it tonight (138 pages with the Appendix).