So government credit expansion encourages malinvestment, which is typically funneled into long term projects, particularly higher order capital goods, expanding the early stages of the structure of production in the Hayekian triangle. Austrians claim that this is because investment in higher order capital goods receive a lower rate of return, and therefore investors need to be able to borrow at a low interest rate if they are to profitably invest in these higher order goods.
My first question is: why do investments in higher order goods systematically offer lower rates of return than investments in lower order goods? Higher order investments take more time to complete and become profitable so I suppose that plays into it, but shouldn’t these higher order investments reap greater profit margins in the long run once they are completed?
Granting that long-term projects are encouraged by a low interest rate: Say the government increases the money supply, and as a result some entrepreneurs invest in capital goods manufacturing that only appears profitable because of the government-suppressed interest rate. Even though consumer preferences haven’t actually shifted, suppose the government keeps inflating the money supply until the entrepreneurs projects are completed. Once the capital goods are completed and can be put into use in the economy, shouldn’t they result in lower prices for consumer goods? In other words, as long as the government doesn’t contract the money supply, what makes the boom unsustainable? Is it that we would physically run out of resources for other sectors of the economy that are more highly valued? Once the projects are completed, couldn’t resources be shifted back into their original uses established by consumers time preferences? Obviously some frictional unemployment would be involved, but wouldn’t the economy be producing at a greater rate after the market adjusts?
If someone could post a concrete example of the ABCT at work, giving examples of specific malinvestments that occurred due to government manipulation, that would help me a lot.
I’ll try and answer everything according to paragraphs, for some reason the quote thing isn’t working on my computer.
Austrian claim that the expansion of fiduciary media that artifically lowers the rate of interest distorts the profitability of the “higher order goods”/longer production possibilities because projects profitabilities that take alot of time are heavily influenced by the interest rate. This is referred to as the Time discount. If your going to build a skyscraper that takes 5-7 years or so (guesstimate), your going to want to do some serious calculations in order to see if your investing your money in the right place or not. Obviously, a skyscraper will cost a great deal of money, so a lower interest rate will make it easier to pay back the borrowed funds. In addition,Financers and investors use Present value calculations in order to see if certain projects are worth undertaking. If the interest rate is high , then the profiability of constructing a skyscraper is diminished because you would need a higher future income in order to compensate for the fact that there is a higher rate of interest. Unless your expecting to receive alot of money in the future, you don’t want to borrow money at high rates or even spend money in a risky avenue when you could easily earn an 8% return in a bank account or a shorter investment. In addition, the heavy equipment that is used to build these big goods are usually leased rather than outright bought, so a lower interest rate further increases long term projects profitabilities because the tools used to make them are also cheaper. Higher order goods don’t offer lower rates of return (like you suggest), but they just have higher costs and aim for consumption in the future so the interest rate plays a crucial role in their profitability.
Investments in the “higher order goods”, or longer production processes aimed at consumption in the future, yield greater returns over time then shorter production methods. Thats why they can be classified as roundabout methods, they take longer to build relative to shorter production methods (It would take me ALOT longer to build a computer than a quill/paper, but the increased productivity of a computer typing up documents is enormous relative to hand writing).
The boom is unsutainable because (along with other reasons) since the complimentary factors of production haven’t been released from the lower orders or shorter production methods in order to fuel the longer production methods, investors financing the investments in the earlier stages of production have to bid away these resources and increase their borrowing costs in order to be able to use the complimentary factors. However, since consumers consume more and don’t want to save, there is an increasing demand for those resources to be used for consumption in the near future rather than consumption in the long term future. The rising interest rate and the increasing profitability of investing in consumption now rather than consumption later becomes apparent, and entrepreneurs start to liquidate their long term investment projects (the beginning of the bust). Resources have been wasted in making these goods, so thats why Austrians say it is a theory of malinvestment because the investment was done in the wrong lines. Sure, some projects may be completed, but that doesn’t mean they can be used by society in the way the builder’s wanted them to. In the case of the skyscraper, all of the raw materials used to make the building have been wasted, construction workers have wasted time in pursuing a now unproftiable line of work, etc etc. With the bust visible the company may not be able to sell it to the business that was going to buy it Those resources could have been used to create smaller buildings for companies, instead the society squandered it resources in building something too big it couldn’t afford. Take the example of the current housing bubble. Sure all of these houses are built, but its apparent that nobody can afford them now. If people were demanding more places to live but didn’t want to save for the “good stuff” (i,e a higher interest rate is prevalent in society), investors would have built cheaper places for people to live in (smaller houses/apartments etc). I
Thanks that explanation helped, but I am still unclear on the direct connection between long term projects and interest rate. Would you say it is the fact that long term projects are generally more expensive and are more of a risk, and that is why they need lower interest rates to be profitable? Or is there something more fundamental about the fact that they are long term that necessitates a lower interest rate before investment?
Suppose I’m an investor and I’m considering two projects, a long-term project that will take 5 years to complete and provide me a 10% return per year once completed, and a short-term project that will take 1 year to complete and provide me a 5% return per year once completed. If the interest rate is 8%, I will borrow funds to invest only in the long-term project. But if the interest rate drops to 4% then I will borrow to invest in both projects. In this case, lowering the interest rate has induced me to invest in unprofitable short-term ventures. Is this scenario not feasible?
Oh and btw it’s not just your computer, the quote button doesn’t work. Neither do some of the other buttons. I wish the forum would scrap this software and use something better like vbulletin.
The interest rate is the measurement of how much an individual prefers present consumption to future consumption. The lower the interest rate, the less the individual prefers present consumption to future consumption. With a low interest rate, entreprenuers will invest in longer processes of production because it appears that individuals prefer present consumption to future consumption less than they did previously.
Long term projects are more profitable when there is a lower interest rate because of the time discount effect. When recieving funds in the future, money is discounted because of time preference, you are getting funds in the future and not in the present, so in order for you to want to give up funds now and recieve funds in the future, you have to recieve a greater amount than what you sacrificed in the present (There is a premium on present goods over future goods). For investors, this time preference is the current rate of interest, because its represents (or is supposed to) society’s desired ratio between savings (future goods) and consumption (present goods). When investing in something, you don’t want to be recieving funds less than the rate of interest because your’e earning less than the present value of the money your are giving up. You could just hold on to those funds or invest them in a bank account where you just earn the going rate of interest (or another more profitable investment). So, for example, using a simple finance present value equation (Not a finance major, so bear with me :D)
PV:N/(1+A)^R
PV=Present Value
N=The money you will receive in the future
A=going interest rate
R=the amount of years in the future
So, if you’re given the option of making an investment where you will earn $500 in 10 years (all in one lump sum), at an interest rate of 8% at an initial cost of $300, then
PV=500/(1.08)^10…PV=$232 (rounded). So since the investment costs more than $232 then it is an unprofitable investment at the current rate of interest because the money you will receive in the future $500 does not outweigh the cost of sacrificing $300 now (of course subjective pyschic evaluations are dismissed, we’re just assuming your’e only concerned with pecuniary value). Now, lets say that if the interest rate was 2%, then the Present Value equals $410 dollars, a value much greater than before and something that would make the project viable.
Based off the equation above, the profitability of those two projects depends on the initial costs of each.
ook that made sense. so it’s the fact that they have to pay interest every year (or whatever payment-schedule they determine) that causes cumulative costs to be higher for long term investments, and that’s why the long term projects require lower interest rates before investors will fund them. Yes?
“if teh abct actually describes current monetary/currency phenomena couldnt i tjst as easily fund good investments faster than an alternative?”
Sure not every single investment made will be a bad one, but credit expansion does lead to poor investments that wouldn’t have been made if the interest rate wasn’t being held below it’s natural rate. The investments fueled by credit expansion only look profitable because the interest rate is being suppressed. In actuality our time preferences have not shifted to the point where we are saving at a great enough propensity to sustain the investment being stimulated by credit expansion. These bad investments bid up the prices of production factors, drawing labor and capital away from good investments.
Yeah, its the law of time preference, is the fact that you will be recieving the funds from the investmetn in the future, and that money is discounted because it is recieved in the future and there is a premium of present goods over future goods. In order for you to want to invest present money now to recieve future goods later, you will want to make sure you are earning above the opportunity cost (interest rate). Durable capital equipment/goods that yield services over a time and projects that require a long amount of time are heavily influenced by the interest rate because of this.