I am having somewhat of a mental block that prevents me from understanding clearly: how does the fact that the consumers want to save more and spend less drive the interest rates down and the fact that they want to spend more and save less drive the interest rates up? (I am talking now without government interference.)
Is it because in order to spend, the consumers borrow from banks (e.g., sign up for new credit cards), thus making credit more desired, thus driving the price of credit up? (And vice versa, if they are not interested in spending, they are not interested in borrowing, so the price of credit goes down.) Or does it not have anything to do with credit cards and borrowing, but has to do with what the consumers do with their already existing money? (In that case, how does spending it drive interest rates up?)
Also: is it the fact that the entrepreneurs are using interest rates consiously to predict the consumers’ time preferences, or is it that low interest rates are better for investing in long-term projects (capital goods industries), while high interest rates are better for investing in short-term projects? I.e., consumers’ choices whether to buy or to save change the interest rates, which in turn make it more profitable for entrepreneurs to invest in short-term or long-term projects.
In this talk, Robert Murphy says something like “because [after people decide to save more] banks have more money, they can afford to charge lower interest rates for loans”. So, does this mean a) my decision to put more money in my bank account leads to lowering interest rates, b) if I decided to save money by putting it under mattres, it would have no effect?
Also: presumably, if there was no fractional reserve banking, this would mean putting money into long-term savings accounts that I can’t touch for a long-term period of time, not just keeping more money on my checking account, right?
It’s about borrowing. But keep in mind that banks don’t “have” money, they lend out money that savers deposit. If lots of people save, that means there’s more money sitting in banks. Banks want to earn interest on that money, and because they are in competition with each others they have to charge less to borrowers. Essentially this is just marignal utility; money became less scarce, so it’s cheaper. If people spend instead of saving, then money is more scarce and interest rates go up.
In a fractional reserve banking system this becomes a little more complicated, because banks can loan money into existence. In a way the money saved and the money loaned out isn’t the same money, these are just two actions that have opposite effects on the money supply. If you borrow money from the bank, they just create it causing a tiny bit of inflation. And if you save or pay back a loan you destroy fiat money, reducing the money supply.
Low interest rates cause malinvestments because long term projects are interest rate sensitive, not because entrepreneurs are actually mislead about consumer preferences. One common objection to ABCT is that entrepreneurs would not be deceived by inflation because they could just figure out what the real time preference of consumers is. But that’s misunderstanding the theory. Particular long-term projects are prefectly profitable, even if they are a part of something that’s unsustainable in the long run.
If you put your money under the mattress, it’s effectively removed from the economy, causing deflation, because now there’s less money chasing more goods.
Nero touches on it, but here’s the answer you’re looking for:
Supply and demand. These are the two factors that determine price. An interest rate is literally the price of money — more specifically, loanable funds. Microeconomics tells us that as the price goes up, quantity supplied goes up, quantity demanded goes down.
So real loanable funds come from savings. The more people have saved, the larger the supply of funds available. As these funds get loaned out (i.e. supply is diminished), the price of the remaining funds goes up, because they are more scarce.
The second one. Entrepreneurs are only trying to make a profit. You do this in large part by cutting costs. This means borrowing at the lowest rate possible. For more on this and how it translates into the business cycle, see here, and for more info here.
It’s not that high interest rates are “better”…it’s just that the shorter-term your project is, the less sensitive to interest rates it will be. Think about it. If you’re only borrowing for 6 months, a few points on an annual percentage rate aren’t really going to make much of a difference in your overall cost. If your project is 20 years, even a fraction of a point can make a huge difference.
So the higher the interest rate, the less and less likely longer term projects will be undertaken, as their return would have to be higher and higher to actually be profitable.
Thanks, I understand now how saving lowers interest rates. I have a few more questions, however:
I understand that it is less costly for entrepreneurs to borrow money long-term if the interest rates are lower. But that in and of itself should not be enough incentive to invest long-term — one must also expect to reap greater rewards from the long-term investment than from a shirt-term one.
How do the entrepreneurs know that a long-term investment (that is, yes, cheaper to borrow for) will bring greater benefit if they are not consciously thinking about consumers’ time preference (after having read Rothbard and MIses)? More specifically, how is that knowledge affected by lower interest rates (cost of borrowing money from the banks notwithstanding)?
Isn’t it also the case that when interest rates become lower (either naturally or through FED’s meddling), that discourages saving? I mean, it’s true that some people’s time preference for money won’t change if the bank is offering 1% interest on savings account vs. 4% interest (for instance, my wife and I decided to save more recently, because we are expecting a baby — and we won’t decide to spend more if the banks give us an even lower interest rate for the savings account). But that’s not the case for all the people — some will be encouraged to spend more if the interest rates are lower.
So, besides the fact that it creates a negative feedback loop with time preference (i.e., deciding to save lowers interest rates, which discourages saving — but because, as I said, not everyone’s time preference is affected by interest rates, the effect of time preference on interest rates is greater than the reverse), lowering interest rates does encourage spending.
So, that leads me to two questions (the second one is probably the Keynesian argument, but I want to know why it’s wrong):
a) if lower interest rates encourage long-term intestment but entrepreneurs, but lowering interest rates artificially encourages short-term spending, doesn’t that exacerbate the problem of malinvestment even more? I.e., when Bernanke and Krugman say: “we will lower the interest rates to encourage spending”, doesn’t that more the problem even worse?
b) why shouldn’t the entrepreneurs say: “interest rates are lower, which means people are more likely to spend now, which means I should invest in short-term consumer goods businesses”; i.e., what prevents the entrepreneurs looking at the interest rates not as an effect of consumers’ time preference, but a cause of it?
Again, they’re not economists. They’re business people. They don’t have to think about what people’s time preferences are because the people tell them…through their wallet. The short answer to your question is, they have a good idea of what will be profitable because there is a lot of data out there…and analyzing that data and interpreting consumer trends is what entrepreneurs do.
To get into it, remember, if people are saving their money (thus increasing the pool of loanable funds, thus making interest rates lower, thus enticing entrepreneurs to invest in higher order stages of production), it necessarily means the people are notspending their money on consumer goods. This means that the people’s preferences are showing up loud and clear in sales figures…namely, profits and losses.
This is what the price system is all about. Prices serve as signals to the rest of the market to coordinate production by relaying relevant information about people’s preferences.
If someone is making a ton of profit, (legitimately…not by coercion through government force or some other illegitimate means), then that means he is using resources in an efficient, desired way. He is creating wealth by taking inputs and producing outputs that are valued higher than they all would be otherwise. Think of a sketch artist at an amusement park. She is taking a sheet of paper, a marker, and 9 minutes of her time/labor to create a picture for you. And you pay her $10 for it. But the sheet of paper, the ink from the marker, and her 9 minutes…if you bought them all separately, would not cost you anywhere near that much. That means that she has made a profit. She has taken those resources and made something more desirable out of them.
The fact that she has made a profit is a signal to other entrepreneurs to do the same thing. It says to the market: “Hey. This is a good idea. We need more of this. You will be rewarded if you create more of this.” And motivated by greed, entrepreneurs seek to recreate that same product, thus satisfying more customers and attempting to make a profit of their own. However, people are fearful too. They may want to make more money, but they don’t want to lose the money they already have. This is why so few people are entrepreneurs in the first place. Everyone sees profit being made everywhere they go…but you don’t see everyone trying to start a business and take a share of those market profits. Why? Because there is risk involved. The entrepreneur has no guarantee he’ll be able to earn that profit. He may very well spend his money on a bunch of paper, ink, and waste time drawing a bunch of practice pictures to advertise his work…and no one commissions a drawing because he sucks at it.
When this happens the entrepreneur has suffered a loss. This is just as important as profit. It says to the entrepreneur “Don’t do that. You’ve wasted resources. You’ve taken scarce inputs and combined them in a way that makes them less valuable. It costs energy and time to make paper and markers. And you’re wasting them.”
So take this back to a larger scale. If people are saving their money it means they are buying less consumer goods. This means revenues for companies in those industries may go down, and marginal firms may even go out of business. The fact that the pool of savings has grown larger (thus making interest rates lower) necessarily means that those resources that would have gone to consumption are now freed up and available to be used elsewhere.
There are losses (or at least declining profits) being made in end-user industries (e.g. retailers). Remember, these are all signals. This is saying to entrepreneurs “hey…Bennigan’s-type restaurants are seeing declining revenues. They’re going out of business. You probably shouldn’t try to open one of those restaurants.” But if they are going out of business, what does that mean? It means they couldn’t turn a profit and suffered too much loss, right? Why is that? Quite literally it’s because it cost them more to produce their product than the market was willing to pay for it. In short, expenses exceeded revenues. But…what if they were able to bring those expenses down? What if they were able to have some kind of technology that made the business more efficient…some that made the order process more smooth, the cooking faster, the regulation compliance easier…something. Then they might be able to run the same business and have it be profitable.
This is what investment is all about. It’s about underconsuming so that resources are made available to create goods not for consumption, but for production…goods that end-users don’t want, but that make it easier to produce goods that end-users want. Like a power drill. Nobody wants a power drill. What they want is a hole in the wall. There’s a thousand ways to get the hole there. The drill just makes it much easier, much more efficient, and much higher quality. It is a piece of “capital equipment”.
You might say an industrial dishwashing machine in a restaurant is the same thing. The restaurant owner doesn’t want the washer. He wants clean dishes. Now, he could pay 3 guys $9/hour to wash the dishes everyday, all day. And he could have hold up issues where there aren’t enough clean plates to serve all the customers. (He can’t buy more dishware because he has nowhere to store it). However he might “invest” in a dishwasher. This may cost a lot of money up front. Perhaps even enough that he needs to get a loan. But over time, the money he saves in paying the human dishwashers, and the time he saves, and the space he saves, all pay off because he is now his expenses are lower…and on top of that, he’s able to serve more customers in the same amount of time. What used to be a failing restaurant is a profitable one.
Of course this is an extremely simple example, but it illustrates the point. If interest rates were too high, the owner would not have been able to afford the payments on the washer. But because they were low enough, it was do-able…because the resources were there to warrant the lower price of the money.
Think about this on a grand scale from the entire economy, from the higher-order stages of mining, logging, farming, etc…all the way down to the customer buying a donut in the donut shop.
Production is coordinated through the price system and the signals of profit and loss (which interest rates in large part dictate).
Again, did you actually watch this? I really think it would help.
Yes.
This is what the law of supply and demand is about. They are always moving to reach an equalibrium.
Remember, lower interest rates make borrowing cheaper…they don’t directly encourage spending. It is having more money that encourages spending. So you see, inflating the money supply can do both of these things…lower interest rates and create more spending. (Because obviously, if people have more money, they generally spend more money.) The answer about how it actually works out in practice depends on a lot of variables…essentially how the new money enters the system and in what manner. The fact that prices don’t rise uniformly and proportionally across the economy is precisely why money printing is so distortive and ultimately destructive. The fact that it is entered constantly and in many different channels exacerbates the situation. Mises said if new money entered only once, price relationships wouldn’t be distorted for long.
So to answer your question, borrowing and spending aren’t equally affected. It all depends on how the money enters, and what all the players (including regular consumers) do about it. Remember, consumer behavior is dictated in large part by government mandates and subsidies.
I watched Tom Woods’ video, but I’ll watch it again to review. I have a question, however:
It seems that there are two things that would encourage investors to invest long-term:
Interest rates go down (making it easier to borrow long-term)
People are not spending money, which makes local stores’ revenues go down, which makes them a less attractive target for investment.
In that case, however, when Bernanke artificially lowers interest rates, how can the investors get confused about the consumers’ time preferences if those haven’t changed? What I mean is: consumers are still spending money at the local shops and restaurants; so, the revenue of the latter should not go down. Then, why do the investors start suddenly (mis-) investing in long-term projects, while the retail stores’ revenues say that it should still be profitable to invest in them?
The reality is it’s not that simple and clear cut. It sounds that way when you break it down for an explanation in a few paragraphs, but don’t forget we’re talking about a $14 trillion, 305 million-person economy. It’s much more complex.
For one thing, it’s not that revenues just dip uniformly across the board, across the entire economy in one sector. There are countless factors that can affect certain businesses in certain places, and at certain times and certain spaces. It’s not so easy as just talking about it in an abstract sense. It’s like looking at a map of the United States where an inch represents a thousand miles and saying “Aw come on. How hard could it be to find Ohio from Florida? It’s like right there. See? You just kind of go up and then over a bit.” (Of course imagine there’s no interstate highway or public transit taking you there).
Another factor is the division of labor extends so far that people know very little about things outside of their field. This is the whole reason we’re able to enjoy the comfort and prosperity we do in this modern age…but it’s also a large part of the reason the coordination is so important, and can have such devestating effects when it’s thrown off.
Just because someone is an entrepreneur it doesn’t mean they know everything about commerce and can just look at where profits are being made and simply go into that business. Even if those resources are available (which, in an inflationary environment, they aren’t…that’s the biggest part of the problem), but even if they were, they don’t appear out of nowhere, already structured in the proper fashion for the type of production the entrepreneur wants to go into. You can’t just look at Apple making profits and say “Hey that’s a great business. I think I’ll give up this rug-making business and make revolutionary consumer computing and entertaiment technology.”
But my question is: whatever factors push entrepreneurs into investing into long-term (capital goods) businesses when the interest rates are low — how can these factors be messed up by Bernanke? Supposedly, Bernanke only changes the interest rates. But all the other factors that should influence entrepreneurs into investing into short-term businesses remained unchanged. So, basically, all the indicators are still the same, except it has now become cheaper to borrow.
Unless (going back to the original question), you can say that it’s the interest rates alone that push the entrepreneurs towards investing into long-term businesses. But if that’s the case (and from the answer that I received it doesn’t seem that way), then I still don’t understand how that works, besides the fact that it is cheaper to borrow for long-term investments. I.e. what makes them profitable? If it’s the fact that the short-term businesses lose revenue during the “saving” period, then that does not change as a result of Bernanke’s machinations… so, that should not push entrepreneurs towards making long-term (mis-) investments, as ABCT states.
But the fact that it’s cheaper to borrow changes everything. Remember, the whole point is profitability. At lower rates, projects that were previously unfeasible all of a sudden become profitable. So whereas before it may not have been a good idea to do x and y, now all of a sudden, it is. And again, the longer-term the project is, the more interest-rate sensitive it will be, to a point that only a fraction of a point difference in the rate could mean the difference between the project being in the black or in the red. (Have a listen here as Milton Friedman explains how it could feasibly be artificially made profitable to grow bananas in Utah. (it’s toward the end, but the beginning helps set it up, and it’s a short vid. Watch the whole thing))
Entrepreneurs have no way of knowing if those resources are actually there or not. That’s the whole point. Money is not just supposed to be a medium of exchange, it is also supposed to be a store of value…as in, representative of actual real-world resources. When the money supply is inflated artificially, projects get undertaken for which the physical resources needed to complete them do not exist. This is the meaning of “malinvestment”. Mises used the analogy of a builder beginning construction of a house without enough bricks needed to complete it. He doesn’t realize all the necessary materials aren’t there until he’s already built a considerable amount of the house.
This is generally when the malinvestments get exposed…when the resources just run out. And projects just get shut down. This is exactly what we saw in some of the most inflated housing markets during the recent bust. Tom Woods recounts this in Meltdown. All sorts of projects in and around Las Vegas and Phoenix still sit idle and unfinished to this day.
Remember, prices are signals. And interest rates are the price of money. When the interest rates are artificially manipulated, it’s like price fixing. It distorts the market and leads to shortages and the kind of discoordination you see that leads to bankruptcies and unemployment like we have now, and at an even worse degree, situations of starvation while wheat rots in the fields like in the former Soviet Union.