I have a pretty good grasp on interest rates as a reflection of social time preference and coordinating the intertemporal production structure. But as I’m sure you all know, there are other components that determine interest rates as well.
If one starts to think of interest rates as a price(I know this is an Austrian faux pas), and the function of prices is to ration, then do interest rates ration savings based on risk? All things being equal, is a bankers decision of which loans to make based solely on the risk of having the loan repaid?
If this is true, then it follows that an inflationary/artificial expansion of savings would result in loans being lent to borrowers who would not have otherwise received the money, being necessarily more risky(maybe… embarking on unsustainable ventures?). Obviously this is not the main component of business cycles, but can this contribute to it/compound the affects of the cycle?
I know Tyler Cowen(not a great name to drop in here probably) has written about manipulation of interest rates as affecting risk taking in the economy, and I think William White has also written about inflationary money finding its way into more risky/exotic financial instruments(like CDS,CDOs, asset backed securities, etc.). I haven’t read any of their work but I’m pretty sure it’s out there.
Not really. A faux pas would be to see it as the price of money. Pointing out that it’s a price helps clarify that it works as any other price (e.g. wrt price controls.)
Indeed, Garrison has an excellent chapter on business cycles and risk in his Time and Money. His point is that pushing the interest rate below it’s “natural” rate will cause intertemporal misallocation of resources there are also other issues concerning the risk preferences amongst consumers.
One example he gives is that when the government borrows essentially they’re externalizing the risk as it is now currency holders who will lose in the case of inflation. He also follows a similar line of reasoning that you do, in that in the market rate (rates) of interest there is a risk component. Not only does the lowering of interest rates affect intertemporal allocation of capital but it will have an effect on the types and extent of risk banks will take on.
It’s no wonder everybody traded CDS and other exotic instruments. After all, under inflation and low interest rates, it’s practically impossible to lose money on that. However, people obviously miscalculated the power of CB to inflate.