I’m reading peter schiff’s book " How an economy grows and why it crashes" and in that book he said that,
“a lower savings rate indicated a preference for more immediate consumption. As a result, long term capital investments designed to provide goods for future consumption would be discouraged”.
can someone explain this to me please, what are examples of immediate consumption goods , and examples of capital investements that provide goods for the future? if you can relate this during the housing bubble that would be great!
the immediate consumre goods are goods like food, clothings, and gasoline that most people were spending money on. While the housing market was the investment that should have been discouraged because we had (still have) a low savings rate,
can someone correct me if i’m wrong please, thank you!
Having a roof over one’s head is a consumer good, but actually building a house is making an investment in a capital good. Some non-fungibles like houses or trucks can be both a capital and a consumer good, depending on what aspect of it you’re looking at, or how it is being used. A house that is rented out is a capital good for the owner and a consumer good for the tenants. A house occupied by its owner is both a capital and a consumer good for the owner. Imagine that the house is a dairy cow, and the ability to live in it and enjoy it is its milk.
The issue is not that consumers should have been discouraged or interfered with by a planner. The issue is that the interest rates were artificially low, and the interest rate is one of the most important price signals for consumer time preferences. If it’s artificially low, producers get an incorrect and unavoidable signal that consumers are really saving much more for the future than they actually are, so they’re inclined to make big capital investments (e.g. building houses) that consumers will not be able to afford once built, because they weren’t saving nearly as much as “signalled” by the artificial interest rate.
A lower savings rate means that people are keeping less of their income for future purchases and instead spending it on immediate consumption goods, e.g a vacation condo or new TV, in the here and now. Ussually people save this money in banks which may provide some of this money in loans to investors. If there is less money in the bank to lend, the price of borrowing that money (interest rate) increases due to the law of supply and demand. Therefore, long term capital investments, e.g a new factory or a new housing development, are discouraged because the cost of borrowing the money makes many of these long term ventures unprofitable.
The above assumes a free market. In the real world however, the government through its central bank controls the supply of money and interest rate instead of the free market.
Thanks to the above mentioned government intervention in the market, many investors assumed that their housing investments would be profitable but the market proved otherwise.
The market can be shaken and bruised by a monopoly of force or fraud, e.g the government, but it can never be beaten in the long run.
The interest rate is a price between consumers who supply the savings by deferring consumption and entrepreneurs who uses these savings. If consumers decide to save a lot of their output, ie increase the supply of savings, then the entrepreneurs will pay less for them. Conversely if consumers refuse to save and consume their production then entrepreneurs will have to increase the amount paid for these savings.
Enter the Disaster Looking for a Place to Happen System commonly called a Fractional Reserve Banking System:
Banks through Fractional Reserve Lending artifically create money. This money enteres the system through loans thus artificially lowereing the interest rates lower than they would be absent the fractional reserve banking. These low rates appear to entrepreneurs as extra savings. So entrepreneurs take on longer term projects whose payoffs depend on these savings. Consumers on the other hand view the low interest rates as a low payoff for deferring consumption. So these consumers then tend to consumer more in the present. You can see the mismatch of savings by consumers and projects by entrepreneurs. Eventually the entrepreneurs can not complete their projects as consumers have exhausted their savings and the thing crashes. These are the crashes the USA experienced under the Gold Standard. The system is far from perfect but much more stable than:
Now enter the Central Bank that sets interest rates. So instead having banks compete through fractional lending to set interest rates, the central bank does this by fiat. So now the interest rates tend to be much lower than they would be absent the central bank. In fact the central banks make rates so low that consumers turn to negatively saving by taking loans in the present intending to pay off the loans with future production. And as in the scenarios before, entrepreneurs view these low rates as their being plentiful savings. These entrepreneurs rush to start projects that take progressively longer periods to complete as consumers rush to loan money to consumer in the present. The result is a much bigger mismatch than before and a near frenzy of activity commonly called a boom. Of course consumers can not in the future pay for these projects as they consumed their real savings and then you get the bust.
Also note that a person can be a consumer and an entrepreneur at the same time. As a consumer I may puchase a house to live in but as an entrepreneur I could purchase the same house to live in with the expectation that it will increase in price in the future and provide me a profit.