On Malinvestment, How? and Why?

Economics Economics Questions
181

Admittedly, I’m not an expert on how the financial system works and what the correct terminology is. So you can correct me if I’m wrong or if this has been covered before. But my impression was that there was a difference between a long-term loan and a long-term investment. A long-term loan is one that doesn’t have to be paid back in full for a long time. One takes out a long-term loan to buy a house. The lower the rate of interest, the more likely someone is to take out a loan to buy a house. A long-term investment, on the other hand, is a production process with a long turnover period–that is, it takes a long time to develop the product and make a profit. This is what I thought was meant by “roundaboutness.” But just because a house is bought with a long-term loan doesn’t mean that the construction of houses is more roundabout than the construction of something else, say pharmaceuticals, which require years of research . So while an artificially low interest rate may divert resources from pharmaceuticals to housing, this is not because the production of housing is more roundabout. Rather it is because the end product is more expensive and thus requires a greater level of consumer loans.

I just Googled to see how long it takes to build a house. Most sources said 3-4 months. By contrast, crops might take a year to grow, livestock even longer. If low interest rates serve to increase investment in roundabout production, it seems that agriculture should be hurt more than housing.

182

FOTH,

Say there is a seed of a tree that takes a thousand years to grow. You put in the ground in two minutes, then it takes care of itself. Do you think that buying that seed and planting is…

  1. A long term investment?

  2. A more roundabout means of production than housing? pharmecuticals? livestock? other crops?

  3. Is a loan taken to buy the seed a long term loan?

  4. Will changes in the interets rate affect seed planting more or less than housing? pharmecuticals? livestock? other crops?

there are no right and wrong answers here. [Laughing. Of course there are.]

183

Just part of the reason that lowering interest rates will not prove to be stimulus to the economy. Keynes felt that lower interest would stimulate demand, but wholly negated the fact that lower interest rates are extremely detrimental to supply, and the supply is much more elastic than anyone considers. This current crises started with a lowering of the interest rates (NOT the various businesses that folded in the ensuing cash contraction). It continues to be exacerbated by further lowering of rates and the foolish “stay the course” mantra. It frustrates me to no end the fact that people graduate with economics degrees without a bloody clue as to how the macro economy works; and then they teach economics and advise administrations. If you don’t consider yourself an expert, then you do not suffer the mind numbing indoctrination that students and future professors suffer at the hands of “educated” experts. I have found that an economics education is nearly impossible to put behind you, regardless how ridiculous the curriculum.

184

Those are goods questions. Part of my question pertains to the definition of those words, so I’m not sure how well I can answer. But I’ll try.

  1. If I’m planning on selling the tree/planted seed, then yes. Since I’m not going to live a thousand years, my only hope is to sell the planted seed before I die. However, it doesn’t seem like its value would be much more than when I bought it because I didn’t add much labor to it.

  2. It has a low turnover rate, so if that is what is meant by “roundabout,” then yes.

  3. Depends on the conditions of the loan. One could buy the seed with a short-term loan or a long-term loan.

  4. I doubt anyone would take out a loan to plant one seed, so in that case, less. But assuming I spend a lot on seeds and need loans, I don’t think anything could be concluded apodictically. First of all, since the loans that are spent on housing are consumer loans, they are independent of the length of the production process. If we are going to assume someone will take out a thousand year loan to plant seeds, we might as well assume that someone else might take out a thousand year loan to buy a house.

Second of all, it seems that we are assuming that loans are used to fund short-term and long-term projects in equal proportions. Businesses are always making profits. Where does that money go? It seems to me that the wiser move for a business would be to throw revenues into long-term projects and take out loans for short-term expenditures. Suppose my agricultural business turns over $10,000 in one year. Instead of taking out a long-term loan to buy the seeds for the thousand year trees, it might make more sense to use that $10,000 to buy the seeds and take out a short-term loan of $10,000 to meet my agricultural expenditures for the following year. True, an increase in the interest rate may make it more unfeasible for me to do that, but no more than it would make it more unfeasible for me to increase my investments in short-term projects, such as growing more crops.

Thus, there is no connection between the length of a loan and the length of the production process. If anything, the deciding factor seems to be the amount of capital one has. Those with a lot of capital can get short-term loans. Those with little capital, such as consumers and new businesses, need long-term loans.

185

FOTH,

The point I was trying to bring out with those questions is that length of time for final product to show up is not a measure of “roundaboutness”. The latter is measured by how many things have to be produced before you can produce the final product. That seed pretty much is good to go right away. Its production has no roundaboutness.

A woven basket in a primitive society would have one level of roundaboutness if they first sharpened rocks to make knives to cut the reeds, then weaved them by hand. In a modern society, that knife would be made in a factory, which would need machinery to be built specially for it first, and those machines might themselves need machines to make them, and those latter machines might need still other machines to make them as well, etc. So many levels of production would be needed before that basket would be woven.

ABCT is predicated on the assumption that the higher level machines, the ones that you need first before to make the others, are usually built when interest rates are low, because a lot of time and money is needed to make them, more than for the lower levels of production. Sadly, I forget why this is so. How quickly we forget.

186

ABCT is predicated on the assumption that the higher level machines, the ones that you need first before to make the others, are usually built when interest rates are low, because a lot of time and money is needed to make them, more than for the lower levels of production. Sadly, I forget why this is so. How quickly we forget.

So for the ABCT, the deciding factor isn’t how roundabout something is but that the high order goods are expensive? So an industry with a low level of roundaboutness but an expensive high order good would be more adversely affected by the changes in interest rates than an industry with a high level of roundaboutness but an inexpensive high order good?

This doesn’t seem to explain the relative “malinvestment” in housing vs. other industries. I see no reason to presume that the machines necessary to build bricks, nails, and the other materials for housing are more expensive than the machines necessary to can food, for example. In fact, the situation with housing seems to be precisely the opposite. What makes housing different than other industries is the relative expensiveness of the end product.

187

In the US (and other recent) housing bubbles, government agencies and policies actively directed the credit into housing. The fundamental insights of the ABCT - the boom-bust being a result of the effects of unsustainable credit expansion on interest rates - are all there. In a market that was completely free apart from the credit expansion, we would expect the credit to effect higher order goods more than lower order goods. In the specific case of the housing bubble, government policies sought to directly funnel that credit into housing. This credit expansion was not sustained, interest rates rose, and the bubble popped.

188

The dredit expansion was stable and sustainable until Bernanke started cutting at interest rates.

189

What do you mean? In what period? In the early 00’s, interest rates were artificially pushed below 2%. Do you think this could have continued forever without massive inflation?

190

For the case of the seeds, it makes sense that you can borrow short-term for the initial seed purchase, plant it and pay off the debt using a separate revenue stream before the seed ever produces a marketable product. This doesn’t hold for most actual long-term investments, where there needs to be a continuous stream of costs, not just the initial fixed cost. Consider building a factory. Not only are the natural resource costs spread over time, but labor costs, rent for land, possibly others.

Most business expenses are not financed in one giant loan at a fixed rate but through a credit line that is subject to swings in the interest rate. Even if they were financed by the former, many businesses would not accurately predict and factor in the inflation that the artificially low rates produce, thus requiring more capital than they initially estimate. So they are sensitive to the interest rate.

the recent housing bust showed most of the foreclosures in ARMs - also subject to rates. also walter block has written about why a mismatch in savings and long-term consumer goods financing can cause a business cycle.

If one already has enough capital saved to finance a loan, it makes no sense to take the loan in the first place. You’re paying interest for no good reason. Rather, the smart financial move would be to do the opposite - loan out any capital not needed immediately for profit. You could make loans of several maturities to maximize the revenue earned knowing when you need the cash to finance your investment.

While a single house may take 3-4 months to build, timber harvesting equipment, construction equipment, business structures, trucks for transport, etc. take either a long time to produce or to convert from one industry to another, or move from one location to another.

credit expansion causes inflation and this can manifest in speculative assets such as stocks, commodities, real estate. govt policy channeling credit to start the bubble can get it going then low rates and high credit growth rates keep it going.

191

the rates were actually negative in real terms encorging debt financed speculation rather than saving, value investing, and loaning.

192

Keynes felt that lower interest would stimulate demand, but wholly negated the fact that lower interest rates are extremely detrimental to supply, and the supply is much more elastic than anyone considers. This current crises started with a lowering of the interest rates (NOT the various businesses that folded in the ensuing cash contraction). It continues to be exacerbated by further lowering of rates and the foolish “stay the course” mantra. It frustrates me to no end the fact that people graduate with economics degrees without a bloody clue as to how the macro economy works; and then they teach economics and advise administrations. If you don’t consider yourself an expert, then you do not suffer the mind numbing indoctrination that students and future professors suffer at the hands of “educated” experts. I have found that an economics education is nearly impossible to put behind you, regardless how ridiculous the curriculum.
Now, push nominal rates up, and you ALWAYS get inflation sufficient to put real rates down. So spin spin spin Keynesians and, oh, well, we really should be looking at real rates… like real rates, a calculation derived from the measured inflation rate is a factor to cause the inflation rate, Frig economics is messed. “the lower that x-y is, the larger y is”, duh.
Lower nominal rates kills supply (doing next t nothing to demand). Money is loaned on nominal rate, and the decision to lend and create money circulation does not consider how such lending may increase inflation and reduce the real value of the return payment.

193

Aristippus: In the US (and other recent) housing bubbles, government agencies and policies actively directed the credit into housing. The fundamental insights of the ABCT - the boom-bust being a result of the effects of unsustainable credit expansion on interest rates - are all there. In a market that was completely free apart from the credit expansion, we would expect the credit to effect higher order goods more than lower order goods. In the specific case of the housing bubble, government policies sought to directly funnel that credit into housing. This credit expansion was not sustained, interest rates rose, and the bubble popped.

If the housing bubble was caused by the government directing credit there, then that fact doesn’t do anything to support the claim that credit expansion in general leads to increased investment in higher order goods or more roundabout methods of production. The government could direct credit to housing in a 100% reserve banking system. The claim by the Marxian I quoted remains unrefuted. Why do you suppose the credit would affect higher order goods more than lower order ones?

194

meambobbo: For the case of the seeds, it makes sense that you can borrow short-term for the initial seed purchase, plant it and pay off the debt using a separate revenue stream before the seed ever produces a marketable product. This doesn’t hold for most actual long-term investments, where there needs to be a continuous stream of costs, not just the initial fixed cost. Consider building a factory. Not only are the natural resource costs spread over time, but labor costs, rent for land, possibly others.

Why would spreading the costs over time matter? If instead of requiring $10,000 up front, it required $1000 each year for 10 years, then I’m still advancing the same amount, which I have from my farm business. In fact, wouldn’t spreading the costs make the loans less necessary, since I could fund the project through the profits from my farm business?

Most business expenses are not financed in one giant loan at a fixed rate but through a credit line that is subject to swings in the interest rate.

Yes, that’s close to what I’m saying. But this of course is not the case with housing loans, which (correct me if I’m wrong) are giant loans at a fixed rate. And if most business expenses are financed by loans, then where do their revenues go?

Even if they were financed by the former, many businesses would not accurately predict and factor in the inflation that the artificially low rates produce, thus requiring more capital than they initially estimate.

This is assuming that the interest rate keeps going down, right? But when you talked about a series of short-term loans, the problem was that the interest rate went up unexpectedly. Shouldn’t we compare the same periods of time? It seems to me if the interest rate went up unexpectedly, then the rate of inflation would go down unexpectedly. So those with long-term loans might require less capital than initially expected.

(I’m not sure of this last part–just trying to think things through.)

195

Why would spreading the costs over time matter? If instead of requiring $10,000 up front, it required $1000 each year for 10 years, then I’m still advancing the same amount, which I have from my farm business. In fact, wouldn’t spreading the costs make the loans less necessary, since I could fund the project through the profits from my farm business?

Right, which is why I don’t think we should focus on the example where all the cost is up-front. We should focus on the main example, which is best described as making a factory. It is possible one has a stream of capital capable of fulfilling the costs over time and would not require a loan. This would actually indicate a balance in time preference, so there would not be any business cycle.

Or it is possible that other people have farms that are earning profits which they save. And they take their profit streams and lend long. Then those who want to build a factory but don’t have the capital can borrow long to do so, requiring the factory’s revenue to pay off the loan.

Both the decision to lend and borrow are determined by the interest rate. At a lower rate, profitable businesses may choose not to lend their profits but to expand their business or speculate on commodities. Entrepreneurs will borrow more to invest.

Yes, that’s close to what I’m saying. But this of course is not the case with housing loans, which (correct me if I’m wrong) are giant loans at a fixed rate. And if most business expenses are financed by loans, then where do their revenues go?

You ignored my point about adjustable-rate mortgages, which exploded in volume during the housing boom and which were the majority of the delinquent loans as the bust came in.

I never said most business expenses are financed by loans. Long-term investments often are, especially when there are low interest rates. Businesses that are making profits can either reinvest their earnings or save cash or lend them. This is also determined by the interest rate and calculated returns on investments and other forecasting.

This is assuming that the interest rate keeps going down, right? But when you talked about a series of short-term loans, the problem was that the interest rate went up unexpectedly. Shouldn’t we compare the same periods of time? It seems to me if the interest rate went up unexpectedly, then the rate of inflation would go down unexpectedly. So those with long-term loans might require less capital than initially expected.

No, the interest rate doesn’t need to keep going down. Even held steady, there would be a business cycle. The reason is that it takes greater and greater volumes of credit expansion to maintain that artificially low interest rate. Let’s assume investment A and investment B are virtually identical, competing for the same group of workers. Let’s say A starts one month ahead of B, and has plans for 5 years of the same steady payroll costs. It borrows $1,000,000 every month to meet these costs. Well, then B comes on the scene. It has to offer more to convince labor to leave A for B. So it borrows $1,005,000. Now A is short labor. It has to borrow $1,010,000 to get the labor back. So then B outbids, etc etc. Notice the loan volume is increasing each time, putting UPWARD pressure on the interest rate. The bank(s) can only maintain the interest rate if more and more individuals increase their savings rates and inject more and more capital into the bank(s) OR if the bank(s) increase the amount of money created out of thin air each time.

Since the workers are maintaining their time preferences as well, rather than saving a greater proportion of their paychecks, consumer prices are increasing, and consumer goods industries are also bidding up labor costs. The only way to arrest inflation is to allow the interest rate to rise to its natural level.

Now to answer your key question: Why does a lower interest rate stimulate long-term investment vs. short-term?

  1. Roundabout processes are assumed to be more productive. This means the same amount of materials or labor can produce more goods or services. IE - given the same amount of labor, a factory can produce the far more of some good as can be made using hand tools. Another way to view this is that roundabout processes have a far lower cost per unit, and thus a much higher profit margin.

Of course, it’s not the roundabout-ness of the process that makes it more productive. It’s obvious that you can add non-productive steps to a production process and it is both more roundabout AND less productive. Just take it as pure coincidence that many goods are more productively produced by more roundabout processes involving higher order capital.

  1. Thus, creating a more roundabout production process often represents a profit opportunity. The economic factor in deciding whether to engage in these investments is largely driven by time preference. If an investment requires $10,000,000 of cost per year and 10 years before ever generating revenue, that means you actually have $172,691,506.20 in debt at a 7.5% at that date vs $143,941,482.15 at 4%.

At 7.5%, the INTEREST alone on that debt may out-strip your annual profit. So it is IMPOSSIBLE to pay it down - the whole investment is insolvent. At 4%, it is possible to pay it down, with the same annual profits. If you started a project at 4% but had to roll the debt over to 7.5%, you may end up insolvent.

Even if the project is solvent at both rates, it will still take exponentially longer to pay off at 7.5% vs. 4%. The principal is larger on the day you start actually paying it down, and the interest rate is higher. This means the interest paid is much larger, and it continues to grow and grow until it is fully paid off. So even if a project is solvent, an entrepreneur may not be willing to wait so long into the future to actually have a net positive asset.

  1. Numerous short-term investment do not equal one long-term investment. For instance, you can’t build half an oil well, put it to work and earn revenue to pay off a short-term loan, then take another short-term loan to build the other half. You need the whole thing to do anything. Similarly you can’t dig a coal mine halfway to the coal, or make a half of a factory.

Such investments also cannot be liquidated when the interest rate rises making the investment unprofitable until very far into the future if at all. This compounds the bust portion of the business cycle.

  1. Short-term investments are generally not to expand the production structure to make it more roundabout. For instance, rather than build a new factory, you might hire a crew for an extra shift or make small alterations to allow more workers to operate on the line without necessarily increase the productivity of each laborer. Because these costs must be paid to make a product before you can earn revenue from your additional output, you must either invest savings/profit to do this, or borrow short-term.

Keep in mind the average profit per unit is actually diminishing by doing this. The cost per unit remains the same, or may even increase. While the supply of the good increases, pushing down its price. So short term expansions may not make much sense, indepedent of where the interest rate is. There is generally more flexibility in the interest rate on whether to pursue such an expansion or not.

…

So in a nutshell, long-term investments increase productivity, creating large profit opportunities, while short-term investments often decrease productivity but increase absolute profit. For long-term investments, the largest factor preventing their undertaking is time preference - we have little doubt there is a large payoff in the long-run but are we willing to forego current consumption for as long as it takes to get there. If so, we would increase savings and push more and more capital into such processes for smaller and smaller returns, represented by the interest rate. Trying to acheive such a rate without increasing individual savings only creates the illusion of the availability of the real resources required to complete the investment.

For short-term investments, the interest rate determines the interest cost of the undertaking, but it likely plays a much smaller role than other factors. In many cases, expansion makes no sense. If profits are already thin, expansion may make the business unprofitable. It wouldn’t make sense to do so even at a 0% interest rate.

196

Both the decision to lend and borrow are determined by the interest rate. At a lower rate, profitable businesses may choose not to lend their profits but to expand their business or speculate on commodities. Entrepreneurs will borrow more to invest.

Makes sense.

You ignored my point about adjustable-rate mortgages, which exploded in volume during the housing boom and which were the majority of the delinquent loans as the bust came in.

Oh, sorry. I guess I didn’t realize the mortgages had adjustable rates. Does this mean that existent borrowers had to pay more as the rate went up?

I never said most business expenses are financed by loans. Long-term investments often are, especially when there are low interest rates.

Know where I could find empirical data on this?

It borrows $1,000,000 every month to meet these costs. Well, then B comes on the scene. It has to offer more to convince labor to leave A for B. So it borrows $1,005,000. Now A is short labor. It has to borrow $1,010,000 to get the labor back. So then B outbids, etc etc. Notice the loan volume is increasing each time, putting UPWARD pressure on the interest rate. The bank(s) can only maintain the interest rate if more and more individuals increase their savings rates and inject more and more capital into the bank(s) OR if the bank(s) increase the amount of money created out of thin air each time.

I think I follow. If there were 100% reserves, then B would have to pay a higher rate of interest than A and thus would be less likely to take the loan? What (eventually) prevents the banks from increasing the money indefinitely?

Roundabout processes are assumed to be more productive. This means the same amount of materials or labor can produce more goods or services. IE - given the same amount of labor, a factory can produce the far more of some good as can be made using hand tools. Another way to view this is that roundabout processes have a far lower cost per unit, and thus a much higher profit margin.

Makes sense, at least with the factory example. Could we say that lower interest rates increase investment in more fixed capital instead of roundaboutness? (I’m think especially of Marx’s definition.)

At 7.5%, the INTEREST alone on that debt may out-strip your annual profit. So it is IMPOSSIBLE to pay it down - the whole investment is insolvent. At 4%, it is possible to pay it down, with the same annual profits. If you started a project at 4% but had to roll the debt over to 7.5%, you may end up insolvent.

Even if the project is solvent at both rates, it will still take exponentially longer to pay off at 7.5% vs. 4%. The principal is larger on the day you start actually paying it down, and the interest rate is higher. This means the interest paid is much larger, and it continues to grow and grow until it is fully paid off. So even if a project is solvent, an entrepreneur may not be willing to wait so long into the future to actually have a net positive asset.

This is assuming the mass of nominal profits for the investment doesn’t increase above expectations, right? If the mass of nominal profits increased enough, that would negate the extra time needed to pay off the loan. Of course that wouldn’t help to pay the interest before the project is completed, and I do mean to say nominal profits would necessarily increase … just trying to include all of the possible counteracting factors.

Short-term investments are generally not to expand the production structure to make it more roundabout. For instance, rather than build a new factory, you might hire a crew for an extra shift or make small alterations to allow more workers to operate on the line without necessarily increase the productivity of each laborer. Because these costs must be paid to make a product before you can earn revenue from your additional output, you must either invest savings/profit to do this, or borrow short-term.

Are there examples of this in the present crisis? You chose factories as your example of increased roundaboutness. Did factories experience an unsustainable boom?

As regards the housing crises, all that you’ve said about roundaboutness would lead me to predict that a housing crisis would develop in the following way. The low interest rate would cause the producers of houses to invest in machines that would make it more efficient to produce houses in the long term. This would be at the expense of hiring more construction workers to build the houses on site. Once the interest rate goes up, the house producers’ investments in the new machines would no longer be profitable. Thus, resources would have to be reallocated, etc.

Do you see why I’m still having trouble connecting the ABCT to the housing crisis? It doesn’t seem to have predicted it in quite the right way.

Thanks a lot for your post though. It was helpful.

197

…and I do mean to say nominal profits would necessarily increase…

Should be “don’t.”

198

Oh, sorry. I guess I didn’t realize the mortgages had adjustable rates. Does this mean that existent borrowers had to pay more as the rate went up?

Yes, in some cases their monthly payment more than doubled. Consider an “interest-only mortgage” (otherwise known as rent) when the interest rate goes from 2% to 5%. The payment could go from $2,000/mo to $5,000.

Know where I could find empirical data on this?

Unfortunately, no. Most statistics lump investment together. The best proxy we may be able to find is the average maturity length of corporate bonds. As the interest rate goes down, we should see corporations issue longer-term bonds, extending the average maturity of their debt. I’d normally be happy to research such but I’m too busy to do so.

I think I follow. If there were 100% reserves, then B would have to pay a higher rate of interest than A and thus would be less likely to take the loan? What (eventually) prevents the banks from increasing the money indefinitely?

Correct - for the banks to attract the capital to lend to businesses, they would have to offer higher interest payments for time deposits, and they would have to charge even higher rates to businesses wanting to borrow. There is another possibility, but it is highly unlikely, which is that a large amount of individuals suddenly change increase their time preference, saving more of their income and lending it to the banks at the banks’ current interest rate.

The second question is actually kind of a laugh. Since we have a fiat currency, and deposit insurance pretty much dismisses the possibility of bank runs, the banks have no real liability they have to meet that they can’t simply create out of thin air. The true limitation upon them is actually government regulations. The capital and reserve requirements are regulations, and if they breach such, they get taken over by the government and shut down. So it is actually a political policy that both allows banks to create money out of thin air, and prevents them from lending “too much” money out of thin air.

Ultimately, government backs this limitation to basically cartelize the banks and preserve their control over money. If each bank could engage in as much FRB as they wanted without limitation, it would be a race to the bottom. There would be massive price inflation, bubbles, etc. and the currency would get destroyed. Then the public would start using an alternative currency, and it would be harded for the government to finance itself.

Makes sense, at least with the factory example. Could we say that lower interest rates increase investment in more fixed capital instead of roundaboutness? (I’m think especially of Marx’s definition.)

Yes, I think I would agree, at least in the modern sense. But think of being stranded on a desert island. You may produce a net to catch fish that is consumed over 2 days. It allows you to catch more fish in a given time period than you could by hand, but it also took a certain amount of time to make that could have been spent catching fish. The net is a more roundabout method of production, but it isn’t permanent - it doesn’t last longer than how we think about an accounting period. But it did require a lower time preference to produce, which would be reflected in an economy that uses money by the interest rate.

I can’t really think of a modern piece of capital that is consumed within a single accounting period that a lower interest rate would stimulate the production of. If it is consumed that fast, it seems like it would also not take very long to produce, thus not requiring a long-term loan to finance. So on the whole, I would definitely agree that lower interest rates increase fixed investment.

Just keep in mind that fixed investment can mean expansion in scale rather than increasing the productivity of a production process. For example, a store expansion is a fixed investment, but that’s not usually going improve the store’s profit margin, only its absolute return.

This is assuming the mass of nominal profits for the investment doesn’t increase above expectations, right? If the mass of nominal profits increased enough, that would negate the extra time needed to pay off the loan. Of course that wouldn’t help to pay the interest before the project is completed, and I do mean to say nominal profits would necessarily increase … just trying to include all of the possible counteracting factors.

That is a good point, and it should indeed be taken into consideration. The crazy thing about price inflation is how unpredictable it is. If anything it adds uncertainty to business forecasting, increasing the risk of any long-term undertaking. A forecasted sale price of the final merchandise may go from a range of $1.05-$1.08 to $1.30-$1.60. In the first range, it just affects how profitable the business is. In the second range, you might be quite profitable or you might be going bankrupt.

Are there examples of this in the present crisis? You chose factories as your example of increased roundaboutness. Did factories experience an unsustainable boom?

You have to think back to everything that goes into building houses all the way to raw materials. I would imagine timber companies wanted to add more tree-cutting and chopping machines/vehicles into their fleet. This requires more refined rubber and steel, etc. They also needed to distribute such, so more 18-wheelers were built, more belts or pallettes or whatever is used to bundle shipped wood was produced. Also, bricks, cement, glass, tar, granite, etc. etc. All of these industries likely added long-term investments to increase the efficiency of how these intermediary goods could be provided to construction companies who actually turn them into a house. It might be additional mines or refineries. If intermediary goods were produced overseas, companies may have produced more ships to transport them across the ocean.

None of these things are at the expense of construction workers. It actually increases their productivity, allowing them to build more houses in the same amount of time for less cost, causing their wages and employement rate to rise. Similarly, the industrial revolution RAISED the real wage rate for workers.

The investment in capital is one aspect of the housing boom and bust. The other is the actual financing of the final product. As mentioned above, banks were putting people in mortgages that couldn’t afford to pay them. Perhaps they believed that if they had to foreclose then they assume possession of the collateral, the house, which still increased in value, so they still make were making a net positive return on their investment. IE - the banks were acting as virtual landlords. They did not anticipate that the rise in houses were temporary, and that when the loans eventually went delinquent they would be stuck with an asset far less valuable than the loan used to pay for it. When this happened the banks were essentially bleeding capital, requiring them to stop lending and/or dramatically increase rates.

ABCT is not the only explanation of the housing boom and bust. I do not believe it directly attempts to explain asset bubbles; however, such as logical behavior when an asset class is rising in price at a greater rate than the interest rate, so much that the risk in the investment seems minimal, which is often caused by massive credit expansion from thin air, which lowers interest rates as it puts upward pressure on asset prices. The process reverses as rates rise and money supply growth diminishes.

There’s the gov’t regulations designed to boost housing. There’s also the implicit guarantees of bailouts and the roles of the GSE’s Fannie and Freddie. All of these things at least help start blowing the bubble. The Fed’s easy credit policy allowed it to reach absurd heights.

The current downturn has very little to do with ABCT. The bust for ABCT is the realization of the business errors that were committed from the mismatch in time preferences and interest rates. The bankrupt investments get liquidated, prices are reestablished and business moves on. There is temporary unemployment as prices adjust and clear profit signals reemerge.

What is actually happening in this bust is that there is extreme regime uncertainty. Potential employers and investors know that the government has a debt it cannot afford and is doing nothing to arrest it, which signals that it will eventually need to dramatically raise taxes, likely on their future profits. They do not know how Obamacare is going to affect their bottom line. They know the government is trying to recreate the housing bubble, but they’ve already seen how that ended and don’t want to end up on the chopping block. They know the current state of the economy is marked by severe gov’t intervention, which is unsustainable in nature and could reverse course after ANY election. So they’re sitting out. That’s why we have a prolonged bust. Just like in the Great Depression, private net investment has dramatically fallen and will not return until there is a business environment that has more certainty of long-term stability.

199

Correct - for the banks to attract the capital to lend to businesses, they would have to offer higher interest payments for time deposits, and they would have to charge even higher rates to businesses wanting to borrow. There is another possibility, but it is highly unlikely, which is that a large amount of individuals suddenly change increase their time preference, saving more of their income and lending it to the banks at the banks’ current interest rate.

OK, so when A borrows $1,000,000, the interest rate goes up. What about C who started before A and is using a series of short-term loans to fund a long-term project? When A starts borrowing money and raising the interest rate, doesn’t that mess up C’s plans–extending the amount of time it will take for C’s business to be profitable?

And if businesses are willing to get into a bidding war over labor, then why wouldn’t they also get into a bidding war over credit? In fact, if they’re borrowing more each month to bid up labor costs, they are already taking on a larger amount in interest, if not a greater percentage, given a constant rate of interest.

The second question is actually kind of a laugh. Since we have a fiat currency, and deposit insurance pretty much dismisses the possibility of bank runs, the banks have no real liability they have to meet that they can’t simply create out of thin air. The true limitation upon them is actually government regulations. The capital and reserve requirements are regulations, and if they breach such, they get taken over by the government and shut down. So it is actually a political policy that both allows banks to create money out of thin air, and prevents them from lending “too much” money out of thin air.

My understanding is that the government doesn’t actually have the ability to limit the amount of money that the banks create. The money ends up back in the system, so the requirements don’t prevent the banks from lending money. In fact, some countries, such as Canada, don’t even have any reserve requirements. So something else must prevent the banks from expanding the money supply indefinitely and keeping the interest rate constant.

Just keep in mind that fixed investment can mean expansion in scale rather than increasing the productivity of a production process. For example, a store expansion is a fixed investment, but that’s not usually going improve the store’s profit margin, only its absolute return.

What about building a second factory? Does the first factory that one builds increase roundaboutness, but the second one doesn’t? It seems like a store expansion could be a candidate for a long-term loan (or series of loans) as well as a factory could be.

That is a good point, and it should indeed be taken into consideration. The crazy thing about price inflation is how unpredictable it is. If anything it adds uncertainty to business forecasting, increasing the risk of any long-term undertaking. A forecasted sale price of the final merchandise may go from a range of $1.05-$1.08 to $1.30-$1.60. In the first range, it just affects how profitable the business is. In the second range, you might be quite profitable or you might be going bankrupt.

Considering the amount of money being added to the economy is proportional to the amount the interest rate is being artificially lowered, it might not be too unreasonable to expect businesses to experience a likewise proportional increase in their nominal profits. On the other hand, this wouldn’t help someone who purchased a home with such a loan, as houses don’t make profits.

You have to think back to everything that goes into building houses all the way to raw materials. I would imagine timber companies wanted to add more tree-cutting and chopping machines/vehicles into their fleet. This requires more refined rubber and steel, etc. They also needed to distribute such, so more 18-wheelers were built, more belts or pallettes or whatever is used to bundle shipped wood was produced. Also, bricks, cement, glass, tar, granite, etc. etc. All of these industries likely added long-term investments to increase the efficiency of how these intermediary goods could be provided to construction companies who actually turn them into a house. It might be additional mines or refineries. If intermediary goods were produced overseas, companies may have produced more ships to transport them across the ocean.

I’m sure a lot of these higher order goods were expanded for the production of houses. However, I think a lot of that could be explained as a result of the increased demand for houses rather than the low interest rates on capital loans.

ABCT is not the only explanation of the housing boom and bust. I do not believe it directly attempts to explain asset bubbles; however, such as logical behavior when an asset class is rising in price at a greater rate than the interest rate, so much that the risk in the investment seems minimal, which is often caused by massive credit expansion from thin air, which lowers interest rates as it puts upward pressure on asset prices. The process reverses as rates rise and money supply growth diminishes.

That’s why I currently find the Financial Instability Hypothesis (FIH) more appealing. It attempts to explain asset bubbles in relation to the interest rate and credit expansion.

200

OK, so when A borrows $1,000,000, the interest rate goes up. What about C who started before A and is using a series of short-term loans to fund a long-term project? When A starts borrowing money and raising the interest rate, doesn’t that mess up C’s plans–extending the amount of time it will take for C’s business to be profitable?

And if businesses are willing to get into a bidding war over labor, then why wouldn’t they also get into a bidding war over credit? In fact, if they’re borrowing more each month to bid up labor costs, they are already taking on a larger amount in interest, if not a greater percentage, given a constant rate of interest.

First, if there is a long-term investment, it’s not going to be a series of short-term loans. It’s going to be a series of long-term loans. Let’s assume your first loan can be paid off the first month your factory goes online and is producing goods, and it affords the first month of labor and materials to build the factory. If that’s 7-10 years away, that’s a long-term loan. Your second loan covers the 2nd month of labor and materials and gets paid off the second month the factory is online. So you have a series of long-term loans with virtually the same maturity. If you simply borrowed everything up front, the loan-term would be longer, and the interest paid on it much greater. You’d be sitting on a pool of cash, slowly spending it down each month. If you were to do that you could put the unused cash right back into rolling CD’s, and the effect would be relatively the same.

Yes, everyone (even C) with long-term investments is going to get hurt by an unexpected rise in the interest rate or in other costs. Both of these typically happen in ABCT, which explains why there is a cluster of business errors. Remember that the business cycle is not simply an inevitable force of nature but defined by why many trained businessmen simultaneously make large-scale business errors and such events repeat cyclically.

As far as a bidding war, again, the investments themselves are not highly liquid. If you don’t produce a finish product, you are likely bankrupt. ABCT predicts that the sooner businessmen recognize their error and abandon the investments and liquidate what they can, the sooner recovery can occur. Some businesses might realize their error and wisely not get involved in a bidding war, either for credit or factors of production. Others may blame the rises in temporary anamolies or seasonal conditions, etc. Some may think that it makes the project potentially less profitable but not unviable.

Also, consider that my example was clearly a hypothetical. In real life, the factor of production in question would not be bid up uniformly and not all of them would move in lockstep. One month labor costs may go up, whereas gasoline might go down. The next month is the opposite. If B or C abandon their investment, A will perhaps see several months of stable or diminished costs, leading him to believe previous rises were similar temporary trends.

Like the stock market, the trends in the long-term only become clear far past the date when action could have been taken to take advantage of gains or avoid losses.

Also keep in mind that as knowledge of ABCT becomes more widespread, the extent of business cycles will diminish as investors take the additional risks (or impossibilities in some cases) into account.

My understanding is that the government doesn’t actually have the ability to limit the amount of money that the banks create. The money ends up back in the system, so the requirements don’t prevent the banks from lending money. In fact, some countries, such as Canada, don’t even have any reserve requirements. So something else must prevent the banks from expanding the money supply indefinitely and keeping the interest rate constant.

Reserve requirements are only one kind of regulation. There are still capital adequacy ratios and leverage to capital ratios that need to be met. In fact, Mish (an economic blogger) was arguing that the Fed’s infusions of cash into the banks would not result in anything resembling hyperinflation partially because it was reserve ratios that prevented them from loaning but capital adequacy ratios.

You show me a banking system that lets freely competitive banks lend fiat currency out of thin air without any form of government regulation, and I’ll show you hyperinflation.

What about building a second factory? Does the first factory that one builds increase roundaboutness, but the second one doesn’t? It seems like a store expansion could be a candidate for a long-term loan (or series of loans) as well as a factory could be.

If it’s the exact same factory then right, it would be no different than a store expansion. It wouldn’t decrease the cost of each unit produced but increase it, because the supply of that good would be higher and price pushed lower. But usually newer factories have newer technologies and production techniques and are more efficient. Or they are not duplicating an existing factory’s output but producing intermediary capital. For instance, let’s say some of the parts in an existing factory naturally wear out relatively quickly without maintenance (1-2 years), so they require stringent maintenance, as reproducing them would be very time-consuming and costly. Well another factory could be made that exclusively produces these parts, with a cost less than current maintenance.

Think about an automobile factory, with all the robots working on the line. The tools used to make those robots may not be very specific to them or efficient. So maybe there’s a profit opportunity in making a factory that produces robots.

So your point is indeed valid in some cases, but in many cases a new factory replaces a less efficient older one, or it adds more steps to the production process, more efficiently making capital goods that makes capital goods…and eventually we’re more efficiently producing consumer goods.

Considering the amount of money being added to the economy is proportional to the amount the interest rate is being artificially lowered, it might not be too unreasonable to expect businesses to experience a likewise proportional increase in their nominal profits. On the other hand, this wouldn’t help someone who purchased a home with such a loan, as houses don’t make profits.

Sure it could - rent the house. If other prices are rising, surely rents are as well. He could increase the yearly rent he collects in step with the rising value of the home.

Again, there are two things to consider. Price inflation increases the uncertainty in business forecasting. This means things become more risky. If an investor may potentially bankrupt himself but knows he can bail out now and take the losses on the chin, he may choose to do so rather than enter riskier waters. Secondly, because the interest rate is higher, the growth rate of the debt is faster. Even if nominal price increases rose in lockstep with the cost increases, the growth rate of the debt is still higher, and thus it will take longer to repay the debt. Imagine a house taking 30 years to pay off versus 60, BUT no one is willing to buy it. You’re 1 year into your mortgage. Do you stop paying it, and start over, or do you stay in debt for the rest of your life?

I’m sure a lot of these higher order goods were expanded for the production of houses. However, I think a lot of that could be explained as a result of the increased demand for houses rather than the low interest rates on capital loans.

Well certainly that’s part of it, but the interest rate corresponds to the time aspect. The higher demand for houses will see more workers move into construction and related industries. We will see more housing materials being supplied, etc. But will we see long-term investments designed to make houses ultimately cheaper to produce? That is the role of the interest rate.

For instance, let’s say a timber company wants to cut down more trees. It can either work existing machinery harder and longer, creating greater need for maintenance, or it can purchase new machinery. The new machinery may take a long time to produce. Or maybe they even decide to create a factory or other dedicated capital to producing such machinery. This would add even more roundaboutness to the production process, and require even more time to produce a marketable product.

That’s why I currently find the Financial Instability Hypothesis (FIH) more appealing. It attempts to explain asset bubbles in relation to the interest rate and credit expansion.

FIH fails to explain why the financial system moves cyclically and why scores of businesses would make business errors all at the same time. It is no different than Keynes’ animal spirits argument.

FIH seems an extension of Keynesianism, which should have been thoroughly discredited by the stagflation of the 70’s, not to mention the countless examples of “stimulus” failing to arrest economic declines. Read Murphy’s critiques of Krugman in the Mises Daily articles. Krugman always says that there wasn’t enough stimulus. But it’s a logical error. Anytime the economy does not recover, Keynesians will say there wasn’t enough stimulus. It is baked into their theory that stimulus will revive the economy. Yet that has never happened. Murphy puts the stimulus numbers into perspective. We’ve spent so much and pushed interest rates so low this time, it’s starting to beg the question - shouldn’t we be analyzing the cost of stimulus? It may just be that “stimulus” is pushing us deeper into recession.

Again, the biggest statistic is private net investment. It has declined and it hasn’t come back. This is despite a huge rise in the savings rate. So what gives? Interest rates are at all time lows. Everything is stimulated, according to the Keynesian playbook. Their only retort is reverse animal spirits. That investors have become fearful fools - where they once invested whimsically and carelessly now they are afraid to make sure bets.

No, a much more plausible explanation is Higgs regime uncertainty explanation. Again, there are numerous possible government regulations/taxes that will potentially make investments unprofitable. From “green” policies to the gov’t’s spiraling debt, Obamacare, and the massive intervention in financial markets, investors are wisely awaiting a more stable long-term environment to invest in.

As for the boom and bust itself, you should read Tom Woods’ Meltdown. It’s a very simple-to-read, yet powerful explanation of all the various forces at play in the housing boom and bust. ABCT plays a part, but Fannie and Freddie, and implicit bailout policies are technically not part of ABCT.

So why housing? As I explained about bubbles, when the interest rate is far lower than the average price increase in some relatively liquid asset, you will get a bubble in that asset. Housing’s price increases started back in the late 90’s when Clinton removed taxes on first home sales and pushing for more aggressive enforcement of the Community Reinvestment Act. Bush continued this trend by making homeownership a national goal. Many of these policies were implemented through the GSE’s Fannie and Freddie, who had implicit gov’t backing, which proved to be correct when they went bankrupt. The big banks took the same risks on the “too big to fail” mentality, and most of them were rewarded for it.

For the few banks that did get burned, their executives still made a bundle in the good times. None have been investigated and convicted of any crime or been found to be derelict to shareholders. We could further the case against gov’t intervention for the big banks. Gov’t tax, lobbying, and regulatory policy (not to mention bailout policy) rewards size, creating an artificial economy of scale. The SEC is incompetent or even supportive of big companies using questionable accounting practices. The credit-rating agencies have perverse business models but they are endorsed by SEC rules. Size, just like in a nation, makes effective control over the business and executives more difficult for each shareholder. This combined with the leniency of the law in the wake of what happened are a moral hazard that encourages executives to behave in an extremely risky manner.