CaptainMurphy. Two questions.
Do you know what the important roll interest plays in time coordination on the market?
Even if business men could anticipate mal-investment by witnessing tampered interest rates, how would they know what interest rates SHOULD(So that they could plan their future expansions on the time schedule most compatible with consumers) be at? And how could they remain competative if they chose not to participate in the easy credit.
You are concentrating on the interest rate effect alone, which is not exactly the primary problem. The primary problem lies with the relative prices.
When the Fed prints new money and lends it to businessmen, the interest rate plunges down (just another example of diminishing marginal utility). Note that the change in the interest rate is only the effect of new money entering the system. The new money then is used by businessmen to bid up the prices of capital goods. So, you see, the relative prices (of capital and consumer goods) change. This higher price paid for capital goods when compared with consumer goods can only continue until new money keeps coming from the Fed. When it stops, the bust follows.
Prash your above response just points to a symptom of the inter-temporal disruption caused by manipulated interest rates. A rise in capital goods pricing(And not just capital goods alone) is a symptom of the problem. It is also a key element which will later explain the crack-up boom but the cause is originally from a inter-temporal imbalance between consumers and producers. Interest rates offer a coordination mechanism for the timing of lateral production expansion.
Obviously when resources become even more scarce, and there are more agents making claims on them the price for those resources and capital goods will be bid up. Perhaps we are just both saying the same thing in a different light.
Consider the following 3 drawings.
Notice they both say good, and the resource pool has remained stable. Prices will have for the most part also remained stable. And now finally back to our issue.
Both present and future consumption have risen. Typically if one rises the other must fall, but since interest rates have been distorted this economic calculation does not occur correctly. Interest provides a calculation feedback mechanism to business’s on when they can expand. It tells them that consumers have begun withdrawing present consumption into savings, offering available resources during the expansion period. Instead, since interest rates have been manipulated business’s are tricked into thinking consumpers have restricted their consumption (Which is what low interest rates usually means, excess savings). What results is a depletion of resources and the costs which get bid up in the process are one of the results.
Eventually as that pool of “generic resources” gets bid up in price the consumption for future and present goods will have to be curtailed to compensate. This will be the bust.
Back to the original post. The question is why can’t entrepreneurs anticipate these changes on the market and prepare themselves accordingly to avoid upcoming business cycles.
The problem with that question is
Hopefully with those two questions left un-answered the original poster will find resolution to his original question.
Prashanth Perumal
First, inflation (low interest rates) doesn’t necessarily lead to exclusive investment in either long term durable goods or capital goods; it could also flow towards consumers. There’s just a propsenity towards investment because the funds usually take the form of producer credits, and because lower interest rates allow for investment in more profitable, longer-term projects. But the nature of finance has changed over the years, and a lot of funds now flow to consumers. But this still arbitrarily alters the structure of production away from actual preferences, which is the ratio of demand between current goods and future goods.
The alteration in the nature of finance is also a direct result of artificially low interest rates. The return on deposits is often below the rate of inflation and individuals chase higher yielding assets in order to protect their wealth (bonds, stocks, commodities) which fuels asset bubbles. Either way, those dot.com and media companies didn’t “just exist on paper.” They drew labor and resources away from other activities.
Next, the economy is not guided by extremely intuitive entrepreneurs. It is guided by the price mechanism and the profit/loss constraint. Good entrepreneurs are able to interpret the price mechanism and act accordingly; but interpreting prices correctly assumes that prices are actually revealing preferences, as opposed to arbitrarily changing because of alterations in the money supply and interest rate. When the price mechanisms are arbitrarily altered, people invest and consume resources that they shouldn’t (insatiable demand). When funds are available to all, you get all sorts of investments which seem ridiculous ex post (or maybe ex ante in some cases). The fact that the dot.com bubble now appears absolutely ridiculous is immaterial.
But you’re oversimplifying the matter at hand. Low interest rates do fool the masses, but the important part is how they fool the masses. It tells actors that there are additional resources available, that is, that time-preferences have fallen. This is not to say that investors go, “oh look, time preferences have fallen, let’s extend the structure of production!” But rather that their ideas (many of which are terrible) are now possible, or so they think. Every shmuck borrows and invests in some “great idea” until the correction reveals to them that they were mistaken. But more than this, the inflation actually changes consumer desires (income and substitution effects) due to the nature of marginal utility (leads to Cantillon effects).
And higher interest rates would tell them that it’s foolish. Kind of hard to flip houses when the interest rate is at 25%.
Immaterial. The question is not why they wanted houses, or what they were going to do with them, but why they were able to invest in real-estate and drag away resources from other economic activities.
You need to read Hayek’s Prices and Production.
filc, the artificial interest rate is the symptom of new money being poured in into capital intensive projects. The interest rate plunges down because the new loans (that are created out of thin air) are used to fund business projects with progressively lesser returns(as supply of a product increases, marginal units of the product go into satisfying demands of progressively lesser importance). Just like any other market mechanism.
And as you must be knowing, lower interest rates can help fund projects which take a lot of time to complete, and still promise profits.
Well, Esuric, glad to see we agree.
hayek is probably way beyond my powers. I’m more a 3 stooges kind of guy. But thx for the suggestion.
What do you mean? Re-read my comment, I edited it.
Prash your saying the same thing only in a different way.
filc, okay!
