According to Austrian Business Cycle Theory, the boom in the capital goods industries generated by artificially low interest rates will end unless interest rates are continually cut further.
Why is this? It seems to me that all of the investment in the capital goods industries for that low interest rate would not be malinvestments unless the interest rate was raised to the free market levels. Why then, do the capital goods industries require rates to be cut further and further?
Because the definition of a malinvestment is an investment that possesses no real yield potential; if one is to then continue production further and further one needs to borrow more and more as the yields will not pay for the investments.
Could you clarify this, please?
Be carefull here. The ABCT does not predict that the boom can be kept going indefinitely by continually lowering the interest rates. Eventually raw material costs for capital goods will be bid up beyond the level at which a profit can be made even at the lower interest rates.
While not all of them would be malinvestments in order to maintain the boom you cannot allow those businesses that are to fail. Artificially low interest rates also help to create an optimism about the economy that perpetuates poor investment decisions so those malinvestments are much more common.
If the interest rates were adjusted by the market, low interest rates mean two things for investors. 1) Money is cheap and because of that it is a good time to expand. 2) People have a higher percentage of capital in banks, causing lower interest rates, giving another indication it is a good time to expand. With more capital available to more people, when the business gets it’s product to market there should be plenty of people with money on hand to buy whatever they are selling. In the case of manipulated interest rates the second one doesn’t have to be (and usually isn’t) true.
If anyone sees anything wrong with the above, please correct me, I’m an engineer by trade, amature economist by hobby.
As I have interpreted ABCT (an interpretation which might be completely wrong), lower interest rates create real booms in the capital goods industries, booms which cannot survive under free market levels. Due to these booms, more is invested during the low interest rates in the capital goods industries. When low interest rates cease, however, the boom in the capital goods industries ends, and those investments in the capital goods sector are revealed as malinvestments, and then are liquidated.
Why, however, does the boom require continual rate cuts; in the words of Rothbard: “Like the repeated doping of a horse, the boom is kept on its way and ahead of its inevitable comeuppance, by repeated doses of the stimulant of bank credit.” It seems to me that those investments are not malinvestments at that low interest rate, but only malinvestments at free market levels.
Also, traditional Misesian ABCT says that consumers will rush out to reestablish their old time preferences; they will spend on consumer goods rather than capital goods. What consumers buy capital goods anyway, though? If they save, it seems that it won’t matter anyway; the credit has already been made available by the government, so the business expansion that fuels the Capital goods industries will occur whether or not people save.
I really want to believe in ABCT, but I’m having difficulties (which are most certainly due to my brain) understanding it fully.
First of all, if you have a checking account, a savings account, a retirement plan, or an insurance policy, your money is invested in the stock and bond markets. You might not be directly investing in these markets, but the bankers and plan administrators who control your money are.
Secondly, even the first investments that are spurred by Fed rate cuts beyond market rates are mal-investments. All investments compete for a limited amount of investment funds. Investors are constantly evaluating the trade-off between risk and return. In the absence of the Fed, they would be able to look to market interest rates for accurate guidance in this respect. Instead, the interest rates on certain investments that are more sensitive to Fed rate cuts than others receive preference. Consequently, other investments that would have been funded in the absence of these rate cuts are not.
I suggest that you take a look at the Fed & Interest Rates thread for a more complete explanation of the following.
If the value of the dollar is falling rapidly investors will try to get their money out of dollar-denominated assets. They will probably spend more on consumption goods and put some of the remaining funds in inflation hedges, such as precious metals. In order to attract these funds back into stocks and bonds, the sellers of these securities must lower the prices, thus increasing yields.
In the case of treasuries, however, the Fed is buying securities, thus raising prices and decreasing yields. When this happens, investors who own treasuries can profit by selling them to the Fed and buying other securities, thus driving up the price and driving down yields of non-treasury securities. Consequently, the Fed is fighting free market forces in an attempt to keep stock and bond prices from falling. Every time the Fed raises treasury prices, the market tends to knock them back down again, so the Fed has to buy up more securities just to stay in place.
Be careful with that sentence. The boom in capital goods must be perpetuated by increasing inflation, but that can be achieved simply by leaving interest rates where they are (below the natural market rate), or increasing them more slowly than the natural market rate is rising.
Please note Rothbard’s use of the word “inevitable”. He doesn’t say you can keep the boom going indefinitely.
To grasp the reason they are malinvestments even at lowered interest rates you must bear in mind that ultimately what we are all competing for is not money or finished goods but raw materials. Naturally low interest rates indicate that consumers are saving - that is they are forgoing the consumption of raw materials. Those raw materials are then available to be reallocated to other lines of production. But when interest rates are artificially lowered the price of raw materials gets bid up by the competition between new producers and old producers. The new producers are usually less profitable than the older existing producers - otherwise they would have been in business at the higher interest rate.
Here is the link to that thread:
Ok. Here’s the reason that the boom requires ever increasing injections of money:
In an economy without monetary inflation, the structure of production is in sync with the time preferences of consumers. The economy is stable, and grows at a rate consistent with the overall time preference.
But when money is injected into the economy, (and interest rates are thereby artificially lowered), projects which once looked unprofitable, particularly those involved in the early stages of the production process or those requiring long time horizons to complete, (think mining, steel making, construction) now look viable because of the low interest rates. Thus a boom ensues, but the boom is particularly concentrated in these early stage industries. This is the malinvestment.
At the same time, lower interest rates discourage saving and encourage increased consumption. Thus in additon to malinvestment we also have overconsumption.
The boom, which consists of malinvestment and overconsumption, draws factors (think labor, natural resources etc) away from the middle stages of the production structure (think manufacturing), and a competition for these factors ensues. The price of factors therefore rises. As they rise, the nascent early stage projects now look less viable, and the malinvestments start to become apparent, even though interest rates are still low. The only way to prevent the liquidation of the malinvestments is to continue the monetary injections, but such injections must be made at an ever increasing rate in order to keep one step ahead of the ever rising factor prices.
There are only two possible outcomes. Keep expanding the money supply at an ever increasing rate (to keep the boom going), which ultimately leads to hyperinflation and destruction of the currency, or, stop expanding the money supply, which leads to depression (the necessary corrective) and the ending of the boom.
For a great graphical explanation of this process see Roger Garrison’s powerpoint presentation at:
Click on the 2006 edition of “Sustainable and Unsustainable Growth”