So I understand the basic premise of the saving-based interest rate theory, which is very logical. The more savings, the cheaper the price of credit is, since credit comes from savings. It’s basic supply and demand.
Now, I can see how this is a good thing. The cheaper the credit, the easier the investments and the new projects. But then, how come artificially low interest rates cause malinvestment? How come free market low interest rates do not cause malinvestment.
Interest rates are a pretty common topic around here. See for yourself…
You can definitely find the answers you’re looking for in there, but I’ll give you a brief answer and then some specifics.
The brief answer is: “you don’t have the boom/bust if the interest rates are real because if the interest rates are real, then by definition there is no distortion as to the actual amount of available capital.”
For more, check out the links here.
The cheap credit means that people are putting money in the banks and therefore consuming less. When the government prints money, you can have low interest at a time where consumption is high, therefore distorting the market.
So the thing is, when there’s no central bank expanding credit, increasing investment over savings, there’s a natural check on the amount of investment that firms will undertake and also that banks will permit. To try to sustain lending activity due to whatever spontaneous increase in demand for loanable funds which may occur, banks may foreseeably draw down on their reserves at first. This is because no bank wants to be the first bank to jack up the rates, thus driving business to other banks. Eventually though, banks will approach a critical reserve ratio and fear for their solvency and thus be forced to increase the rates. This increase in rates thus tempers the sudden demand for loanable funds which may have occurred.
Hayek concedes such an odd scenario, though it’s not obvious to me that such a synchronized increase in the demand for loanable funds would happen. I think that he answered the concern more to show that market forces would respond to such a concern.
Capitalists calculate their decisions, so in one situation where the interest rate is a certain rate which reflects real savings, total business costs would be too high to justify certain ventures. Consider the next situation, where most of the business costs are the same, but this time the credit is much cheaper, making the venture a net profit.
Now imagine you increase the money supply by a certain sum, expanding credit. This makes the further acquisition of further removed capital goods on the part of capitalists more attractive as it ‘rhymes’ with an increase of savings as we showed above. Those capitalists then use the loans to invest in capital, but because they are all investing at once and the ‘real’ costs (non-credit costs of business) are unaltered by the new credit, the cost of capital goods will rise in accordance to the new purchases. The venture now appears unprofitable, and capitalists will eat the losses, resulting in a slight slowdown … as long as credit expansion was a single instance. If the credit expansion is just an incident capitalists backtrack. But if the credit continues to expand, it allows for the increasing real costs of capital (due to the bidding up of prices initiated by the extra credit, which makes investment greater than savings) to become more or less invisible. This is where people start talking about speculative booms. Capitalists see the rising prices and try to get in, enticed by cheap credit and ignoring the capital costs because “Hey, they’re only going to keep going up.”
Eventually this gets to a point where you can either fundamentally destroy the currency in what Mises termed the crack-up-boom, or the central bank can pull back the credit, whereafter the malinvestments will be revealed.
I hope that answers your question.
It comes down to what economists call the “non neutrality” of money. This means that as new money enters, or exits the economy, that prices will adjust at different times. For instance if I print off a million dollars and then give it to you, and you spend it, do you honestly believe that all prices will immediately start to rise? No, they will rise depending upon what people spend money on first, so for instance if good X is really popular then as the new money circulates throughout the economy more and more people will spend it on good X, so the price of good X will rise first, then other prices will rise, but the fact is that prices will not rise simultaneously. It is also important to point out that this will lead to long term changes in the structure of production, because during the period of new money circulation people will begin to invest in things with the short-run price structure that results with the injection of the new money.
Now there are no “artificially low” interest rates as such, when central banks tamper with interest rates they do so through the injection (or removal) of money in the loan market. This means that the economy then acts as though there are legitimate new savings, and thusly it begins to invest in more capital intensive projects which take a longer period of time. Because money is not neutral, it takes time for the interest rate to adjust back to the market rate of interest, but it will as prices throughout the economy begins to rise. This means that the economy is in an inherently unstable position, because projects being undergone by entrepreneurs are inherently unstable. With a sudden rise in the interest rate capital plummets in value and it’s no longer profitable to perform long term projects.
It’s important to note that it is the suddenness of the entire thing which causes the crash, sudden changes in the production structure will always have more violent effects. Indeed Rothbard, quite rightly, said that a “bust” would happen if there was a sudden natural change in time preferences, and therefore the interest rate. If the interest rate increased slowly then there would be no problem, but as it is a relatively rapid process, it is not.
So to answer your question in short, free market interest rates are stable, but when there is a large injection of credit into the system, this is no longer the case because the interest rate is constantly attempting to rise dramatically to its market rate.
You’re also making something of a mistake in making savings synonymous with investment, which is false. Savings and investment are different things, although arguably investment can only happen as a result of “savings”. A more accurate description of affairs is that investment can only be undergone by abstaining from consuming current goods while at very least maintaining demand for future goods. For instance, if you simply keep your money out of your mattress instead of spending it then this will, in an amazingly small way, lead to a fall in the interest rate because now the amount of money being spent on consumer goods has fallen while those being invested remains the same, thusly the proportion of investment to consumer spending has increased, and a lower interest rate and longer term projects will result.
This video sums it up pretty well:
I stilll don tknow how to put a video on a post =(
I don’t mean to cloud the waters of this thread, but I believe you’ve contradicted yourself. You say there’s no such thing as artifically low interest rates and then say that in response to these low rates, the market acts as though they were legitimate, implying that there is a natural rate and an unnatural rate. Neither Hayek nor Mises depended on a single rate of loanable funds for ABCT to be true, in fact I believe Mises framed it mainly in the context of credit expansion and Hayek, perhaps more usefully, in the context of investment temporarily exceeding savings.
The credit expansion is definitely the source of an artificially low interest rate, as it is through monetary means that investment may exceed savings. Without the central bank to coordinate inflation, investment and savings would tend towards parity in the same respect that the market tend towards equilibrium. But this is not so, as you yourself have said, by talking about the non neutrality of money, as inflation is successfully enacted and coordinated by a central body with control over the currency.
Sorry, I meant to throw in there that it’s a rate determined by the market and not a price control. In this sense it is not artificially low, it’s as low as the market sets it because of the new state of affairs on the market.
Ok I see what you were saying now. The market is determining the rate, but whence is the new data? From the state’s monopolized currency production.
Yeppo.
Let me see if I get this straight.
If the interest rates are low, then that will lead to more capital investment by producers because money is less costly to obtain. On the other hand, if the interest rates are “too” low, consumers may instead save less and spend more because they don’t see a high enough return on their savings.
It’s been my understanding that when the Fed keeps interest rates artifically low, this induces more capital investment because it’s cheaper to obtain, but it is disproportionate. I think Ron Paul uses the term malinvestment. It’s malinvestment because the consumers have not indicated a shift in their preference to spend more.
Is the decision to save or spend more is a function of the interest rate? The interest rate should reflect real market conditions with respect to the actual rate of return on an equal amount of capital investment. For example, if I could make 5% opening a hot dog stand, then I would not loan my money out for less than 5%. Of course, that’s not an absolute, but I think the principle is probably valid. What are the correct savings-consumption-interest rate dynamics?
Because those investments aren’t actually backed by real savings (differed consumption). It’s merely an expansion in the supply of money, which takes the form of credit, and arbitrarily suppresses interest rates. The lower interest rates signal to entrepreneurs that longer-term investments (though not always longer-term) are now feasible and profitable. Unfortunately, the investments begun as a result of these artificially lowered rates cannot be completed on time or at all, because, again, there isn’t a sufficient supply of real resources to actually finish them.
Remember, investment is always a function of real savings (not the supply of money). In other words, printing money (i.e., lowering interest rates) sends out false signals to market actors.
“If the interest rates are low, then that will lead to more capital investment by producers because money is less costly to obtain.”
There’s a few things at work here. First is that the opportunity cost of money goes down. For instance no one will invest in a project where they will receive a return of 3 percent if the interest rate is 5 percent. More importantly, however, is that it is now less expensive to invest in long term projects. For instance if I am investing in a project that’s going to take 5 years, then depending upon the interest rate the amount of money which I owe is going to change dramatically, a mere percent change in the interest rate could make the difference between slight loss and significant profit. This is why in Austrian theory we generally believe that the most interest sensitive areas of production are the “original factors” of production or the factors which are furthest away from the consumer’s good, because those are the factors which go through the longest time to actually make into the final good.
At any rate a lower interest rate will mean that longer productive processes can be performed. If these longer processes can produce a greater quantity then they could theoretically be economically viable, and therefore firms will attempt to produce them. This means that greater physical output will be produced in the long term, and this is why saving, and abstention from further consumption is considered the key to growth.
To think of it holistically, the interest rate tells society how much it wants to save or spend. From a primitive economy/ hunter-gatherer point of view we have to decide whether or not we want to focus on building new spears/ baskets which can increase how much we can hunt, or whether or not we want to merely spend our time focusing on hunting/harvesting as much food as we can. We must decide whether or not to maximize our current output, or increase output in the future, and it is this absolutely crucial fact which the interest rate determines.
“On the other hand, if the interest rates are “too” low, consumers may instead save less and spend more because they don’t see a high enough return on their savings.”
If we assume that there are no changes in the money supply then this is the wrong way round. The interest rate functions in the same way as all prices and ratios do on the market, through supply and demand. The supply curve depends upon how much people are willing to save, the demand curve is the resulting price output of a loan at any one interest rate. Therefore, if there are no changes from the demand side, then there is no way that the interest rate can fall “too low”, without a change in the money relation, so that people will stop investing their money, the only thing which could happen is that people have a change in time preference and decide not to loan out at the same amount as the same quantity.
However, with the injection of new money into the economy the supply of money shifts to the right, so more money is offered at every interest rate, this in turn will cause people to stop saving their money (all else equal) based upon the slope of the supply curve at that interest rate. Thusly real investment decreases, and the further that it turns to consumer spending the worse the resulting crash, but at the same time government investment keeps interest rates lower than they were before, boosting actual investment on an unstable basis.
“It’s been my understanding that when the Fed keeps interest rates artificially low, this induces more capital investment because it’s cheaper to obtain, but it is disproportionate.”
Once again, it’s artificial only in that it’s new money and that ultimately it is unsustainable. The interest rate is a rate which is set by the market and influenced by the government, not the other way around.
“It’s malinvestment because the consumers have not indicated a shift in their preference to spend more.”
This alone wouldn’t make it malinvestment. It is from the perspective of the unaltered market, but from this standard all changes caused by governments are. There’s a reason why booms caused by an increase in money into the system, and not every spending projects by governments are deemed as “malinvestments” by Austrians, what makes it a malinvestment is that it’s ultimately unsustainable.
“Is the decision to save or spend more a function of the interest rate?”
Yes and no. In a world of a perfectly stable price level, no, because it’s entirely time preference which determines the interest rate, the interest rate doesn’t increase or decrease without a change in the supply or demand for money. When there are other factors involved, then yes, because money being injected into the loan market changes the interest rate regardless of the preference of most investors.
“The interest rate should reflect real market conditions with respect to the actual rate of return on an equal amount of capital investment.”
It’s not about return, the demand side for loans, but rather the supply side which matters here.
“What are the correct savings-consumption-interest rate dynamics?”
Have I answered this for you?
It depends. They didn’t respond to any kind of critical reserve ratio during the housing bubble.
If an incidental credit expansion increases asset prices, and lifts bank balance sheets, this will cause a chain of further credit expansions when banks leverage these assets. Even during an incidental expansion, capitalists may not backtrack.
The other question is why speculative bubbles seem to concentrate in specific sectors of the economy, rather than fairly evenly across capital markets as a whole as ABCT would suggest.
In this case, self-fulfilling expectations cause capitalists to continue investing in capital due to price inelasticities in regards to interest rates. What is the inverse of this phenomenon, when contracting credit causes falling capital costs to become more or less invisible? A liquidity trap.
The third possibility is that capital costs accurately correspond to either current or anticipated interest rates, both capital buyers and capital sellers set prices so that capital markets are efficient, and as long as information symmetry holds and agents act rationally, increases in investment are offset by increases in capital prices.