I’m reading the chapter about the business cycle from Rothbard’s book For a New Liberty, and I found something that confuses me a little bit.
"Problems surface when the workers begin to spend the new bank money that they have received in the form of higher wages. For the time preferences of the public have not really gotten lower; the public doesn’t want to save more than it has. So the workers set about to consume most of their new income, in short, to reestablish their old consumer/saving proportions. This means that they now redirect spending in the economy back to the consumer goods industries, and that they don’t save and invest enough to buy the newly produced machines, capital [p. 189] equipment, industrial raw materials, etc. […] There seems to be a flaw in the theory, however; for, since workers receive the increased money in the form of higher wages fairly rapidly, and then begin to reassert their desired consumer/investment proportions, how is it that booms go on for years without facing retribution: without having their unsound investments revealed or their errors caused by bank tampering with market signals made evident? In short, why does it take so long for the depression adjustment process to begin its work? The answer is that the booms would indeed be very shortlived (say, a few months) if the bank credit expansion and the subsequent pushing of interest rates below the free-market level were just a one-shot affair. But the crucial point is that the credit expansion is not one shot. It proceeds on and on, never giving the consumers the chance to reestablish their preferred proportions of consumption and saving, never allowing the rise in cost in the capital goods industries to catch up to the inflationary rise in prices. "
My question is this; Exactly how does a low interest rate for a long period of time make the boom longer? If nobody buys the stuff capitalists produce, shouldn’t that mean that the boom necesserily ends sooner? If nobody buys your stuff, how would a lower interest rate help you?
If interest rates are below their market level for a long period of time, then the supply of credit expands for a long period of time. This long-term expansion of credit artificially inflated demand for higher order goods for long periods of time. But after a while, when relative prices begin to adjust in order to reveal true consumer preferences, demand for higher order goods collapses, unless even more credit is injected into the economy.
I think one of us is not understanding the other. My question is how an artificially lowered makes the boom continue, even though nobody buys those higher order goods.
The business cycle as I understand it.
The interest rate is artificially lowered by the banks.
a) The low interest rate makes people save less, and instead they consume more in the present.
b) It also makes businesses borrow more, because it is much cheaper to do so when the interest rate is lower.
Businesses produce high order goods, since people don’t want to spend now. The products they produce cost more than regular commodities, but since the businesses belive that people save money, they don’t consider this a problem.
The people who are employed to produce the products spend the money they earn on consumer goods, just like other people, and not on the higher order goods.
The producers realize that they wasted money on things that people can’t buy, because people didn’t save enough money.
Now, this is what I don’t understand; Somehow, if the interest rate continues to be artificialy low, the boom continues, even though nobody sells anything. But does that really make sense? If nobody buys anything, does cheap money help?
The businesses in trouble substitute the lost revenues for this new credit (created by the artificial lowering of interest rates). This continues until the credit dries up or they go bankrupt.
Think about it in terms of supply and demand. If the government sets interest rates below the market level, it needs to expand the supply of credit. One time credit expansion causes a short boom and bust cycle, as the money injected into the financial system quickly filters through the economy. But if the government permanently lowers the interest rate below the market level, then it continually injects credit into the system.
If you still don’t get what I’m trying to say (I know I’m very poor at communicating) I think I know a longer explanation that would make sense.
I suggest you temporarily take a step back from your #1 through #6 “step by step” approach. You’re trying to match the business cycle into a sequence of events. This can be a confusing way to understand the concept. A better way, IMO, is to make sure you first have a firm grasp of capital formation and the structure of production. The reason is, that it is the structure of production that becomes distorted, or unsustainable, causing the boom and bust. This is in direct response to central bank money printing (lowering the interest rate).
The way the boom is extended is through continued, and accelerating, money printing. But all this does is cause more and more capital to be consumed by a malinvested capital structure. This process can’t be extended indefinately. It’s not overinvestment, it is investment in the wrong lines of production; “malinvestment”. That is a critical distinction to make. This is not merely entreprenuerial errors; it is a cluster of errors simultaneously across mulitple industries in the entire economy. There simply are not enough real resources in the economy to sustain the malinvested capital structure of production AND the consumption. (Housing boom and bust come to mind?)
Your #6, the part you don’t understand, might be addressed by looking at the capital structure instead of the sequence. The following are good examples, in simple terms, of the capital structure and how it becomes distorted.
The Importance of Capital Theory
It’s Mises or Bust - Lilburne specifically mentions the extended boom you are asking about.
If this doesn’t address your question, keep asking.
Herein lies the misunderstanding. Higher order goods does not mean expensive high quality stuff, like exotic coffee instead of the cheap stuff.
Higher order goods is a technical term used in Austrian economics to mean goods that are not made to be consumed, but to produce other goods. And there are levels of this.
A hamburger in McDonalds is a low order good, made to be eaten. The building that houses McDonalds is a higher order good. The bricks that make up the building are higher order still. The brick factory is of higher order still.
Usually, the higher up on the chain we go, the longer it takes to make the thing. A hamburger takes a few minutes. the building a few months, the bricks, errm, well, they are an exception I think. The brick factory takes longer to make than anything else.
So that it will take years before the guy building the brick factory will set up shop and realize nobody wanted the bricks in the first place.
Do you know other books or articles I can read?