Stupid question about the business cycle...

Economics Economics Questions
1

Why do Austrian economists state that an investment made by new credit injected into the market by a central bank turn out to be unprofitable? Is this due to a perceived change in consumer spending/saving habits?

I can understand how artificially low interest rates can be bad in regards to artificially inflating the prices of capital goods like houses, vehicles, factories, office space, etc., but I don’t quite understand how it negatively affects businesses overall and not just the housing market, etc.

2

The central bank does not inject new cash into the market. The banks do that, when they lend money. They in turn require injections of cash from the central bank only when their capital ratio or reserve ratio is becoming tight.

Is an investment which is funded by created money necessarily unprofitable? No. If it were, then no country with a modern banking system would be able to fund profitable activities.

Does it increase the likelihood that the investment will be unprofitable? Yes. If a project would have been unprofitable at the undistorted rate of interest, then it is quite likely that it will be unprofitable at the depressed rate of interest. The reason is that a lower rate of interest would normally imply a diminished preference for present consumption versus future consumption, but in the distorted market that is no longer true. On the contrary, lower interest rates will discourage saving and hence increase present consumption at the expense of future consumption. Thus, when the project is complete, the intensified future consumption that it anticipated is lacking. The actual demand for the product is less than the expected demand. The project is a failure.

Many projects will be fine-tuned over time as economic reality sets in. Some investments will be made good. But the probability of malinvestment is increased by credit expansion.

Thus, all businesses are affected, not simply the present value of assets. Their expectations of successful expansion will in many cases prove misplaced.

There is an excellent summary here:

3

The interest rate under a gold standard, for example, would be set by the demand for loanable funds, and the supply of savings. Another term for this would be time preferences (high time preference means you borrow, low time preference you save).

The interest rate on loans determines those projects that can occur. So say the interest rate is 5%. All investment projects with an expected ROI exceeding 5% will occur, while those at, or under the interest rate are not profitable.

When commercial banks create new money by lending out demand deposits (current accounts) they create a fictionally large amount of supply of loanable funds. Effectively, money is created as debt when it is desired. Thus, with the scarcity of loanable funds no longer reflecting real savings within the economy, interest rates will fall.

As interest rates fall, the amount of projects than can be undertaken increases. However, all of these projects are mal-investments, since they are not supported by any real savings within the economy. It’s like draining resources faster than they are coming in. Sooner or later you run out, and that’s when the recession comes in, at which point in time the mal-investments must be liquidated. This however, would have a negative effect on GDP, and thus the government steps in and prevents liquidation, prolonging the recession, and inflating the next boom…

Hope this helps!

P.S. There are no stupid questions!

4

It’s all about The Compound Interest Paradox. You don’t understand why fiat debt-based money is evil until you understand The Compound Interest Paradox.

5

What they said plus all the projects that are undertaken at the artificially low interest rate drive up the price of the inputs to normally profitable businesses causing them to undertake projects or loans that they wouldn’t normally do under free market conditions.

This is how the ‘people who ought to know better’ get caught up in the bubbles…in order to compete they have to play by the rules set by those who skew the field.

6

Good point, I never thought of that for some reason [:S]

7

I’m not really buying the whole money is removed from the economy as the loan is paid off argument.

Care to explain how that works?

8

Maybe this explanation is simpler.

Money is created when a loan is made. Money is destroyed when a loan is repaid. That’s how debt-based money works. I also work some examples. The Compound Interest Paradox (also referred to as “The Debt Virus”) is a KEY concept.

9

Firstly, the evidence is already there. Look at MZM, which is at around 5-6 trillion. Then look at overall debt within America, and it’s over 40 trillion. I’ve got an excel spreadsheet somewhere mapping the rising discrepancy between the two over the last thirty or so years (since the gold link was completely cut off), with recessions creating interesting hiccups that I have yet to explore…

The theory I think goes like this:

I make a demand deposit of $1000 to a bank. Said bank then loans out $900 to someone else. Let’s forget interest for a moment. When that someone else pays the $900 principal back, that money disappears. This is because while he had the loan, there was a total of $1900 in the economy. If the bank did not erase the bookeeping entry, they would now have $1900, and everyone would wonder where the $900 came from. Of course, banks don’t show these conflicting claims to money, they treat demand deposits as time deposits, so when they loan out $900 they show a decrease of $100 in the depositors account.

That’s not to say this money disappears however. As soon as a new request for a loan comes in, the money is created out of thin air once again. This is where interest comes in. The interest we pay back adds to the bank’s reserves, allowing them to loan out more than $900. That interest must also be drawn from somewhere else in the economy, since interest itself is not created by loans, hence the need for new debt to be created faster than it is paid off. We are at a point that if everyone were to pay off their debt today, there would not be enough money.

Does this explain things or am I just rambling?

10

OK, here’s what I’m seeing.

If there were a completely static money supply new wealth would still be created and the ‘extra’ money to pay off the interest would come from deflationary (for lack of a better word) pressures on prices. This phenomena still exists under an inflationary monetary system hence the need for ‘price stability’, basically the whole justification for inflationary policy in the first place ignoring the obvious real reason for inflation.

This theory seems to ignore the price decreases, wealth increases and treat the economy as a zero-sum game.

Assuming that banks are fully capitalized at all times as long as the reserves sit on the Fed’s books that extra money that the banks create is always going to exist somewhere. It may get shifted around but as long as the Fed doesn’t take any reserves out of the system through selling assets someone, somewhere is going to FRB that money to remain fully capitalized.

Now you have the absolute minimum amount of money that can exist in the system, Fed reserves times the money created through FRB.

Lest we not forget the lesson of the day, leverage. Banks leverage their assets to create even more money that is backed by nothing at all, it just exists as a ledger entry in some accountant’s book. Which brings us to one of my favorite pet peeves, the velocity of money. This allows the limited amount of money to support the large amount of phantom money since it changes hands at a high enough rate to give the appearance of a much larger base of support for this inverted pyramid that we have created through magic beans.

If one were to create an evenly rotating economy out of this no money would ever leave or enter the system and all profits would be reduced to simple interest. If you were to add some economic growth prices would fall as the economy grew but still no money would enter or leave the system. If you then added monetary growth at a rate that equaled economic growth everything would stabilize at a ‘price stability’ level as all the ‘money is backed by GDP’ folks claim but money would still not leave the system nor would profits go above simple interest, assuming away the wealth redistribution nature of inflation.

If you were to take into account the wealth redistribution then the consumers’ levels of spending would eventually fall as the money was increasingly concentrated into the hands of the bankers and their big business allies but still no money would ever leave the system. It would also be safe to say that the overall consumer spending level wouldn’t necessarily have to fall but would just get shifted around but that would destroy the even rotation as does inflationary policies.

As a bit of an aside I never realized that an evenly rotating economy is impossible under an inflationary monetary policy…new ammunition to use against the monetarists methinks.

The only way I can see that money would ever leave the system is by the Fed decreasing reserves or for banks to de-leverage their investments and that’s just phantom money, the base is still fully intact. Normal economic activities wouldn’t cause this from what I understand.

But I admit that I’m pretty tired and could be completely wrong.

11

I disagree with this part of your argument. This line of reasoning was never used by Mises.

First, the bank may pay out the interest on the $900 to its shareholders by way of dividends. It will add it permanently to its capital base only if it wants to expand. But let’s assume that it retains at least some of the interest, even if it is only to keep its capital base constant in real terms.

It is not true that the interest on the $900 must be withdrawn from somewhere else in the economy. Money circulates: the same money is used over and over again. It is even possible that the entire loan could be repaid with just $100 in banknotes. For example, if the loan is to be repaid as $100 per month (in principal and interest) in cash by a bank employee, then the bank might pay him the same banknotes back the next payday as part of his wages.

That example, of course, is far fetched. But it is equally fanciful to imagine how everyone might pay off their debt on the same day. The reality lies somewhere between. It is not necessary for the money supply to expand indefinitely so that all debts can be paid. It is true, however, that if credit expansion stops, then a bust sets in, and many debtors who then own negative equity will default.

12

Yeh you’re probably right LanceH, I’m going to have to read what Mises said about this.

And AC, let me think about this and I’ll come back to you later.

13

Why are we exclusively bound to discuss “What Mises wrote about”? He’s dead, so we can’t ask him to clarify. Are we allowed/able to think for ourselves?

You should evaluate the Compound Interest Paradox or “Debt Virus” on its own merits. Even if Mises never wrote about it, that doesn’t affect whether it’s true or false.

14

I think you misunderstand. Rothbard is acceptable too.

15

Thanks for the clarification guys, explained very clearly!

[:)]