Hi
I have been researching/learning about the Austrian theory of the trade cycle. I have listened to a few lectures and read a few pieces. I understand everything, and I think it makes perfect sense, right up until the time (when discussing the boom caused by an artificially low interest rate) that the lecturer says “which is, of course, unsustainable”.
Why is it unsustainable - it’s not obvious to me.
Thanks
Fred
i recommend http://mises.org/daily/3220 and scroll down the page till you hit the section, Mises example of the Master Builder.
Thanks very much. That is a good analogy. However, I still don’t quite understand. What is the real economy equivalent of not enough bricks? Is it not enough money? I don’t think so, because there’s plenty of money. I think it means that there is not enough capital goods, but why don’t the people just use all that extra money to produce the capital goods they need when they realise there isn’t enough - or to go back to the analogy, so the builder discovers there aren’t enough bricks, why doesn’t he just use all that easy money/cheap credit to buy (or make) some more bricks?
What is it that causes us to suddenly find out that there aren’t enough bricks? It can’t be people’s realisation that govt monetary policy has been perpetuating a fraud on them - they still don’t understand that now. It’s one thing to say that there isn’t enough bricks (and putting aside the fact that I don’t exactly understand what that equates to in the real economy) as long as the money is flowing into my pockets, I don’t care that there isn’t enough bricks - I probably don’t even know.
Are you able to shed any light on these questions?
Thanks again.
The real world economy equivalent of “not enough bricks” is “lack of real savings”.
Basically the low interest rates and associated monetary expansion sent out the wrong signals to investors and consumers. Low interest rates told entrepreneurs “Go! Build! Invest! Savings are plentiful!”. Those extra pieces of paper maqueraded as real savings so consumers went out and spent spent spent.
Roger Garrison has some excellent powerpoints on this. He shows in pictures what happens in a boom and why it turns to bust:
OK - thanks. But why it is unsustainable - as long as lose monetary policy keeps pumping money into the system, why can’t it go on forever?
You might find the following (my own blog - not from any of the great Austrian economists) helps explain the unsustainability - this is my own take on things and it concerns the fact that interest rates are a price:
https://forum.freecapitalists.org/blogs/jimmy/archive/2008/10/07/socialism-and-central-banking.aspx
Here’s a little snippet to give you an idea:
What’s difficult to grasp here is that savings are not just abstract dollar notes. When I save, I am implicitly producing something of value (e.g. I bake some bread) and providing it to the economy whilst simultaneously not consuming anything (I don’t take anything back from the economy). As the baker, I might save a couple of hundred dollars a week. What I’m actually saving though is not dollars, but loaves of bread - I’m creating a surplus of a few thousand loaves of bread in the economy which have been created, but not consumed, and are available to be “invested” by a borrower who can eat that bread for a while, during which he will not be baking any bread (e.g. while he’s building a garage in his back yard). All around the economy there are millions of people in all walks of life that are saving in this manner. Some of them are saving flour, some are saving metal, some are saving wooden planks - yet others are saving accounting services and computer programming services and yet others again are saving health insurance or health care. All of these things are very real physical resources - resources that will be required by investors that need to “borrow” from the economy to start new companies or buy tractors for their farms etc. and the interest rates that savers negotiate with borrowers is the “price” of savings.
Jimmy
The Boom is typically more investments in expensive capital goods or producers goods that require more capital investment. The entrepreneur invests more capital in these things because they believe consumers are holding off on consumption (they’re saving more) so they can accumulate more wealth to consume later. The investor will have new & more products available for future consumption for that new accumulated wealth.
The boom induced by expansion of credit is unsustainable for two reasons:
People’s preference for future goods -vs- present goods have not changed if savings rate have not changed. They want to consume now. Investors taking capital in the form of credit expansion (created money) are trying to invest & create expensive future products using the commodities that the savers are supposedly not consuming - because they’re foregoing consumption. Walmart starts to lay people off while factories begin to hire. But if consumers don’t save more this won’t happen. Instead, new investment in capital goods and producers goods (higher orders of production) have to compete with producers of consumer goods (which people haven’t stopped buying) for capital and commodities and labor, causing commodity prices & wages to get get bid up - new investments will in the end turn less profits. As a result, when the eventual future day comes that the new lines of production turn out goods they realize that consumers have no accumulated savings / wealth to afford these goods.
A credit induced boom relies in accellerating inflation of prices of sales compared to expenses and therefore exponentially growing money supply. Companies that are barely turning a profit suddenly appear to be making good profit because future prices have become higher than expected. Companies that were previously turning a profit now bring in even more profits. This is because prices are rising due to inflation (expanded money supply, not healthy demand). When businesses can predict what the future inflated price will be (say 5% higher next year) then that will immediately drive the price up today because buyers of these products buy today at the lowest expected price. This buying now will immediately drive up prices and flatten them out, meaning there won’t be future profits. Costs rise with sales and no more profits are made. The Central bank that expands money supply have to be one step ahead of the bunch trying to predict future inflation and prices. They have to keep turning up the rate which the printing press dishes out money to keep inflation rising more rapidly. Inflation rate first year = 3%, 2nd year 5%, 3rd year 7%, and so on until you either get hyper-inflation or the banks become unstable and go broke. To prevent both these disasters the central bank has to eventually crank up the interest rate when people start to loose faith in the value of money. The higher rate reduces inflation and wipes out any profits these originally barely-break-even companies had. They go bankrupt.
Also, when credit is expanded and you get inflation the rising prices distorts the cost / price structure in the economy. Wherever the new money flows first (say gov’t gives GM $20 Billion of new money, the cost of steel & autoparts become inflated) is where the prices rise first. And those prices in those areas are the ones that have to keep rising above the rest for the inflationary boom to work. This distorts the structure of prices in the economy and therefore businesses structure themselves to profit around this distortion. When the bust occurs all those companies that focused on profiting from the boom will all have to bust as well.
Yes, and no. In the master builder analogy, the bricks are not the money, but what the money will buy. Because there is price inflation, the money buys less than planners expect (the cost of bricks rise as the project moves forward). This is not necessarily a problem, as the builder can just go borrow more money. As the price inflation can be explained by the monetary inflation, the builder should accordingly expect that his final product receives a higher price than he originally planned. Thus, it is still profitable.
The real problem is that the increase in loanable funds (used to drive down interest rates) did not come from a reduction in consumption. Lowering the interest rate artificially actually promotes less real saving, as marginal loaners decide instead to spend their money on consumer goods (or speculative assets). Because the interest rate is artificial, it is impossible to identify how much marginal real savings are instead spent. While we can follow changes in monetary aggregates to the number, we can only speculate the degree to which they will change individual economic behavior.
There can only be a few outcomes of this, all of which are economical disastrous. Price inflation drives savers to speculative investments, starting bubbles. It won’t be long before the rate of return on such assets exceeds the rate to borrow money from the banking system and the bubbles flare up exponentially. Subsequently, demand for credit skyrockets. The government/banks must create greater and greater amounts of new money to hold down interest rates, but thereby exacerbate the problem. The money is being abandoned as any form of savings. Note that money is always being saved, only by alternating individuals. By destroying the ability of money to retain predictable purchasing power, you create hyperinflation, where there is effectively no efficiency in using money as opposed to barter.
The other outcome is massive defaults should interest rates be allowed to rise (by halting the printing presses/credit expansion). The initial investors may have insufficient borrowings to finish their project, but find the cost of borrowing to complete their project too high. They can either liquidate what they already produced at a loss, or finish the project at a loss. Either way, there will be more defaults on loans (further pushing up interest rates by diminishing expected loanable funds). Businesses serving consumers directly will also feel the hit. Many will also use credit to expand during the boom. However, that expansion was only justified when an artificially low interest rate drove savers toward consumption. Such businesses will default. Finally, speculative bubbles will burst. If the boom went on long enough for borrowing to be used to fund speculative purchases, such borrowers will almost uncertainly default.