Why does the interest rate affect higher and lower order goods disproportionately?

Economics Economics Questions
1

What is it about the higher order goods or higher order stages of production that leads them to be affected relatively more than lower order goods?

One reason I can think of is that a business’ ability to express demand for physical/productive capital is more directly affected by its cost of capital, of which the interest rate is a major component. But this doesn’t hold up for me as there are many different ways a company can fund its capital expenditures and there seems to be no reason why this fact would have a stronger bearing on higher order stages of production than others.

So here I stand. Been pondering for a few days but I can’t seem to remember the reason. It was Hayek in Prices & Production who made this point stick for me but I can’t remember for the life of me what his reasoning behind it was.

2

The answer is basically that the longer term the project is, the more interest-rate sensitive it will be…and the higher you are in the stages of production, by definition, the farther removed you are from end consumption in the production chain. This is largely described here, but just as some extra explanation,

Tom Woods in Meltdown:

The central bank’s lowering of the interest rate therefore creates a
mismatch of market forces. The coordination of production across time
is disrupted. Long-term investments that will bear fruit only in the dis-
tant future are encouraged at a time when the public has shown no letup
in its desire to consume in the present. Consumers have not chosen to
save and release resources for use in the higher stages of production.*

To the contrary, the lower interest rates encourage them to save less and thus
consume more, at a time when investors are also looking to invest more
resources. The economy is being stretched in two directions at once, and
resources are therefore being misallocated into lines that cannot be sus-
tained over the long term.

As the company works towards completing its projects, it: will find
that the resources it needs, such as labor, materials, replacement parts—
called by economists “complementary factors of production”—are not available
in sufficient quantities. The pool of real savings turns out to be
smaller than entrepreneurs anticipated, and thus the complementary fac-
tors of production they need wind up being scarcer than they expected.
The prices for these parts, labor, and other resources will therefore be
higher than entrepreneurs expected, and business costs will rise.

Firms will need to borrow more to finance these unanticipated increases in input
prices. This increased demand for borrowing will raise the interest rate.
Reality now begins to set in: some of these projects cannot be completed.
The economy is not yet wealthy enough to fund them all, although the ar-
tificially low interest rate had misled investors into thinking it was.

——————————————————————————————————

  • What does it mean to say consumers “release” resources for use in the higher-
    order stages of production? Think of your income as your compensation for
    goods and services you have produced or helped produce. The less of that money
    you use to enter the economy and claim goods for your own use and the more
    of it you save, the larger is the pool of real savings from which producers can
    draw.

I highly recommend checking out some of the ABCT resources (in particular, the audio/video section and the related forum threads section for more info.)

3

JJ prettymuch hit the nail on the head.

Although in any specific instance this depends upon the particular expected yields and production structure, generally higher stages of production take longer to yield their fruit and therefore the interest rate will directly affect the longer production structures, those involving higher and higher stages of production the most, or at least most directly, production structures involving fewer, or at least shorter stages being affected only indirectly.

4

Damn, you are the man JJ. Or is it JJs? There has to be more than one writer behind this username. You’re everywhere, all at once, so you gotta be a pseudonym :stuck_out_tongue:

Anyway, thank you very much for the reply. Your first link is exactly what I was looking for. I’ve been trying to fit Austrian capital theory into the capital budgeting math I learned in my most recent finance class and it’s been staring me in the face the whole time. NPV, I actually face palmed at my desk when I read the de Soto quote. de Soto’s text has been sitting on my “to read” list for a while now, guess I’d better finally crack that tome open.

Anybody suggest I read anything else to go along with Huerta de Soto’s book? Or anything else pertaining specifically to capital theory? I’ve Been through Human Action once and a bit, halfway through Prices and Production, read a bunch of Garrison and Murphy and have a commerce degree under my belt.

Thanks again JJs!

5

Yeah, Garrison is probably the foremost Austrian macroeconomist. Check out his Time and Money resources if you can. The one specifically on capital structure doesn’t seem to be available in the Mises.org resources, but is in the store. His short overview of general macroeconomic theorizing (by the same name) is available here (but the writeup there appears to be for the book). I would also check out his lecture/slide resources if you haven’t yet. They’re excellent.

You may also be interested in Theory of Money and Credit and Mises on Money, although they’re obviously less focused on capital theory.

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6

Question: What if higher order goods are produced horizontally, so that production isnt long-term because it is done by different producers who immediately sell it on. Then being further removed from the consumer wouldnt really make a good more interest sensitive.

7

Of course you can find examples of projects in higher order stages that will be shorter-term than others, but there’s really no way to force profits out of e.g. research and development, or expanding mining capacity, or drilling exploration, or planting a logging forest…in the short term. If you can find a way to do that, you’d be a very rich man.

8

I see. For some reason I pictured higher order goods being those that are further removed from the customer because they go into making the product that the customer ends us seeing. For example the plastics that the tires are made of that go into the car. But higher-order goods are those that expand capacity, like new mining operations. (They should have just called it “expanding capacity” or something like that, instead of inventing a new confusing term.)

And nice work collecting those lists.

9

jj are you saying that the rate of interest is indicative of the supply of capital goods? if this is so then shouldnt the interest rate in the year nineteen hundred be muc much lower than in the year eighteen hundred? or are you saying that lowering the interest rate encourages people to consume their savings and that that money consumed could have been used for capital goods?

10

@Jargon

The interest rate directly affects the production of capital goods, due to the fact that the very characteristic of capital is that it takes time to produce it, in order to give a greater future yield. Due to the fact that it takes time to produce it requires money to be taken out of current use, consumption or shorter projects, and invested into longer term production. Therefore if the interest rate is higher it will be more costly to produce capital, and thusly greater future output is not attained, while a lower interest rate makes it less costly to produce capital, and so will experience greater future output.

However, due to technological advancement and what I’ll call “capital plateaus” it becomes possible to produce more capital at any output. For instance let’s say that we’ve produced 20 units of capital, making our economy 5 times larger than it initially was. Now, even if the interest rate rises from what it took to reach this point, the new production structure might justify a continued increase in capital goods, because now we’ve reached a new “plateau”, a new possible production output which allows us to produce more. Therefore through our ability to yield more at any interest rate, the interest rate can change, and a lower interest rate need not be necessary to maintain or even expand the production structure, although a lower interest rate will precipitate a greater expansion in this area.

It’s a little wordy, but does this answer your question?

11

I don’t think that it does. JJ, and Mises as well, say that a big part of the problem with embarking on malinvestments is an insufficient supply of capital goods. He says “The pool of real savings turns out to be smaller than entrepreneurs anticipated, and thus the complementary factors of production they need wind up being scarcer than they expected.” I always thought that the problem with this real smaller pool of savings as opposed to the perceived larger pool (as brought about by credit expansion), was that the savings did not exist to purchase the products of the projects being undertaken by the malinvestors. So my question is this: what is the connection between the savings held in banks and the supply of capital goods? Because JJ is talking about the pre-existing supply of goods not the goods that might come into existence depending on the interest rate.

But you did answer my question in the historical context, on why the interest rate isn’t way lower than it was 100 years ago, so thanks. I dunno maybe I read your answer incorrectly but I don’t think I worded my question well enough.

12

" what is the connection between the savings held in banks and the supply of capital goods? Because JJ is talking about the pre-existing supply of goods not the goods that might come into existence depending on the interest rate."

There is no connection as such, the problem is that there is a money illusion. If the government could, with a flip of a switch change the consumption V. investment ratio to create a interest rate of whatever percentage that they are trying to reach then there would be no business cycle, furthermore if the government could engage upon credit expansion, dictate that projects A-Z would be completed, and then ended its credit expansion, ensuring that no other projects were embarked upon or were being embarked upon at the point where the interest rate rose and prices adjusted, then there would be no business cycle. What happens is that the government injects credit into banks that didn’t exist there before, they haven’t changed the consumption V. investment ratio, they have merely “enlarged” the whole pie in favor of investment, and because money isn’t neutral it takes prices to adjust and for the ratio to fall back to its original state.

What happens then is that firms start behaving as if the rate of interest is whatever the new rate is. This means that they bid up prices of existing capital goods. Now this may lead to scarcity in the higher orders of production, but successful and hopefully wise entrepreneurs will be able to recognize the fact that there will be this bidding war. If the interest rate remained where it was at that point then this would be fine, entrepreneurs would be able to wait, or plan accordingly, until there is a proper capital buildup. This does not happen, however, because the entire savings v. investment ratio is attempting to shift back to its “real” spot.

If credit expansion ended then inflation would occur throughout the entire economy and entrepreneurs would bid the interest rate up to its initial level. For this reason entrepreneurs are going to be continually engaging in projects, and when the interest rate comes back down or when inflation becomes to volatile, the entire house of cards crashes down, and the projects which these entrepreneurs were engaging upon could not be completed because they no longer had the funds necessary to complete the project at the adjusted price level. This is why Rothbard acknowledged that on the free market a “sudden and large change in time preference” would lead to a small crash and period of business difficulty. And, as Mises stated, some malinvestment will always occur so long as men aren’t infallible, but the volatility and false signals given out by significant credit expansion in the investment sphere make large malinvestments much more probable and at least small business cycles almost certain. The connection between the “lack of complementary goods” and the business cycle, is that when the interest rate readjusts the capital structure in existence cannot complete the projects at hand, and so price reflects this, causing many projects partly in development to fail.

So then, to answer your question as concisely as possible: There is no direct relation, it merely leads to expectations about future capital goods which changes the way that entrepreneurs use existing capital and factors of production, but this cannot last indefinitely because, due to the fact that the money is newly created credit, the economy is constantly trying to drift radically away from the current picture of prices and resource availability that the economy is currently using as a map to guide future projects, as it were.

Once again, hope that answers your question.

13

Might one say that the ‘evidence’ of an insufficient supply of capital goods is the relative investment-inactivity before the reduction in interest rates? So the insufficient supply of capital goods is to be understood in relation to the number of projects being initiated under new money?