The question sounds simple, yes. Ceteris paribus, when the supply of loanable funds increases, the interest rates drop (basically because supply increases while demand stays constant).
Now merge this with the Austrian capital theory which says that as savings increases (which conversely means final consumer demand decreases) more roundabout methods of production become more profitable than less roundabout methods of production. Shouldn’t this increase in the prospects of profitable investment in more roundabout methods of production actually cause an increase in the interest rate? I mean, an increase in economy’s savings causes the need for a change in the structure of production giving an opportunity for entrepreneurs to gain profits from the allocational disequilibrium and hence cause their ability to pay higher interest on loans.
PS: I’m taking the Misesian approach of profits being a phenomena of disequilibrium in the allocation of resources.
John, I am not sure if that answers my question. Those two threads talk about the interest rate sensitiveness of projects. Yes, at lower interest rates longer term projects become more feasible. I kind of know that, I guess. For instance, a $10,000 investment that promises $10,302 at the end of three years would be feasible when the interest rate is 1%, but the same investment wouldn’t be possible if the interest rate is 10% unless the return is at least $13,310 at the end of 3 years (note the huge gap in returns required to break-even). So a higher interest rate cuts down a number of less-profitable business projects, more the time it takes to complete those projects.
I hope I’m not missing something else that’s relevant that you wanted to get my attention onto. If I’m looking at something else, please be more specific.
My question has more to do with the Misesian approach towards profits. If I’m not wrong, Mises says profits are about disequilibrium in the allocation of resources in an economy. So if there is a sudden change in consumer preference (like, for instance, when people suddenly become more oriented towards the future, so they value producer goods more than consumer goods; or more roundabout producer goods over less roundabout producer goods), then there would exist a greater disequilibrium, which would mean higher profits for entrepreneurs who take advantage of the “allocational” disequilibrium. If that’s the case, higher savings would mean a greater disequilibrium in allocation, which should lead to higher interest rates.
More roundabout method of production (or more roundabout producer good) = more time it takes to break-even on investments (made on the method of production/producer good). Does that make things clearer?
Profits are not the only that is in equilibrium in the ERE, so if people’s demand schedules suddenly shift, you need to explain what caused this.
I don’t have time to go into depth answering your specific question so let me just give the very high-level view and hopefully you can work out your own answers.
The interest rate is like any other price, it is the price of borrowed funds. The more “borrowable funds” (savings) there are, the lower the interest rate and vice-versa. The higher the demand for borrowable funds (investment demand), the higher the interest rate, and vice-versa. And just like any other price, the interest rate is locked in a circular causation with supply and demand - the higher the interest rate, the more savers will want to save and the less investors will want to invest, and vice-versa.
If we are talking about a fiat money economy, that’s the end of the story (except that central banks are constantly price-fixing the interest rate, thus discoordinating savings and investments). However, in a natural money economy where there is no central bank and, therefore, the interest rate really does coordinate savings and investment, you also have to look at the supply and demand for money (purchasing power of money) and how this is affected and affects the interest rate.
This is standard Austrian terminology and Prashanth is using it correctly. Higher-order goods are defined as goods that require more roundabout methods of production. A consumer good is something that people directly consume. It is the first order good. The second order goods are those which are directly used in the production of consumer goods. The third order goods are those that are used in the production of second-order goods and so on. It is the use of the good which determines its order, not its SKU. For example, an automobile can itself be a consumer good (used to take a pleasant evening drive) or as a higher order good (to deliver pizza). The attributes of the material object itself are not what determine its order.
Not really…I don’t understand why something simply having a longer production process makes it a more “roundabout” good. But I guess the nonsensical nature of the term is irrelevant for this discussion. Clayton pretty much answered your question (as far as I can tell.)
Ok. I think I need to get my question across first. I’ll try to explain it in a better way.
Initial consumer allocation of income towards Consumption and Investment = $20 vs. $80. In this case, it would take four rounds of consumer spending of $20*4 to get $80 worth of returns.
Lets say people now decide to save more, and the C-I matchup becomes $10 vs. £90. In this case, it would take 9 rounds of consumer spending of $10*9 to obtain break even returns of $90.
The return from each round of consumer spending narrows (from $20 to $10), but the production process lengthens (from 4 to 9). Basically, the production process has become more roundbout but narrower. Note: the lengthening and narrowing happens because there won’t be profits unless it happens. That’s what pushes entrepreneurs to take up longer projects. (All this is explained in Hayek’s ''Paradox of Saving", in tables named “scheme A” and “scheme B”)
Now, getting down to the point on profits, Mises says profits are about “allocational” disequilibrium. If entrepreneurs are going to adapt instantaneously to longer production methods in response to higher investment (savings), then there would be no profits at all. But we know that’s not how things happen in the real world. Entrepreneurs who first adapt to the changed fundamentals will gain profits, while others would make lesser profits, or no profits or outright losses (depending on when they adapt to new economic conditions).
So my point is, if profits are mainly about disequilibrium, and interest rates depend on profits (because interest is basically paid out of profits), shouldn’t the disequilibrium caused by higher savings (which requires that the production process adapt to the new fundamentals) actually cause a temporary (is that the crucial word I’ve missed?) increase in interest rates?
If we did not have central banks and we had a free market in banking. Would we have a centralized interest rate? Would not each bank independently set its own interest rate on savings and loans based on the product/service that the bank offers the specific individual?
edit: What I mean is to say is the bank’s then would have to consider all factors, from the supply of its own loanable funds to the availability of loans in the market to the credit worthiness of the individual and other factors.
You’re mixing incompatible methodologies. There are no “rounds” of investment/consumption in the ERE.
Either you or we are completely misunderstanding the other. Why don’t you link to the specific passage you have a question about. In the meantime, take a look at this which explains Hayekian means-ends analysis and the theory of production-possibility frontiers from an Austrian perspective.
I don’t think I had ever heard that term before. On its face it wasn’t obvious to me what was meant by it. I see Shostak (twice) quotes von Strigl using it here and here, but I’m not sure I’d come across it in Austrian text. Probably because I’m behind on my old school scholars. Especially Böhm-Bawerk.
Interest rates and profits are entirely seperate components that do not depend on each other. The entiere question in the OP is based on this false premise. Understand the concept of “originary interest” as Mises called it (or “natural rate of interest” as others call it) and you will answer your own question.
@DD5: I think that entry is incorrect because it does not discuss the market (real) interest rate. I’m not sure if Mises is distinguishing between originary interest and real interest but the fact is that increases in the real interest rate result in increases in investment. Perhaps it’s more accurate to say it’s a ratio of prices but it acts like a price in the sense that it alters people’s calculations.
Investment increases can occur as a result of savings-depletion, consumption-deferral or both. The individual’s propensity to defer consumption is, in fact, affected by what he expects he can enjoy in the future as a result. If I forego eating 2 out of 3 tarts in the expectation that eating the remaining two after dinner will result in greater satisfaction than eating them presently, I am calculating that a better expected future state is worth giving up present consumption. The same is true of investments - if I expect to have a higher total income as a result of deferring present consumption, the amount of that future higher income matters in deciding how much present consumption to defer.
Mises: “People do not save and accumulate capital because there is interest. Interest is neither the impetus to saving nor the reward or the compensation granted for abstaining from immediate consumption. It is the ratio in the mutual valuation of present goods as against future goods.”
I think this is a bit like saying “People do not buy apples because there are prices.” Well, of course not. But when the price of an apple is less than the amount of money I prefer to having than an apple, I am willing to exchange away my money and receive an apple in return. Similarly, when the interest rate exceeds the ratio at which I prefer money now to money later, I am willing to exchange away present money for the larger amount of future money, and vice-versa (for borrowing/investing). This is ignoring the whole issue of risks and how those factor into the investing market, of course.
People do not save and accumulate capital because there is interest but the market interest rate absolutely affects the propensity to invest (whether through savings-depletion or consumption-deferral or both) just like the price of apples affects the propensity to consume apples. In fact, ABCT is built squarely on this fact so I think the Wiki page has a fundamental misunderstanding of what Mises is saying in HA.XIX though I don’t have time right now to try to root cause the problem.
Ah, I found the issue: “The granting of credit is necessarily always an entrepreneurial speculation which can result in failure and the loss of a part or of the total amount lent. Every interest stipulated and paid in loans includes not only originary interest but also entrepreneurial profit.”
When we speak of “interest”, we ordinarily mean “the interest stipulated and paid in loans” which includes both the originary interest Mies describes in HA.XIX as well as the entrepreneurial profit (the profit that incentivized taking the risk of giving a loan in the first place). Mises’s point is that you cannot reduce the “stipulated interest” to originary interest because the latter is an expression of purely psychological factors, like an individual’s preference of oranges to bananas.
There is a market interest rate for loanable funds and this is a major factor in determining the stipulated rate of interest in a particular investment - for a given entrepreneurial risk for project A and a group of savers with a given risk-tolerance, I will sign the loan contract with the saver who has the lowest time-preference, that is, who will agree to the smallest ratio between future and present funds. This is the portion of the stipulated interest rate that has only to do with originary interest and not the entrpeneurial risk component which varies depending on the nature of the specific investment project and also on the risk-tolerance of investors generally.
I’m afraid you have completely misunderstood the Austrian time preference theory of interest rate. The problem is not your lack of “time right now” but that you probably never took the time in the past to really study this stuff in depth. You have it all backwards and your analogy with the price of apples fails for precisely the reason that interest rate is not a price.
@DD5: Yes, I’ve studied it in some depth and Mises is not beyond question - please see Hulsmann’s Mises daily which actually disagrees with Mises on the interaction of interest rates with the money supply.
Prashanth’s question was about interest as generally understood which is not originary interest, it is the interest stipulated and paid on loaned funds in Mises’s terminology. Note that the portion of this rate that is due to originary interest cannot be separated from the whole interest rate itself, so originary interest is a wholly theoretical discussion of the interaction between time preference and consumption-deferral.
This is basically the Keynesian theory of interest rate. Is this news to you? People like Mises, Hayek, and later Hazlitt worked very hard to refute this nonsense and to show why this is exactly backwards, i.e., the “propensity” to invest affects the market rate of interest , or for better words, time preference affects the maket rate of interest. If it was your way (or the Keynesian way), then people would indeed adjust their “propensity to invest” (as you call it) to whatever the new arbitrary rate set by some dictator and you would never really have a problem with malinvestments because the funds would increase (or decrease) accordingly.