Negative Interest Rates

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Since the 2008 financial crisis, the policy of central banks to forcibly push down interest rates, followed by the rapid expansion of their balance sheets in order to attempt to “stimulate” economic growth has, to say the least, been something of an abysmal failure. Unemployment is still high, economic growth barely makes it any higher than a rounding error and real wage rates continue to stagnate as they have done for the past ten years or more. Benefitting only Wall Street, the new money has pushed stock markets to record highs and bond yields to record lows, so much so that owning these assets over the past five years has been the closest one can get to a sure bet. Main Street, however, having had to deal with the reality of the fact that the debt-fuelled consumption mania is no longer sustainable and that real savings to grow businesses are in short supply, continues to languish in what seems like a completely separate realm from the casino operations of the financial markets. With positive interest rates now as low as they can possibly go and with little to show for it, it is no surprise that the prospect of negative interest rates in order to force everyone to spend their way into a recovery is now a real one. Indeed, it is already very much a reality in Switzerland and Denmark.

The proposal for negative interest rates rests on a typical Keynesian plea that the government and central banks did not act “drastically enough” in attempting to defibrillate the economy back to growth. Contrary to understanding the lack of any meaningful recovery as a failure of their policies, they instead turn around and say “if it is this bad now then imagine how terrible it would have been had we done nothing at all!” The patient is therefore prescribed ever greater doses of bad medicine in spite of the fact that it is the medicine that is killing him. (Has it not also been said often that the definition of insanity is to repeat an act continuously with the expectation of a different outcome?) Indeed, the economy is so saturated with debt that only paying people to get deeper into it has any prospect expanding the volume of spending.

Negative interest rates are, of course, a praxeological absurdity and could not come about through anything except government force. It is tantamount to placing a premium on future goods as opposed to present goods, so that the prospect of receiving £100 today is less valuable than receiving £100 in a year’s time. Practically, what this means is that, if you deposit £100 in the bank today with an interest rate of -5%, you will have only £95 in one year’s time. You are, therefore, quite literally paying the bank to borrow your money, a proposition absurd to anyone except a tenured professor of economics. Since when, to invert a popular proverb, has a bird in the bush been worth two in the hand? The idea, of course, is that you will be so keen to avoid the interest charges that you will cease to be an “evil” saver and rush out to spend all of your money as soon as you can. Thus the magical Keynesian multiplier will burst into life, restoring us to the land of milk and honey. What’s more, they hope that it will encourage a flurry of borrowing as all the excess reserves piling up in bank vaults (or, rather, on their computer screens) are now lent out to those eager to be paid to hold cash. Traditionally, of course, banks earn their revenue by paying depositors a lower interest rate than they charge to borrowers. With negative interest rates it seems as though the situation will reverse: the bank will make its money by charging its depositors more than it has to pay its borrowers.

Such a ridiculous idea does, of course, run into the unfortunate fact that every unit of money has to be in someone’s cash balance and if all cash balances attract a negative interest rate there can only be an incentive to borrow if the rate on your deposit account is less than the terms of the loan – in other words, you have to pay less to hold the cash than you get paid for taking out the loan. Further, if someone can only get rid of their cash by passing it onto someone else and that latter person can then only do the same then the logical end of the proposal is hyperinflation. That aside, however, what will be the likely effects of the introduction of such a policy?

The first likelihood is that, with bank deposits now charging an interest levy, holding hard cash under the mattress becomes an attractive alternative. In both inflationary and deflationary environments it will lose less and gain more than a bank deposit. Indeed, at first blush, libertarians should welcome this possibility. After all, it is free deposit banking that has resulted in people willingly stashing all of their cash in fractional reserve banks, enabling them to pyramid loan upon loan on top of them and thus causing the disastrous business cycle. When money consisted of gold or silver stored in full reserve banks it was natural for banks to levy a charge for this storage service. People could either choose to accept the charge in return for the safekeeping of their assets, or prefer to keep the cash in their own storage provisions at no cost. Viewed this way, negative interest rates give the appearance of a return to something more akin to cash handling as it would be in a libertarian world. Unfortunately, of course, the negative interest rate is an arbitrary figure and does not represent the true value of storage services to holders of deposit accounts, and having been accustomed to the provision of such services for free anyway a mass withdrawal will be the most likely response. Indeed, it would not be unsurprising if something akin to Gresham’s Law emerged where, legally, bank deposits and cash notes trade at par but where undervalued cash becomes hoarded and people keep only a minimum amount of overvalued bank deposits with which to use for their exchanges. Such an outcome would, of course, utterly defeat the purpose of negative interest rates which is to swell the volume of spending through electronic exchange. In other words, the point at which negative interest rates begin a flight into cash will mark the true limits of monetary policy in creating a spending splurge.

Needless to say, of course, the likely government response is to restrict cash holding with a view to eliminating cash altogether in order to concentrate as much money as possible in commercial bank deposits. Such an end has, in and of itself, been a cherished aim of government, as it permits oversight of and control over every single financial transaction. Under the guise of “combating terrorism” such restrictions have already been tightened recently in France, where, from September of this year, cash payments in excess of €1000 will be illegal. Similar restrictions have appeared, in the last few years, in Spain, Italy, Russia and Mexico. Where cash remains less restricted, any attempts to convert deposits into cash may be met with refusal and obstinacy, as a Swiss pension fund discovered recently when it attempted to switch its deposits to paper notes stored in a vault. Indeed all of this harkens back to the era when banks overinflated on a monetary base of redeemable gold. Back then, redemption in gold was restricted to concentrate people’s cash holdings in paper notes. Now, redemption in paper notes is restricted to concentrate cash holdings in deposits.

The likely reaction to this is that, with deposits and fixed income securities losing value in both nominal and real terms, people will abandon these assets in pursuit of safer stores of value – probably gold and silver. In other words, shorn of the ability to withdraw hard cash, people will keep on deposit only the amount they need to meet their current expenditures while the rest of their savings will be ploughed into harder assets. A flight out of debt instruments would trigger a deleveraging and usually, in such circumstances, the safe home for such funds would be cash. But if cash will also be subject to a negative interest rate and with no ability to withdraw paper notes, then movement of the money into gold would cause the gold price to rise. We would therefore have the peculiar effect of increasing asset prices during an era of deflation. Such are the ways in which monetary policy can turn the world upside down.

The likely effects of a negative interest policy as outlined here demonstrate the limits of a monetary policy that attempts to kick the economy back into gear through spending. You can print all of the money that you like; you can lower interest rates as far as they will go; you can make it impossible for people to withdraw their cash; but like the proverbial horse to water, you cannot force people to borrow and spend. In short, you cannot cheat the market with increasingly absurd tricks that would have baffled even the monetary charlatans of yesterday. Only liquidation of the existing debt and a return to sound money with interest rates determined by the supply of and demand for saved funds will create a proper, sustainable recovery on the path to prosperity.

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“Austrian” Business Cycle Theory and the Rate of Interest

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In an earlier essay, the present author explained “Austrian” Business Cycle Theory (ABCT) as an analogy to basic price theory, namely the specific law that a price ceiling for a specific good will lead to a shortage of that good. Here we will build on this analogy with an elaboration of what is meant by “the interest rate” with an additional emphasis that stresses the mismatch between the rate of saving and the rate of investing.

The reason for this new elaboration is that ABCT typically concentrates on “the rate of interest”, explaining the business cycle as an effect of “the market rate” of interest falling below “the natural rate”. This has opened “Austrians” up for criticism because any adherence to the pure time preference theory of interest runs into the problem of there being many “natural” rates for different capital goods and so we never know precisely which rate it is that is being undercut by credit expansion1. Moreover we might as well also point out that different borrowers pay a multiplicity of interest rates and that is dependent upon their specific contract so there is no, single “uniform” rate paid by every borrower.

What will be demonstrated here is that, while ABCT’s emphasis on interest rates is valid and is necessary to explain why particularly lengthier, roundabout projects will be engaged in, the most important aspect is that credit expansion simply permits borrowers to access funds for durations that lenders are not willing to lend for and it is this lack of harmony – made clear by our analogy to the results of price fixing – that is the key to unlocking the business cycle.

Robinson Crusoe Economics

In the situation where we have a lone human being (who, for argument’s sake, we shall call John), the fact of scarcity results in the necessity for John to choose which ends he will pursue and which he will discard. There are costs and benefits related to everything he does – such are the logical implications of the action axiom – but exchange of these costs and benefits is unilateral. If John decides to pick apples instead of picking oranges, the benefit he derives from picking apples comes at the cost of picking oranges. He cannot pursue both ends – he therefore exchanges picking oranges for picking apples, albeit unilaterally and in his own mind. This is the nature of basic, simple choices between presently available goods and services.

If John wishes to increase his consumption by investing in capital goods he must also make an exchange, but an exchange of a different nature. At any one moment John will have an array of resources available to him. His basic choice over these resources is whether to consume them now or to invest them to yield consumer goods in the future. It is plainly clear that John cannot do both at the same time – he cannot consume resources and invest them. If he wishes to invest the resources in a capital project that will yield consumer goods in one year’s time then he must be prepared to abstain from the consumption of the resources that he will invest in that project for one year’s time. If the period of investment will be two years then he must be prepared to abstain from consumption for two years, and so on. The precise length of time for which he will abstain from consumption and engage in investment is determined by his relative weighting of the value of time against the value of the quantity of consumer goods yielded – if the quantity of future consumer goods is more valuable to him than the waiting time then he will invest, wait and then enjoy the larger quantity of consumer goods when the investment project reaches its completion; if time is more valuable to him than the additional quantity of future goods then he will not invest but consume the lower available quantity of goods now. The result of such a valuation is summarised simply by the term “time preference”.

Is it possible for John, in his lonely world, to experience the unilateral equivalent of boom and bust? Will he experience a sudden spurt of investment followed by a downturn in his investment activity? The answer is yes, he could, because his capacity to keep on investing is connected solely to his willingness to carry on with the abstinence from consumption of the resources that are required for the investment project to come to fruition. If, half way through his investment project, he changes his mind and his desire for consumption increases so that he must divert resources away from the investment project then he will experience something of a bust – the project must now be liquidated as it has been starved of resources for completion. The viability of the investment project is wholly dependent upon his willingness to abstain from consumption and invest those resources that he could have consumed. The investment therefore turns out to be a malinvestment, unconnected to his consumption/waiting preferences as they are now revealed to be.

Bilateral Exchange

In an economy of more than one person, exchange of a simple good is now bilateral rather than unilateral but it is still based upon the same principles. We make a choice of what to receive in exchange and what to give in exchange. Normally, of course, we give money in exchange rather than a concrete good but we can think of the real cost as being other goods that the money could have bought. If, for example, I only have enough money to buy an apple or an orange and I choose to buy the apple, the cost of me buying the apple is the orange which I could have bought had I not purchased the apple. We can say that I exchanged the orange for the apple, even though the actual physical exchange involved not the orange but, rather, the money that could have been used to purchase it. It is clear, moreover, that I cannot have both the apple and the orange at the same time – or both the apple and the money used to buy it at the same time. I must choose between them because of the eternal condition of scarcity. Only an increase in wealth can alleviate this so that a person is in a position to be able to afford both an apple and an orange.

The market price of a good is the price at which the quantity of the good demanded is equal to the quantity supplied – in other words, it is the price where the number of willing buyers is equal to the number of willing sellers, the level where those who wish to give up in exchange equals the number of those who wish to receive. There is, therefore, not only a harmony of interests at the market price but also the market price regulates the amount of consumption of a certain good that is sustainable by the current level of wealth. Attempts at price controls interfere drastically with this harmony. Artificially lowering the price of, say apples, may, on paper, make it appear as though one now has enough money to buy both an apple and an orange rather than just an apple. The problem, however, is that at the new, sub-market price for apples, the number of willing buyers exceeds the number of willing sellers; the shrunk supply will be bought rapidly by the swollen demand and, therefore, shortages will ensue and there will be no apples left anywhere. This much is standard economic theory. What we can note, however, is that price controls are solely an attempt to allow people to have their cake and eat it – that, whereas at the market price, they could only afford an apple or an orange, the fixed, low price attempts to give them the ability to afford both the apple and the orange at the same time but without any corresponding increase in wealth. On our Robinson Crusoe island we noted that John could not enjoy apples and oranges at the same time because his wealth was insufficient to do this. Any attempt to do so would be at variance with reality and he would end up having to choose between them anyway. Exactly the same law operates in bilateral exchange. Simply trying to forcibly change the prices that emerge in bilateral exchange cannot defy reality and the whole scheme collapses precisely because the objective of providing more and cheaper goods cannot be sustained – you cannot have more of something without increasing wealth. People will find that all of the apples are gone and all that will be left is oranges so they are in the same position as before with only one fruit being available to them, except now without a choice of one or the other. Sustainable trade cannot exist under terms where the suppliers are not willing to offer goods for sale to the demanders.

A further feature of general buying and selling that we might note for our comparison with lending and borrowing that we shall explore in a moment is that every buyer pays the same price as every other buyer and every seller sells for the same price as every other seller. One buyer’s dollars are as good as any other’s and one seller’s good is interchangeable with another’s. In other words, except in cases where there is favouritism or prejudice for the individual personalities, there is insufficient qualitative difference between the different buyers and sellers to make an impact upon price.

Bilateral Investment

On our Robinson Crusoe island we noted that if John wished to increase his consumption in the future he had to abstain from the consumption of resources today in order to use them in investment projects that will yield consumer goods in the future. John’s level of investment was precisely correlated with the amount that he refused to consume and channelled into his project.

In the complex economy, where the abstinence (or saving) on the one hand and the investment on the other is carried out by different people the transaction is effected through the market for lending and borrowing. The market for money loans is actually little different from the sale and purchase of ordinary goods, except that what is being traded and at which prices is a little more difficult to understand. Specifically, what is being traded is not a hard good such as an apple or an orange; rather, it is the purchasing power over resources. A lender, in making a loan to a borrower, transfers his purchasing power over resources today in exchange for the borrower transferring an (at least nominally) higher purchasing power over resources at a point in the future. The market price for these loans – that is, the rate of interest that the borrower pays – is the price at which all willing lenders would be able to lend to all willing borrowers.

There are several key aspects of this market that must be highlighted. First, all loans contracts are for a specific duration which, for argument’s sake, we will say is three years. The lender here must be prepared to sacrifice his purchasing power over resources for three years. During this time, the borrower will use the resources purchased for his investment and will arrange himself to be in a position to transfer back purchasing power in three years’ time. More specifically, what this means is that the lender gives up his power to consume the resources that his purchasing power would afford him and transfers them to a person who wishes to invest them for a three year period that will yield consumer goods at the end of that period, thus earning him an income and the wherewithal to transfer back the purchasing power to the lender. This is the fuel of sustainable growth because the lender relinquishes consumption for exactly the same period as the borrower engages in investment. The basic theory is therefore nothing different from John on the Robinson Crusoe island. Just as John had to abstain from consumption for the duration of his investment project, so too must the lender be prepared to do the same so that the borrower’s project can be completed.

One notable difference of this market when compared to the market for simple, present goods, is that the rate of interest paid by different borrowers will be different rather than uniform for all borrowers. This is because the business of lending money contains an entrepreneurial element. The borrower is making a business decision that his investment will accrue enough income to enable him to pay back the capital and the interest. The lender, wishing to maximise the chance that he will receive his money back, shares this entrepreneurial burden and hence adjusts the rate of interest he charges to different borrowers. The riskiest borrowers – those whose entrepreneurial efforts appear the least likely to succeed – will pay higher rates of interest than the less risky borrowers. There are two possible ways of analysing this. Either we can say that there exists a single market for money loans which, all else being equal, every borrower would pay the same “core” interest rate determined by supply and demand for loanable funds with the difference between the actual rates constituting an entrepreneurial profit and loss element for the lender. Or, we could suggest that the qualitative difference between borrowers creates distinct markets for different categories of lending that attract different rates. In the markets for lending that contain the least risky borrowers the supply of loanable funds will be relatively high so interest charges will be low; in the markets with the most risky borrowers, however, supply will be relatively lower to demand resulting in higher interest charges to these borrowers. We shall use both analyses below although we will conclude with a preference for the latter – that of distinct markets that attract different rates. However, the most important fact that we need to concentrate on is that, whichever analysis we use, all lenders are prepared to fund all borrowers’ enterprises for the duration of their projects under whatever interest rate is agreed and hence these projects can be fully funded to completion.

The fact that the exchange between borrowers and lenders is facilitated by an intermediary – usually a bank – makes little difference to this situation. The bank simply borrows from the lender (or “saver”) at a certain rate and lends to the borrower at a slightly higher rate, the difference between the rates compensating the bank for its efforts in channelling the savings of ordinary people into the profitable projects of borrowers. The key aspect, again, is that there are real funds that can fuel all projects through to their completion under the terms agreed.

Credit Expansion

In order to understand the effects of credit expansion, let us first of all posit the case where a direct lender creates a mismatch with a borrower. Let’s say that a lender is prepared to lend for three years whereas the borrower thinks (erroneously) that he is borrowing for five years. The borrower’s project takes five years to complete and he needs purchasing power over resources for five years as his project will not earn an income to transfer back that purchasing power before five years is up. If, after three years, the lender, wishing to take back his purchasing power for present consumption, calls in the loan the borrower will have a shock. His project is only 3/5ths complete. Only two options are possible. Either the lender must change his priorities and save for the full duration of the investment project; or the borrower must liquidate the investment in order to pay back the lender2. If the latter option is necessary then we have a mini boom-bust between these two individuals; the investment is revealed to be a malinvestment as the borrower was not willing to lend purchasing power over resources for a time sufficient to complete the investment project. In order to create a sustainable investment project the lender must be prepared to advance purchasing power to the borrower for the full duration of the project. If he is not then the project cannot continue.

Now let us examine what happens when an intermediary bank engages in credit expansion and brings about effectively the same thing. The borrower is now a depositor of the bank and the borrower borrows from the bank rather than directly from the lender. Above we cited two possible analyses of the loan market – either there is a “core” rate of interest governed by supply and demand for loanable funds with individual variations in loan contracts representing the entrepreneurial risk that the lender takes; or, there are distinct markets for different types of loan, each of which attracts a different rate. We will use both analyses here.

On the eve of the credit expansion all willing lenders will have lent, through the bank, to all willing borrowers at whatever terms in the individual contracts. The willing lenders will be prepared to lend the funds for exactly the duration of the loans of the willing borrowers. Let us call these fulfilled borrowers Group A. When the bank expands credit, however, it gives the impression to unfulfilled borrowers – let’s call them Group B – that the supply of loanable funds has expanded. Under the first analysis, if the supply of funds expands then the “core” interest rate will reduce as the fresh funds have to find new, willing borrowers as those who were prepared to pay the highest charges have already been loaned to. This brings down the total amount of interest (“core” interest +/- the entrepreneurial charge) that Group B borrowers pay. Before credit expansion a core interest charge of (for example) 10% plus an entrepreneurial element of 5% would have given a Group B borrower a total interest charge of 15%, which may have been too high for him to take out a loan. Now, however, if the effects of credit expansion reduce the “core” interest charge to 5% leaving the entrepreneurial element unchanged then the total rate payable will be 10%, at which rate he may become a willing borrower. Hence the number of willing borrowers begins to expand. Under the second analysis, where there are distinct markets for different loans to different categories of borrower, expanding the volume of credit will expand the number of markets to which funds can be lent. As all of the Group A markets are fully lent to the new funds must seek out new, unfulfilled markets in Group B. This has the effect of bringing down the individual interest rates in these markets. Before credit expansion, the interest rate in these markets was infinitely high as supply in these markets was zero. Now, credit expansion has created supply that moves into these markets and depresses the interest rate to a level at it may reach demand. Hence loans will start to be made in these new markets.

To the present author, the second analysis seems preferential for visualising clearly the reconciliation between ABCT with the multiplicity of interest rates that are paid by borrowers. Indeed, while separating out the “core” rate from the entrepreneurial rate may be easy to conceptualise to a degree3, the idea of lowering rates is less straightforward to perceive when we think of the market as a unified whole. Conceiving them as separate rates in distinct markets which are individually depressed by credit expansion removes this conceptual difficulty4.

Under both analyses however, we can see that increased credit expansion leads to loans at rates that are lower than those that would be paid on the unhampered market. It is important to realise, though, that the contracted interest rates paid by borrowers in Group B – the new borrowers – may actually be higher than the rates paid by Group A. What we may observe is new borrowers in Group B paying what appear to be increasingly higher rates rather than increasingly lower rates. But the crucial point for ABCT is that the rates paid by Group B are lower than those that they would pay on the unhampered market. Such rates do not have to be lower than Groups A’s and thus it is still true to say that, overall, credit expansion has lowered interest rates.

How is it, though, that Group B borrowers, if they may pay higher rates than Group A borrowers, channel these funds into longer, more roundabout investment projects? Wouldn’t the interest rates have to be lower than Group A’s in order to accomplish this? The comparison to Group A’s rate is not relevant, however. It is still the case that extending loans to Group B will cause an overall lengthening of the structure of production as funds that previously were earmarked for consumption will now be channelled into investment5.

However, whatever the duration of a loan and whatever terms on which is it advanced the cardinal fact remains as follows: lenders are not prepared to devote real resources towards the investment projects of the borrowers for the entirety of their duration. Just as in the same way as price controls in our example above tried to give people the ability to have their cake and eat it – afford both one apple and one orange at the same time even though the level of wealth could not sustain these purchases – and just as in the same way that John on the Robinson Crusoe island not consume his resources and invest them at the same time, so too is credit expansion a societal wide attempt to indulge in both consumption and investment simultaneously. The borrower thinks his new money allows him to purchase resources for investment whereas the lender, not having relinquished his purchasing power, thinks that he can still use his original money for consumption. What happens in practice, of course, is that the credit expansion forcibly transfers purchasing power from the lender to the borrower. The increased money supply causes an increase in the prices of capital goods and a relatively weaker increase in the prices of consumer goods. The lender still loses out, therefore, as he must now pay higher prices for the things that he wished to consume – in just the same way as he would lose out from price controls when he sees that the shelves are empty. As the cycle gets underway, higher doses of credit expansion are necessary to maintain purchasing power in the hands of the borrowers as prices rise sharply and inflation premiums begin to be written into loan contracts. Once the inflation gets out of control and the credit expansion is halted or reduced funds are cut off to the borrowers in Group B as they must now rely upon the genuine saving of lenders. But lenders are not prepared to lend real purchasing power under the terms that these borrowers are willing to pay. Thus, starved of resources to complete their projects, Group B borrowers must liquidate their half-finished investments which are now revealed, after the true consumption/saving preference of lenders becomes apparent, to be malinvestments. The bust phase of the cycle therefore sets in.

Conclusion

What we have seen from this analysis, therefore, is that while the “Austrian” claim that “credit” expansion lowers “the interest rate” leading to the business cycle can be elaborated and defended to account for multiple rates paid by multiple borrowers, the primary fact is that lenders are not prepared to lend purchasing power over resources to the borrowers for the duration of their investments. It is this lack of harmony in the use of resources which is the key to understanding the start of the boom and the eventual collapse and this should be the focus of anyone wishing to understand and expound “Austrian” Business Cycle Theory.

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1See, for example, the relatively well known Hayek-Sraffa debate. “Austrian” economist Robert P Murphy has stated that “Austrians”, or at least those who ascribe to the pure time preference theory of interest, are yet to provide a sufficient answer to Sraffa’s objections. Robert P Murphy, Multiple Interest Rates and Austrian Business Cycle Theory, unpublished.

2We are, of course, ignoring the real-world possibility of refinancing.

3Although the length of time may itself be an element that is accounted for in risk.

4It is also the case that, even if all else was equal, there would not be one “core” interest rate in the loan market anyway as different lending periods would also attract different rates. Again, the second analysis overcomes this problem as different time periods would constitute individual markets.

5From a simple cost account point of view, the longer a particular business enterprise takes to come to fruition the harder it becomes to fund interest charges on the borrowing that has funded it. An uncompounded interest charge of 10% on a loan of $1m for a project that will last one year will result in a total repayment of $1.1m, something that might be manageable. If the same loan at the same rate was made for ten years, however, the borrower will to pay twice the capital – $2m – back at the maturity date; a cripplingly high cost for even the most profitable of projects. If the interest rate is reduced to 2%, however, the ten-year borrower would only pay back a total of $1.2m, which would be more manageable.

“Austrian” Business Cycle Theory – An Easy Explanation

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Against the simple and straightforward siren song of “underconsumptionist” and “underspending” theories of boom and bust, “Austrian” business cycle theory (ABCT) can seem contrastingly complex and lacking in communicability. The former types of theory, associated with “mainstream” schools of economics, in spite of their falsehood, are at least advantaged by the veneer of plausibility. A huge glut of business confidence and spending will, it seems, naturally lead to an economic boom, a boom that can only come crashing down if these aspects were to disappear. For what could be worse for economic progress if people just don’t have the nerve do anything? Add in all the usual traits of “greed” and “selfishness” with which people take pride in adorning the characters of bankers and businessmen (again, with demonstrable plausibility) and you have a pretty convincing cover story for why we routinely suffer from the business cycle. ABCT, on the other hand, with its long chains of deductive logic, can seem more impenetrable and confusing. Is there a way in which Austro-Libertarians can overcome this problem?

“Austrian” economics is unique in that all its laws are deduced from a handful of self-evident truths, the most important being the action axiom, often peppered with a few additional assumptions or empirical truths (such as the desire for leisure time). The entire corpus of economic law – right from the isolated individual choosing between simple ends all the way up to complex structures of production, trade and finance – therefore forms a unified and logically consistent whole. This is not true, however, of “mainstream” schools of thought which tend, nowadays, to be splintered and scattered into separate, specialised areas of study that are based upon their own, individual foundations. The fissure between so-called “microeconomics” and “macroeconomics” is a prime case in point; while “Austrians” will read much that is agreeable in “microeconomics” (although it still contains many faults and general misunderstandings resulting from the lack of coherence and soundness that is furnished by deduction from the action axiom), “macroeconomics”, on the other hand, seems to be a completely different ball game, considering only “the economy as a whole” without reference to its individual components1. It is this fact that “Austrians” can use to give them the upper hand when explaining the business cycle. For in ABCT, the explanations of “macro” phenomena are little more than an extension of what is found in “micro” price theory.

The market price for a good is the price at which the quantity demanded equals the quantity supplied. Prices therefore serve to ration goods as a response to their scarcity, the goods available being traded from the hands of the most eager sellers to the most eager buyers. Those buyers who are not willing to pay the market price will go away empty handed and those sellers who are unwilling to sell at the market price will not be able to get rid of their goods. What happens, then, if this relationship is disturbed by a forced fixing of prices by the government? First, if the price is raised above the market price to create a price floor, the new price will attract more sellers into the market for that good because the price that they will receive for a sale is now the price at which they are willing to sell. However, at this heightened price there are fewer people wishing to buy the good. Some, who were not previously prepared to pay the lower, market price, are certainly not going to pay the higher price now. And those who would have paid the market price before may now decide that the new price is too high so they also do not buy. What results, therefore, is an increase in sellers and a decrease in buyers which can lead to only one thing – a surplus of unsold goods. The sellers may be very eager to sell at the new price but they will have a hard time finding anyone to sell to. Secondly, the opposite case, where the price is lowered below the market price (a price ceiling) creates, as one would expect, the opposite effect. This new price will attract more buyers into the market for that good because the price that they will pay for a purchase is now the lower price at which they are willing to buy. However, at this lowered price there are fewer people wishing to sell the good. Again, some, who were not, before, prepared to sell at the market price, are certainly not going to sell at the lower price now and those who would have sold at the market price may now decide that the new price is too low so they also do not sell2. What results, therefore, is a decrease in sellers and an increase in buyers which, clearly, leads only to a shortage of goods. Buyers will swarm into the marketplace eager to purchase the articles at the new, attractive price but, to their dismay, the shelves will be empty, cleared out by all of the more hasty buyers who got there before them3.

It is this latter scenario – that of artificially lowered prices – that is relevant for ABCT. For the business cycle is, according to “Austrians”, little more than price fixing on the widest scale, the fixing and the manipulation of what is possibly the most important price in the economy – the interest rate on the loan market. Rather than being the price at which a single good is traded, the interest rate is the price at which saved funds are borrowed and lent (i.e. demanded and supplied) in the economy.

When the stock of money is fixed, if one person wants to borrow (demand) money then another must have saved it in order to lend (supply) it. The resulting rate of interest is the point at which the quantity of money saved/lent equals the quantity of money borrowed. Any borrowers who want to borrow at a cheaper rate and any sellers who want to lend at a higher rate will find themselves priced out of the market for loanable funds, the sub-marginal buyers unable to borrow any money and the sub-marginal lenders unable to lend any. This situation produces a stable amount of saving, lending, borrowing and investment because the interest rate – the price of saved funds – is in harmony with the preferences of consumers, in particular, their preferences for allocating their funds towards either capital or consumer goods. The portion of his funds that the saver retains for consumption will be spent on consumer goods (i.e., present consumption) whereas the portion that he allocates towards saving and lending for investment will be spent on capital goods that will not provide any immediate consumption but will provide a greater amount of it in the future. At the market rate of interest goods and resources in the economy will be allocated in harmony with these desires. If, for example, a borrower wishes to borrow money to build a factory (a capital good) and his calculations reveal that the prevailing rate of interest is low enough for him to make a return on this enterprise, it means that savers are willing to lend a sufficient quantity of funds in order to make it viable. If, however, the prevailing interest is too high it means that savers are not willing to lend enough funds to build the factory – the money that could be spent on building the factory they would prefer to spend on their own, immediate consumption4.

What happens, then, if the rate of interest is set below the prevailing market rate? Exactly the same as what happens when prices are forcibly lowered for any single good. At this rate borrowers who before found the rate of interest too high for their ventures suddenly find that they can afford to borrow. The quantity of funds demanded, therefore, will rise at this new, low price. Savers, however, will be less willing to lend at this price. Certainly if they weren’t prepared to lend at the previous rate of interest they will not be induced to do so by an even lower rate and some savers who were prepared to lend at the market rate will not be prepared to do so at the new, artificially fixed rate. The increase in borrowers and decrease in sellers, therefore, causes a shortage of saved funds, or at least it should do so. Why, then, does this shortage not materialise immediately at the point that the interest rate is fixed? Why aren’t the banks empty of cash and why can they keep on lending and lending and lending? Why can this situation perpetuate for years and end in a calamitous crash that causes almost unrelenting havoc?

This is where a degree of complexity enters the explanation. What is really being borrowed and lent is not money but, rather, the real goods and resources that they can buy. We said above that if someone wishes to borrow money another person has to have saved it. But what this really means is that the saver has to have worked to produce real goods and resources in order to earn that money. He then lends that money to the borrower and the borrower uses that money to buy those goods that the lender produced and diverts them towards his enterprise. If, of course, saving, lending and borrowing took place with real goods, or if the supply of money was fixed, then obviously a forced lowering of the rate at which these goods could be borrowed would result in their shortage very quickly. But the fact that the saving and lending takes place through the mechanism of an easily expanded paper money supply creates a clever smokescreen. For our entire financial system rests not on the principal of every pound borrowed requiring a pound to be saved, but rather that pounds can be “created” out of thin air by the central bank and lent out even though someone has not saved. By printing fresh money (or its digital equivalent) the volume of borrowing can expand without a corresponding expansion of the volume of saving. This easy ability to produce more money to meet the higher demand for borrowing means that the artificially low interest rate never causes a shortage of money as we would normally expect when the price of any other good is fixed below its market price. A second problem, though, is that the real goods that this new money can buy have not increased in line with the increase of the supply of money, but, rather, have remained constant and there is, therefore, still only the same quantity of goods that have to be allocated towards either consumption or investment. Surely the artificially low interest rate will mean that there will be a shortage of real goods to devote towards investment?

Unfortunately, at the beginning, this is not so. For the newly printed money transfers purchasing power over goods out of the hands of those holding existing money and into the hands of those who have the new money. The result of this is that the borrowers of the new money – those who want to devote the goods purchased to capital investment – now have an advantage over those who wish to devote them to consumption. Let’s say, for example, that I earn £1000 in a given month. This means that I have worked for and created real goods in the economy on which I can spend this £1000. Let’s say that I allocate £750 towards consumption and £250 towards saving and investment. Therefore, what I want to achieve is to consume 75% of the goods on which I can spend the money and save and invest 25%. This £250, the 25% of the goods I wish to devote to saving and lending constitutes supply in the loan market that will help to set the market rate of interest. We can illustrate this allocation accordingly:

Consumption  £750   75%

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Saving          £250   25%

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TOTAL           £1000  100%

If, however, a commercial bank depresses the interest rate and simply prints an extra £500 to meet the new demand at this lower rate, what has happened now? There has been no change, remember, in the quantity of goods – the new money must be still be spent on these goods. The purchasing power of the existing money that I wished to spend on consumption therefore reduces and that of the new money that is to be spent on lending and investment correspondingly increases. All that happens therefore is that the proportion of goods that can be devoted to lending and, hence, to investment has now been forcibly increased from £250 to £750 – and increase from 25% to 50% of the new total stock of money, thus:

Consumption  £750   50%

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Saving          £250   17%

New Money    £500   33%

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TOTAL           £1500  100%

Newly printed money that enters the loan market therefore forces the economy onto a different consumption/investment ratio from that which is desired by consumers. The poor consumer will find that the newly created money has caused the prices of goods to rise; he is forced, therefore, to curtail his consumption in real terms. The goods that he can no longer afford to buy and consume will be purchased by the new borrowers who will devote them towards their capital enterprises. It is for this reason that none of the expected effects of price fixing occur and the economy proceeds along what appears to be a sustainable boom in capital investment. The problem, though, is that capital projects usually take several years to complete and rely on a continuous supply of goods throughout this time. But consumers don’t want to save voluntarily the amount necessary to complete these projects. The interest rate must therefore be constantly kept low and the new money reeling off the printers to meet it if the projects are to continue. It is only down the line when price inflation inevitably begins to accelerate and the central bank forces an increase in the interest rate and a corresponding reduction in growth of the money supply that the problems are revealed. For now the consumption/investment ratio once again begins to reflect the preferences of consumers – they want, if we remember, more consumption and less saving which means that lending and investment has to reduce. Hence half-finished capital projects have to be left incomplete. They have been starved of the resources necessary as they can no longer afford to purchase them at the new rate of interest. This precipitates a collapse in the prices  of capital assets, a collapse that causes widespread bankruptcy and liquidation of firms and enterprises that, hitherto, had seemed sustainable and profitable. Ludwig von Mises describes the perfect analogy:

The whole entrepreneurial class is, as it were, in the position of a master-builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master-builder’s fault was not overinvestment, but an inappropriate employment of the means at his disposal5.

Mises’ last sentence is important. As the prices of capital goods were accelerating upwards during the boom and then suddenly come crashing down, there is a temptation to analyse this as “overinvestment”. While this is true and that “too much” has been devoted to long term investment projects it should be clear from our analysis that the real problem is malinvestment – a diversion of resources from desired consumer goods to capital goods.

Observant readers might say that it is actually the return to the market rate of interest and not the fixed rate that has caused the sudden shortage of capital goods. This would not be a correct interpretation. Artificially lower prices always give the illusion of plenty, of abundance and availability for everyone. It is just that with the fixed price of a particular good the illusion becomes obvious more quickly. But with fixing the rate of interest, because it takes effect through the mechanism of money, the illusion of plenty is obscured and, for a time, looks very sound. For this new money has the very real ability to divert resources away from consumption towards capital investment. Nothing more has been created but it looks like there has. Couple that with price inflation with higher nominal wages and people, at least, think that they are better off than they were before the “miracle” of artificially low interest rates. Real abundance and plenty, however, would not merely divert resources from consumption. Rather, resources for capital investment would exist independently of and in addition to those desired for consumption, as dictated by the desires of consumers.

Conclusion

What we have seen, therefore, is that ABCT sits coherently with the examination of individual price action and is little more than an extension of it. The business cycle is simply a case of price fixing writ large, causing widespread waste, chaos and misery when its effects are finally revealed. There are no separate bases or foundations of this “macro” sphere of economic theory. There are, however, certain special features that make this form of price fixing especially insidious and long-lasting – that of the easy ability to print fresh money to meet the new, low rate of interest, permitting purchasing power to be transferred to new borrowers and, hence, the real diversion of resources. As soon as this situation ceases the smokescreens vanish to reveal the waste and futility of these diversions.

Whenever, therefore, one has difficulty in either understanding or explaining ABCT, think back to what you know about simple price fixing. In fixing the rate of interest, the most important price in the economy, “Austrian” economics, with its strict deductive logic from the action axiom, will tell you that the results will be the same.

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1Murray N Rothbard, Man, Economy, and State with Power and Market, p. 269 (n. 19).

2This isn’t just stinginess on the part of sellers; rather, the cause of their unwillingness to sell will be, in the long run, that they simply cannot – the lower price will usually not be sufficient for them to recoup the costs of production so they have to abandon the particular line altogether.

3These results were seen during the high inflation of the 1970s in the US when price controls led to long queues at gasoline station because the demanded quantity of gasoline could not be supplied at the artificially low price.

4An interesting question is whether the interest rate may strictly be considered a “price”. In the exchange of goods, the price of a good is the quantity of another good that is fetched in exchange. For example, if one apple sells for two oranges, then the “orange” price of an apple is two oranges (and the “apple” price of an orange is 0.5 apples). In the complex economy, of course, every good is exchanged for money so we always reckon prices in terms of the quantity of money received in exchange. However, whatever the other good that is received, it makes no sense to compare the two physically heterogeneous goods in terms of magnitude. For how does one calculate the “difference” between two apples and one orange, or between £2.00 and a bag of oranges? In the exchange of a present good for a future good, which is what happens in the loan market, this is not the case, however. If a borrower agrees with a lender to borrow £100 today and to pay back £110 in one year’s time, strictly the price of one unit of present money is 1.1 units of future money (or the price of 1 unit of future money is approximately 91p of present money). But because the two goods are physically homogenous we can compare the two magnitudes – 1.0 and 1.1 – in order to derive a rate or ratio between them of 10%. We would therefore state that the interest rate per annum in this scenario is 10%. This rate is therefore not strictly a price but an expression of two prices – the price of present money in terms of future money and the price of future money in terms of present money. However, it should be clear that a manipulation of the rate of interest would have the effect of fixing the actual prices of present and future money. If, for example, the interest rate is forcibly lowered to 5% then the price of one unit of present money is now 1.05 units of future money rather than 1.1 units of future money. The resulting effects of price fixing will therefore be felt in this scenario. Hence, it makes sense to speak of the rate of interest as a price just like any other and, indeed, this is how it is treated by acting humans in the loan market.

5Ludwig von Mises, Human Action, p. 557.