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Source link: http://archive.mises.org/7538/manipulating-the-interest-rate-a-recipe-for-disaster/

Manipulating the Interest Rate: a Recipe for Disaster

December 13, 2007 by

The turmoil in the US subprime mortgage market has developed into an international credit crisis. It is eroding investor confidence in credit and credit-related products and, most important, raising concerns about the solidity of the banking sector, as evidenced by banks’ elevated funding terms and diminished stock prices.

As a direct response to the credit crisis, the US Federal Reserve Bank first paired the Federal Funds Target Rate twice — by 50bp on September 18, another 25bp on October 31, and another 25bp on December 11 — bringing the official rate to 4.25%. The lowering of borrowing costs came despite the fact that the FOMC had been stressing “inflation risks” since early 2006.

The cause of the international credit crisis has a name: the government-controlled paper-money regime.The turmoil in the US subprime mortgage market has developed into an international credit crisis. It is eroding investor confidence in credit and credit-related products and, most important, raising concerns about the solidity of the banking sector, as evidenced by banks’ elevated funding terms and diminished stock prices.

As a direct response to the credit crisis, the US Federal Reserve Bank first paired the Federal Funds Target Rate twice — by 50bp on September 18 and another 25bp on October 31 — bringing the official rate to 4.5%. The lowering of borrowing costs came despite the fact that the FOMC had been stressing “inflation risks” since early 2006. Then it dropped rates again in December.

The cause of the international credit crisis has a name: the government-controlled paper-money regime. This is the diagnosis when taking on board the theoretical insights provided by the monetary theory of the trade cycle (MTTC) as developed by Ludwig von Mises, one of the leading scholars of the Austrian School of economics. FULL ARTICLE

{ 53 comments }

Kent December 13, 2007 at 11:44 am

you say “the government-controlled paper-money regime.” The reality is its a private money scheme from a private “Federal” reserve, an all powerful cartel with a huge conflict of interest with the people of the US.

Michael A. Clem December 13, 2007 at 11:50 am

The private Federal Reserve is a government-granted monopoly, so it’s still under government-control.

Jim Berger December 13, 2007 at 2:55 pm

In addition, in the USA, all banks with checkable deposits must have a charter granted by the federal or a state government. Make no mistake about who controls the money monopoly.

Anthony December 13, 2007 at 3:01 pm

It isn’t private. It is a government controlled organization (really, I had no idea that Bernanke was a privately hired individual), at most nominally ‘private’. What the government cannot directly control it seeks to regulate.

Stéphane December 13, 2007 at 3:06 pm

@ Kent :
The governance of the Fed really makes it a government-controlled agency and not a private bank. Of course it still has some “independance” as does any government agency. Government agencies do not share a single brain ;-)

About the post, I wonder what happens to the natural interest rate during the cycle. If we look at the current situation, people have been consuming like mad because their net asset value was skyrocketing. As a result, there was a negative saving during the last years. With the real estate bust, there could be a reversal of this process. Does this mean that the natural interest rate is going up or down?

Dan December 13, 2007 at 6:01 pm

Stephane:
Natural rate of interest is defined for an unhampered economy. You could not observe it in interventionist environment, so how much might have changed is nonsense and pure speculation.

Alex MacMillan December 13, 2007 at 7:46 pm

Can anyone express what factors determine the downward sloping investment curve in the diagrams illustrated, and hence can someone explain what might cause a shift in this curve.

Robert December 14, 2007 at 2:32 am

The Austrian theory of the business cycle happens to be incorrect.

BBB December 14, 2007 at 3:25 am

Can you download that paper (Some Capital-Theoretic Fallacies of Austrian Economics)?

Curt Howland December 14, 2007 at 6:52 am

http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1024311_code457402.pdf?abstractid=1024311&mirid=1

I was able to get it using the above link. Hopefully the link will come through, if not I will repost.

Fundamentalist December 14, 2007 at 8:37 am

Alex: “Can anyone express what factors determine the downward sloping investment curve in the diagrams illustrated, and hence can someone explain what might cause a shift in this curve.”

The curve slopes downward because as the interest rate falls, investment increases. The whole curve could shift because of institutional changes (such as greater regulation or loss of property rights) and changes in technology which create greater or lesser demand for loanable funds.

Alex December 14, 2007 at 8:39 am

I have asked a question of several Austrians, Gene Callahan and others, namely what factors cause the downward slope of the investment curve in diagrams, such as are illustrated in Polleit’s article, and no one has ever given me an answer. I understand the mainstream economics’ factors, but what are the Austrian factors?

Perhaps, if Polleit is glancing at this blog he might enlighten me. Or someone else?

Stephane December 14, 2007 at 9:39 am

Alex,

I recently read the corresponding chapter in Man, Economy & State and found it crystal clear (see ch.6). In short, the S & I curves are just a way of representing graphically the preference tables of numerous individuals. Here is a nice quote :

“Perhaps more fallacies have been committed in discussions concerning the interest rate than in the treatment of any other aspect of economics. It took a long while for the crucial importance of time preference in the determination of the pure rate of interest to be realized in economics; it took even longer for economists to realize that time preference is the only determining factor. Reluctance to accept a monistic causal interpretation has
plagued economics to this day.”

rtr December 14, 2007 at 9:51 am

Robert: “The Austrian theory of the business cycle happens to be incorrect.”

The ABCT is indeed false. But it’s false because *every* economic school’s “monetary theory” is false. They’re also extremely way off on the origination of credit and its effects. Nor are interest rates merely determined by “time preference”, but the supply and demand for savings, investment, and capital.

No exchange whatsoever occurs unless that which is received is valued more than that which is given away in exchange. It doesn’t matter what the goods are (and money is just another good, the most commonly traded good), and it doesn’t matter how the supply or demand of any good changes. Relative individual subjective valuation is still signaled and communicated perfectly from free trade. As there is no such thing as a “mal-trade”, there can be no such thing as a “mal-investment”.

What actually happens when money is manipulated is hesitation of trade caused by a degree of recognition that fiat paper has no supply limit, and in the absence of government force would quickly approach being worthless for exchange. People are less willing to exchange all other goods and services for money. And because every trade whatsoever increases subjective wealth for both parties, the river of wealth production slows to a relative trickle when people are less willing to accept money as a store of value. Just look as houses sit on the market for extended periods of time without trade occurring. This results in a recession. But if you throw protectionist world trade barriers into the mix as they did in the 1930s you get a Great Depression as wealth generating free trade is actively suppressed.

Contracts are compulsion compelling exchange of goods at terms that are no longer voluntarily forthcoming. Contractual compulsion is the *main* reason that subjectively valued credit can spiral out of control. And of course, M3 credit absolutely *dwarfs* even the Federal Reserve currency printing spigot, which leads to higher bubble prices. And there’s nothing that can prevent credit promises from having positive subjective value if contract is permissible and backed by government fiat force. If there’s no guarantee a lender can collect their loan, such as collateral title being transferred, there’s no reason to make that loan in the first place. But with government enforced contract there’s no free market limit to what the positive subjective value of credit promises can ascend to and be used to trade for other goods. So people would save a lot more first in the absence of contract. Real interest rates would likely be *negative* as money remained relatively stable and an excess of savings supply in the face of ever expanding production (people are always better off with more than less, action aims at a state of lesser dissatisfaction from a state of greater dissatisfaction) pushed monetary prices lower. The subjective value of money and credit can vary widely when it is being actively manipulated by violent force, and not corresponding all along to actual free market valuation conditions.

Thorsten Polleit: “Assume banks increase the supply of loans and money. The interest rate in the money market declines. Businesses make use of the artificially lowered interest rate. They invest in new equipment, hire additional staff, buy new raw materials, and build up inventories. They expand the production of investment goods relative to consumer goods. In fact, firms act as if savings had genuinely increased.”

That is a naive picture. What actually happens is those who first receive the newly printed money are better off exchanging that newly printed money for absolutely any other good or service besides money as quickly as possible. They have first information and signal by their transactions that money is less subjectively valuable given its greater supply. It’s no coincidence that they seek to acquire the most valuable hard assets first, such as private equity funds seeking corporate business assets. So you see buyouts, takeovers, mergers and acquisitions. Ceteris Paribus, after the change in money supply, all other goods and services remain exactly as scarce as they were before the change in money supply. There’s no increased investment. Real resources are just as scarce after the change in money supply as they are before the change in money supply. But all those who are holding money are losing value, so a bidding war occurs to exchange money for other things. Of course all trades which ensue generate real wealth, but there’s a simultaneous offsetting in that real wealth creation from trades by a declining subjective valuation of money. But information is indeed wealth, and information spreads and is transferred precisely by trade transactions. AND EXCEPT, there are going to be many compelled “exchanges” that occur from past tense terms CONTRACTS that are not any longer generating *mutual* positive value from trade. But nobody is going to “expand the production of investment goods relative to consumer goods” unless those actions are subjectively more valuable than not undertaking those actions.

Well, that’s enough controversy for one post. :P

Person December 14, 2007 at 10:22 am

Hm, let’s see, why is the economy so screwed up. OH!!! OH!! I know!! I know! It’s because the risk-free interest rate is a few basis points below the market-clearing level! THAT’S IT! Oh, it’s so obvious now!

Curt Howland December 14, 2007 at 11:08 am

Person, you are not reading. It doesn’t matter if the interest rates are too low, or too high. It is the interference itself that causes imbalances between investment and return, which inspires more interference in bail-outs and taxes/regulations.

Do that long enough and the economy gets royally messed up.

I’m glad it’s obvious to you. You’ve certainly been told enough times to have gotten the idea by now.

Blouge December 14, 2007 at 11:11 am

>As there is no such thing as a “mal-trade”, there can be no such thing as a “mal-investment”.

Agreed. In fact, I’m waiting for the interest rate to drop to 0%. Then I can start borrowing unlimited funds for research & development in underwater basket weaving. Since the number of baskets aquatically weaved in the long-term future will ultimately be infinite, any sum of money is justified if it produces even a slight increase in the efficiency of their production. This investment is guaranteed to make a profit and is certainly not a mal-investment.

Person December 14, 2007 at 11:14 am

Curt_Howland: I understand how intereference is bad, whether it makes interest rates too high or too low, but seriously — how far is the interest rate from its market-clearing level? Just a rough guess? And is that really big enough to cause massive malinvestment, especially considering most business financing isn’t even funded by debt, but rather by stock issue and profit retention? The ABCT has always seemed a shaky way to attribute cause of busts.

Alex December 14, 2007 at 11:34 am

Stephane: Thanks for the reply. Since you understand the Austrian nature of the Investment curve, could you explain it in simple English to me? And you anticipate my dilemma in what you say. I have difficulty understanding how it is purely time preference that determines the ‘natural interest’ rate. I assume, for example that the savings curve represents the savings available for investment in new capital goods (that is net of any savings lent by some households to other households for the latter’s present consumption, since such lending doesn’t increase future goods availability at all ).

So, I’m assuming the people behind the investment curve are only those who want to invest in new capital for future goods production. Forgetting the government, these people we could call businesses. Is that correct? If so, the curve says they would only be willing to invest more if interest rates are lower. If the explanation doesn’t have anything to do with the expected profitability of investment projects, how does the expected profitability of investment projects play a part? For example, a new technology that can produce goods more cheaply comes along, and at an interest rate of 10% the project would yield a profit but at 15% it wouldn’t. How do things like that play a part in the investment curve?

fundamentalist December 14, 2007 at 11:40 am

rtr: “As there is no such thing as a “mal-trade”, there can be no such thing as a “mal-investment”.

Don’t look down, but there’s a huge hole in your logic! Investment and trade are not the same things, so mal-trade and mal-investment are not the same things. It’s true that in a free market, no mal-trades can happen because if one person would be worse off from the trade then they would not make it.

Investment is something different altogether. Investing requires planning and knowledge about the future, especially that planning and knowledge in which the investor expects his plans to agree with the plans of others on whom his plans depend. Mal-investment occurs when plans don’t mesh. Mal-investment doesn’t mean that the trading of money for assets was somehow unfair to one party in the trade, but that the plans on which the investor depends are wrong because his plans won’t match those of other investors on whom the success of his plans depend. Mal-investment refers to plans that fail. Why do they fail? Because the investor assumed that low interest rates meant that savers were consuming fewer consumer products, thus freeing up resources for capital intensive production. If his assumptions were wrong, that means he’ll be competing with producers of consumer goods for resources when he thought that those producers would be releasing resources.

fundamentalist December 14, 2007 at 11:44 am

Person: “It’s because the risk-free interest rate is a few basis points below the market-clearing level!”

No. The market-clearing level is the interest rate you read in the paper every day. Markets clear every day. The ABCT says that malinvestment occurs when the nominal interest rate is different from the natural rate, i.e., the rate that reflects the real time preference of savers. Of course, the more the nominal and natural rates differ, the greater will be the malinvestment; a small difference wouldn’t cause much of a problem.

Stephane December 14, 2007 at 12:05 pm

Alex,

I had a kind of “Aha!” reaction when I read the chapter of MES on interest so I highly recommend it.

First you start with methodological individualism. Person A has certain preferences :
- 1 apple now < 1 orange next year
- 2 apples now > 1 orange next year
- etc.

Since there’s a whole bunch of them, you can simplify things by retaining only thoses preferences which concern money. A single person might have different “personal interest rates” for different goods. Thanks to money, this person can make sure that she consumes her favorite present goods today, and her favorite future goods tomorrow. What is important then is how a marginal unit of money today is valued compared to a marginal unit of money tomorrow.

Then you imagine what kind of money exchanges this person would accept where she lends money now in exchange for money later :
- $1 now < $2 in one year
- $2 now < $3 in one year
- etc.
This gives you the part of the upward sloping supply curve which is to the right of the vertical axis. You’ll have to read ch.6 to see it. The left part of the curve is obtained by considering all acceptable exchanges in which the person borrows money now in exchange for future payment. That’s it, you have a complete supply curve for one individual.

Each individual demand curve is obtained by a similar process. Then all supply and all demand curves add up (and fortunately you don’t need to add utilities to do that) and this gives you the famous X chart. Isn’t it great? ;-)

Stephane December 14, 2007 at 12:09 pm

Sorry for the html mess.

You must read :
- 1 orange next year better than 1 apple now
- 2 apples now better than 1 orange next year
- etc.

and
- $2 in one year better than $1 now
- $3 in one year better than $2 now
- etc.

mikey December 14, 2007 at 12:14 pm

No such thing as mal-trade eh? Hmm, my readings on the Weimar inflation show plenty of older people sold valuable assets for millions of marks,
not being able to percieve that they had only recieved a few weeks grocery money.If you wouldnt
call that mal-trade then what??

Fundamentalist December 14, 2007 at 12:45 pm

mikey: “If you wouldnt call that mal-trade then what??”

Buyers remorse. The people wouldn’t have sold valuable assets for worthless marks had they known they would soon be worthless. At the time of the trade, both saw greater value in trading than in not trading. That doesn’t mean that people will always be happy with the outcome of the trade forever.

Alex December 14, 2007 at 1:11 pm

Stephane: Again thanks for trying to educate me in the Austrian determination of the interest rate (in absence of money fiddling). As I said, and I’m referring to the Polleit article, I have no trouble understanding how time preference determines the savings function. It’s the Austrian explanation of the investment function (the downward sloping “I” curve in Polleit’s piece) that confuses me.

Let me have another go at what I’m getting at. First suppose their is no capital investment, only borrowing by some individuals for present consumption purposes and lending by other individuals for these present consumption purposes.

Saving reflects the savers’ preferences for future consumption relative to present consumption. And borrowing for present consumption represents other people’s (the borrowers’) preference for present consumption over future consumption, in that borrowers are willing to pay more future consumption to consume a smaller additional amount now (as reflected by the interest rate they are willing to pay). Great!

Let’s say that all this lending and borrowing would create a natural interest rate of 7%.

Now, along comes an inventor with no savings but with blueprints for a newly invented machine that promisses to create $110 of next year’s production (all in real terms) for a cost of $100 of present consumption. What would happen to saving and the natural interest rate?

I would think that the borrowing by the inventor to finance this machine would raise the natural interest rate above 7%, cause a greater amount of saving, a lesser amount of borrowing for present consumption purposes, and $100 of lending (and borrowing) for investment purposes in the new machine.

According to the Austrian theory of interest determination, would the outcome in the savings and investment market be different than what I have just outlined? If so, what would the Austrian story be?

Person December 14, 2007 at 1:20 pm

fundamentalist: okay, fair point. So the Fed pushes the market-clearning risk-free interest rate a few bps below the natural risk-free interest rate. I’m supposed to believe this causes a disaster?

What business ever makes plans that RELY on the 2-year treasury yielding 5%, but are TOTALLY SCREWED if the yield soon changes to 4.8%? Or to 4.25%?

Get real.

rtr December 14, 2007 at 1:50 pm

Blouge: “In fact, I’m waiting for the interest rate to drop to 0%. Then I can start borrowing unlimited funds for research & development in underwater basket weaving.”

And what are you going to trade to someone for them to trade you “unlimited funds” for your investment?

Jesse December 14, 2007 at 2:25 pm

Fundamentalist: “Buyers remorse. The people wouldn’t have sold valuable assets for worthless marks had they known they would soon be worthless.”

This is exactly what the term “malinvestment” is referring to. At the time the investments are made the people making them think they are good investments, just as when people enter into a trade they believe they are making a good trade. They only experience “investor’s remorse” when the situation clarifies and they find out the investments, ex post, were really poor choices.

As for why investors make malinvestments instead of just taking inflation into account: the point of the inflation isn’t just to alter prices (which would be rather pointless), but to control the real interest rate. If the inflation rate were constant — or otherwise predictable — lenders would simply adjust their rates such that the effective rate tracked the pure interest rate in real terms. Thus, to have any hope of achieving the desired effect the rate of inflation has to be unpredictable. Specifically, to lower the real interest rate the inflation rate has to be higher than predicted, whatever the prediction might be. This makes it impossible to project how the rate of inflation might change, making malinvestment a virtual certainty.

A predictable inflation rate, IMHO, does not create malinvestments. It just slowly siphons off purchasing power as a hidden tax without affecting the real interest rate. This is still bad, of course, but omits the regular business cycles unique to a manipulated interest rate.

Curt Howland December 14, 2007 at 2:31 pm

Person, “So the Fed pushes the market-clearning risk-free interest rate a few bps below the natural risk-free interest rate. I’m supposed to believe this causes a disaster?”

You’re still not reading. Such a small change, in isolation, may very well cause only small problems. Such interventions never happen in isolation.

Not that otherwise viable businesses going under is ever a “small” problem to those effected.

“Get real.”

Yes, please do. It would be a nice change.

rtr December 14, 2007 at 2:47 pm

fundamentalist: “Don’t look down, but there’s a huge hole in your logic! Investment and trade are not the same things, so mal-trade and mal-investment are not the same things.”

They are both *actions* are they not? Someone will not undertake the action of investing unless the action of investing is more valuable than the action of not investing.

fundamentalist: “Investment is something different altogether. Investing requires planning and knowledge about the future, especially that planning and knowledge in which the investor expects his plans to agree with the plans of others on whom his plans depend.”

Changing future subjective valuations and changing future supplies brought about by the actions of others are epistemologically unknowable. I can plan to buy low and sell high, and sell high and buy low, every day, but that doesn’t mean that’s going to happen. The subjective valuation of plans is not constant.

fundamentalist: “Mal-investment doesn’t mean that the trading of money for assets was somehow unfair to one party in the trade, but that the plans on which the investor depends are wrong because his plans won’t match those of other investors on whom the success of his plans depend.”

That occurrence can happen for many different reasons. How is a change in the good=money supply any different than a change in the good=steel? The same effect which occurs from violent government intervention can also occur naturally.

fundamentalist: “Mal-investment refers to plans that fail. Why do they fail? Because the investor assumed that low interest rates meant that savers were consuming fewer consumer products, thus freeing up resources for capital intensive production. If his assumptions were wrong, that means he’ll be competing with producers of consumer goods for resources when he thought that those producers would be releasing resources.”

Low interest rates don’t change the quantities of any actual goods or services which exist. Investing is always a risk because it is impossible to know what the future supply and demand will be, just as trading is a risk because it is impossible to know what the future supply and demand will be. At the time of the trade, or at the time of the investment, that action only occurred because the individual undertaking that action increased their subjective wealth by undertaking that action. They at every moment of every decision always have the option choice possibility of not undertaking that decision.

And if the investor is in the future “competing with producers of consumer goods for resources when he thought that those producers would be releasing resources” that should mean his resources are valued *higher* (demand greater than supply), and he can liquidate his investment resources at a profit to others who have higher marginal uses for those resources. The investor also could have procured those lower order capital goods before he procured those higher order capital goods, or vice versa. And if it was real savers who were investing rather than borrowers who were investing under contract terms, they wouldn’t have to be forced to liquidate higher order capital goods at fire sale prices unless they were increasing their wealth by trading away those higher order capital goods for money.

Fundamentalist December 14, 2007 at 3:07 pm

Person: “What business ever makes plans that RELY on the 2-year treasury yielding 5%, but are TOTALLY SCREWED if the yield soon changes to 4.8%? Or to 4.25%?”

None. But that’s not the point. If they get the yield on bonds wrong, that’s no problem. But suppose a businessman borrows $1 million because the Fed lowers the nominal interest rate from 5% to 4.5%. He borrows at 4.5% because at that rate his venture will earn a profit, when at 5% it wouldn’t. The natural rate of interest is closer to 5%, but the businessman doesn’t know it. He can’t know it. Thinking his new venture will be profitable, he goes ahead with it at 4.5%. He hires workers, buys raw materials and starts producing. But suddenly the wages and the prices of raw materials goes up because his new venture, and others like it, are competing for workers and materials with producers of consumer goods. Only then does he realize that he made a mistake and his business goes bankrupt.

Jesse: “This is exactly what the term “malinvestment” is referring to. At the time the investments are made the people making them think they are good investments, just as when people enter into a trade they believe they are making a good trade.”

Yes, but malinvestment and maltrade have different definitions because they refer to different actions at different times. It’s true that all malinvestments were once good trades, but that doesn’t mean the trade at the time it was made was a bad one because no one can know the future.

Jesse: “As for why investors make malinvestments instead of just taking inflation into account: the point of the inflation isn’t just to alter prices…”

Price inflation has little to do with malinvestments. It’s the result of malinvestment, not the cause. The ABCT says that malinvestment happens when the plans of entrepreneurs can’t all work out due to insufficient resources or resources that aren’t complementary to their processes. Price inflation happens when the Fed pumps too much money into the system.

Without Fed monetary pumping, all investment would have to come from savings, in which case the plans of business people would tend to complement each other. Savings equals reduced consumption, which frees up labor and materials for use in producing capital equipment. Monetary pumping by the Fed causes investment in capital intensive industries without the complementary reduction in consumption. The new workers in the capital industries compete with existing workers for the limited supply of consumer goods. As a result, the prices of consumer goods rise, which increases the profits of consumer goods manufacturers. Now, consumer goods producers are competing with capital goods producers for scarce materials and workers. Someone has to lose and it’s usually the capital goods producers.

Fundamentalist December 14, 2007 at 3:31 pm

rtr: “They are both *actions* are they not?”

I don’t know what you’re trying to argue, but I’m wondering why you think people don’t use the terms maltrade and malinvestment interchangeably? Obviously they have some connection to each other because no one can invest without making a trade at some point in time. But the two terms don’t mean the same thing for a reason; they refer to different points in time and different purposes. Trying to conflate the two only leads to confusion.

rtr: “Low interest rates don’t change the quantities of any actual goods or services which exist.”

Yes it does. That’s the whole point of the ABCT. Capital intensive industries are very sensitive to interest rates. Lower interest rates spurs production of raw materials as well as the transforming of these materials into inputs for capital goods production. So lower interest rates do increase the quantities of actual goods.

rtr: “…he can liquidate his investment resources at a profit to others…”

Someone should have told the owners of fiber optic cable that during the 2001 recession. Many had to sell cable for ten cents on every dollar they invested. Why? The ABCT answers. Part of the problem is that the assets purchased for capital goods production have very specific uses and aren’t easily changed to other uses. Partly it’s because the equipment being sold doesn’t complement the equipment in demand. Yes, it’s true that some materials the businessman purchased he can sell for a profit, but he also has a lot invested in finished products that won’t sell, and on labor and interest that he can’t recoup. It’s not hard to see that most businesses that go bankrupt have to sell assets at a loss. But even if he sells materials at a profit, the business doesn’t earn a profit and the owners loses a great deal. That’s why they declare bankruptcy.

Bruce Koerber December 14, 2007 at 3:45 pm

Yes, manipulating the interest rate is a recipe for disaster as is all economic intervention. Consider the nature and role of knowledge in the economy and how the market process is like the language used to convey meaning.

Instead of being able to simply listen attentively, by some coercive act an interpretation is given by someone not fluent in the language. Instead of coordination there is confusion.

Now not only are there errors from misunderstanding but there are errors compounded upon errors. The solution is not to continue with the inept interpreter but to allow some time for the communication links to re-establish themselves and then to mend all the ‘hurt feelings.’

To those who think that ego-driven intervention is necessary I suggest they read this backwards: ‘ymonoce enivid!’

Fundamentalist December 14, 2007 at 4:21 pm

Bruce: “…the market process is like the language used to convey meaning.”

Excellent analogy. Hayek won the Nobel for such insights. Contrary to mainstream econ, the market isn’t perfectly efficient because of the errors in the language of prices. Gov intervention only makes that language less accurate and useful.

Stephane December 14, 2007 at 4:51 pm

Alex,

OK I think we should have a look at the time preference vs. capital productivity debate. I have done much work on this one yet so I will make a wild guess. Perhaps what motivates the entrepreneur is precisely that 110 is greater than 107. Since the market price of 107 tomorrow is the same as that of 100 today, it would make no sense to borrow 100 and risk them in a venture that would produce only 107. The difference between 110 and 107 is the entrepreneur’s salary : it is profit, not to be confused with interest. The discovery of an invention which permits a 110% return would therefore not alter people’s time preferences and the interest rate would remain unchanged. However – provided there are no patents ;-) – more entrepreneurs would be attracted into this business, etc. Do this sound familiar?

Alex December 14, 2007 at 5:51 pm

Stephane: We have much agreement here. I don’t think the discovery of the new invention would affect people’s time preferences either, and certainly the difference between the 110 and the 107+ is profit, which would attract the attention of new entrepreneurs into the industry, if possible, etc., etc. After all, it’s the hope for profit that is the carrot for new capital investment.

However, I cannot understand how Austrians can think that the increased demand for new borrowing (derived from the blueprints for the new invention) would not cause a higher natural interest rate, which, simultaneously, would do two more things: 1) attract new savings (lending) and 2) discourage some borrowing by consumers for present consumption.

Why the heck wouldn’t that happen?

Anthony December 14, 2007 at 6:00 pm

Wouldn’t the increase in savings slowly lower the interest rate once more?

fundamentalist December 14, 2007 at 6:16 pm

Alex: “However, I cannot understand how Austrians can think that the increased demand for new borrowing (derived from the blueprints for the new invention) would not cause a higher natural interest rate,…

Hayek’s “Pure Theory of Capital” has the best explanation of this, I think. I don’t think that Austrians believe that only time preference determines the natural rate of interest. And the influence isn’t just one way, from time preference to interest only, but interest rates can affect time preferences. In effect, lower interest rates make future goods cheaper so people don’t have to save so much, and vice versa.

New technology does cause businessmen to demand more loans, and therefore the interest rate rises. Hayek calls that the interest rate break on the implementation of new technology.

One of the Austrian arguments against manipulating interest rates to an artificially low level is that such low rates do affect time preferences and savings.

rtr December 14, 2007 at 7:11 pm

rtr: “Low interest rates don’t change the quantities of any actual goods or services which exist.”

Fundamentalist: “Yes it does. That’s the whole point of the ABCT.”

No, there’s always a scarce limited amount of real goods and services which can be owned and traded. You confuse the present tense decision with future changing subjective demand values and future changing supplies directed. Pretending the interest rate is lower than it is, or even foolishly believing the interest is lower than it is, or subjectively mistakenly anticipating an interest rate that doesn’t actually materializes differently, does not change the quantity of all goods and services which exist at the moment the decision is made to invest. There’s only so much finite labor and materials to be traded around at every moment of every decision. And all trade is communicating changing supply and changing demand.

The last marginal entrepreneurs to receive the information that money supply had increased would have missed their opportunity to “invest” because the materials and labor were bid away from his use. Holding onto as yet unspent money, they take a loss on the value of their monetary holdings from the inflation tax. They wouldn’t get the chance to even (falsely stated) “mal-invest”. An increase in money supply SHOULD signal an increase in the amount of money to be traded for all other goods and services. This is NORMAL market information working its way through the economy by changing prices. Of course it sends a STOP LOSS order to higher order production goods as the prices are bid up, just as it sends a BRING MORE order for investment capital. If prices for higher order capital goods didn’t increase, that would be inefficient. The price for all order goods production and the price for all consumption goods is supposed to rise. Nobody will engage in any trade or any investment unless they are better off doing so. The market adapts to constant changes in supply and demand for all goods and services INCLUDING money. It’s completely absurd to restrict a claim of “mal-investment” merely to changes in money supply and not also to all changes in the supply of other goods, and also changes in subjective demand valuation for all other goods.

Fundamentalist: “Someone should have told the owners of fiber optic cable that during the 2001 recession. Many had to sell cable for ten cents on every dollar they invested.”

Only because the subjective valuation demand for fiber optic cable changed in the future tense long after the decision to invest in the production of fiber optic cable. The result is a lowered demand for fiber optic cable. And they only *had* to sell that fiber optic cable at low prices if they were compelled by contract from borrowed money and capital terms. Only if free trade is restricted or compelled by government interference can “mal-” poverty be caused, can production become a “mal-investment”. This happens with taxation and regulation, from forcing money to be fiat accepted, not from changes in the monetary supply. And of course weakening confidence, declining subjective valuation of the fiat currency effects trades, because people would rather exchange that fiat currency for something else. Confusion ensues and people hesitate to accept that fiat currency, hesitate to continue their production plans. Trade slows. And this is precisely what we see in the housing market, with houses sitting untraded on the market for extended periods of time. Of course government manipulation of the money supply has bad effects, but it never *results* in “malinvestment” after the fact of the intervention; it certainly can result in *past* investment being adversely affected (but so can any change in demand or supply), but that is not an active present tense occurrence of malinvesting. Just like no present tense mal-trade can occur, no present tense mal-investment can occur.

Jesse December 14, 2007 at 10:01 pm

My understanding is that time preference and the pure rate of interest are one and the same thing. However, the pure rate of interest is the risk-free rate for a hypothetical “neutral” commodity of fixed value. It does not take into consideration such factors as the short-term demand or any predicted change in the relative value of the commodity being loaned. When these factors are combined the minimum viable rate of interest on a particular real-world loan will generally differ from the pure interest rate, sometimes significantly. Also, as with ordinary trade, there is a range of interest rates between what the lender and borrower are each willing to accept, and the actual rate can be anywhere in this range.

Basically, you can think of the pure rate of interest as the minimum rate you would be willing to accept given a large supply and demand relative to the size of the loan and 100% guaranteed on-time repayment. Like the E.R.E. it’s an abstraction, not a fact, and also like the E.R.E. it least resembles real interest rates when there are sudden, unexpected changes in the supply or demand for money, or in the borrower’s ability or willingness to repay the loan.

fundamentalist December 14, 2007 at 11:45 pm

rtr: “No, there’s always a scarce limited amount of real goods and services which can be owned and traded.”

That’s simply not true. Read Hayek’s “Pure Theory of Capital.” A lowering of interest rates causes increased investments in mining and in trasforming raw materials into an increase in intermediate and finished goods.

rtr: “The last marginal entrepreneurs to receive the information that money supply had increased would have missed their opportunity to “invest” because the materials and labor were bid away from his use.”

You’re assuming perfect knowledge. Businessmen rarely know that the money supply has increased. Economists who track the money supply know that it has increased only months afterwards.

rtr: “They wouldn’t get the chance to even (falsely stated) “mal-invest”.”

So if not malinvestment, what causes so many businesses to go bankrupt?

rtr: “An increase in money supply SHOULD signal an increase in the amount of money to be traded for all other goods and services.”

Only if you have drunk the coolaid of mainstream econ. Austrian econ demonstrates that new money enters the economy at specific points, mainly capital intensive production, and works its way through the economy, causing severe distortions along the way.

rtr: “The market adapts to constant changes in supply and demand for all goods and services INCLUDING money.”

Yes the market adapts to changes in the money supply, but that adaptation involves a lot of bankruptcies as the economy clears out the malinvestments caused by the monetary pumping.

rtr: “It’s completely absurd to restrict a claim of “mal-investment” merely to changes in money supply and not also to all changes in the supply of other goods, and also changes in subjective demand valuation for all other goods.”

No, it’s absurd to ignore the horrendous damage that manipulating the money supply causes. Two observations got the ABCT started: 1) the fact that bankruptcies aren’t randomly distributed but show a systematic pattern and 2) most of the volatility takes place in the capital intensive industries. Other changes, such as “changes in the supply of other goods, and also changes in subjective demand valuation…” would cause systematic cycles, because the random failures and successes would cancel each other out. For example, an increase in the price milk would mean that people spend less on other products in order to purchase milk, but a change in the price of milk will not cause cycles in the whole economy.

rtr: “Only because the subjective valuation demand for fiber optic cable changed in the future tense long after the decision to invest in the production of fiber optic cable.”

You seem obsessed with subjective valuation and believe that it’s fickle. That’s not the case. Why did people value fiber optic cable so much one year and so little the next? A change in fashion? I don’t think so. It happened because they saw the mal-investment caused by excessive growth in the money supply.

rtr: “Only if free trade is restricted or compelled by government interference can “mal-” poverty be caused, can production become a “mal-investment”.

Nonsense. Austrian econ demonstrates clearly that increases in the money supply by the Fed causes enormous malinvestment. I have even read some Fed economists state that.

rtr: “This happens with taxation and regulation, from forcing money to be fiat accepted, not from changes in the monetary supply.”

It’s well-established history that the same thing happened under a gold standard with free banking and no government regulation.

rtr: “And of course weakening confidence, declining subjective valuation of the fiat currency effects trades, because people would rather exchange that fiat currency for something else.”

And what would cause people to lose confidence in the currency, other than that the Fed was flooding the market with it?

rtr: “Of course government manipulation of the money supply has bad effects, but it never *results* in “malinvestment” after the fact of the intervention;”

It certainly does result in malinvestment. Why did people suddenly value homes less? Could it possibly be that home builders built to many? But why would they do that? Because the low interest rates of the past 7 years encouraged them to build.

fundamentalist December 14, 2007 at 11:49 pm

Anthony: “Wouldn’t the increase in savings slowly lower the interest rate once more?”

Yes, it should.

newson December 15, 2007 at 12:53 am

person says:
So the Fed pushes the market-clearning risk-free interest rate a few bps below the natural risk-free interest rate. I’m supposed to believe this causes a disaster?
What business ever makes plans that RELY on the 2-year treasury yielding 5%, but are TOTALLY SCREWED if the yield soon changes to 4.8%? Or to 4.25%?
Get real.

note that few business plans envisage total return of capital in 2 years. most involve npv calculation of returns more in line with long bonds. do the discounting calculation for a long-dated security (10 year +)and you’ll see that even small yield changes dramatically alter the payoff at low interest rates.

Stephane December 15, 2007 at 1:02 am

Alex,

Another guess : this does not affect the interest in the least bit because there is no way of knowing in advance, with certainty, that the revenue will exceed the usual rate of interest. I just listened to Rothbard’s audio 101 lecture and this is how he separates long term from short term profit.

newson December 15, 2007 at 1:05 am

rtr: “Only because the subjective valuation demand for fiber optic cable changed in the future tense long after the decision to invest in the production of fiber optic cable.”

please explain how something could have “changed in the future tense”. sounds like a philip k. dick concept.

rtr December 15, 2007 at 3:57 am

rtr: “No, there’s always a scarce limited amount of real goods and services which can be owned and traded.”

fundamentalist: “That’s simply not true. Read Hayek’s “Pure Theory of Capital.” A lowering of interest rates causes increased investments in mining and in trasforming raw materials into an increase in intermediate and finished goods.”

The number of investments which can be made at any time are limited by scarcity. Santa Claus doesn’t magically deliver extra capital down the chimneys of entrepreneurs if the interest rate is artificially low. The marginal uses of capital are finite limited. The highest marginal productive uses of capital will always outbid the lesser marginal productive uses of capital. At any point in time investment capital equals the total amount of investment capital. It can only be traded and divided a finite number of ways. “Increased investments in mining” can *only* come at the expense of decreased investments in other production possibilities. If any individual prices their marginal investment capital too low, all that does is create arbitrage opportunities for entrepreneurs with better information.

——

rtr: “The last marginal entrepreneurs to receive the information that money supply had increased would have missed their opportunity to “invest” because the materials and labor were bid away from his use.”

fundamentalist: “You’re assuming perfect knowledge. Businessmen rarely know that the money supply has increased. Economists who track the money supply know that it has increased only months afterwards.”

No, I’m assuming imperfect knowledge is spread from trade prices. Each trade lessens the fog. Market trades tell businessmen that the money supply had increased, as people voluntarily trade more money for the same amount of capital goods.

An event occurs: money supply increases. All other quantities of goods and services remain the same at the time of the money supply increase event. More money chases those given quantities of goods and services. Prices rise.

An event occurs: economic productivity doubles the supply of all goods and services. The money supply remains the same at the time of the doubling of supply of all goods and services not money event. The same amount of money trades for twice as many goods and services. Prices decline.

In both cases, the information of the event is communicated through changing prices.

—–

fundamentalist: “So if not malinvestment, what causes so many businesses to go bankrupt?”

Changing subjective valuations. The fad of hula hoops and pet rocks wears off.

——

rtr: “An increase in money supply SHOULD signal an increase in the amount of money to be traded for all other goods and services.”

fundamentalist: “Only if you have drunk the coolaid of mainstream econ. Austrian econ demonstrates that new money enters the economy at specific points, mainly capital intensive production, and works its way through the economy, causing severe distortions along the way.”

Sure, new money is traded for specific other goods and services in ordinal fashion. Why wouldn’t you first trade new money for the most valuable underpriced (given that the information of increased money supply is limited at that point) assets? The distortions are no different than the distortions caused by changing supply and demand for any and all other goods and services. That doesn’t mean the new owners of those capital are going to change production plans for their newly acquired production capital.

——

rtr: “The market adapts to constant changes in supply and demand for all goods and services INCLUDING money.”

fundamentalist: “Yes the market adapts to changes in the money supply, but that adaptation involves a lot of bankruptcies as the economy clears out the malinvestments caused by the monetary pumping.”

The only malinvestments *caused* by a change in the money supply are cash holdings “investments”. There are never any “malinvestments” *going forward* from past given supply and demand information changes.

—–

rtr: “It’s completely absurd to restrict a claim of “mal-investment” merely to changes in money supply and not also to all changes in the supply of other goods, and also changes in subjective demand valuation for all other goods.”

fundamentalist: “No, it’s absurd to ignore the horrendous damage that manipulating the money supply causes. Two observations got the ABCT started: 1) the fact that bankruptcies aren’t randomly distributed but show a systematic pattern and 2) most of the volatility takes place in the capital intensive industries. Other changes, such as “changes in the supply of other goods, and also changes in subjective demand valuation…” would cause systematic cycles, because the random failures and successes would cancel each other out. For example, an increase in the price milk would mean that people spend less on other products in order to purchase milk, but a change in the price of milk will not cause cycles in the whole economy.”

Yeah, the fact that bankruptcies *aren’t* randomly distributed is evidence for localized industry subjective value changes. Housing construction companies go bankrupt because the subjective valuation demand for the final product house declines as the fad of investing and speculating on second and third pet property houses declines. All event changes reverberate like waves throughout the economy whether a pebble is tossed into the ocean or a landslide earthquake causes a tsunami. The entire conception of economic cycles is a fatal error derived from a false conception of monetary theory. Even Mises used the terms “unevenly rotating economy”.

It’s no surprise that volatility is higher in capital intensive less liquid industries. A tanker doesn’t steer or stop as easily as a speed boat. Where the Austrians, and all economic schools, went wrong, was failing to see the “Pure Theory of Trade” and the “Pure Theory of Money”.

—–

rtr: “Only because the subjective valuation demand for fiber optic cable changed in the future tense long after the decision to invest in the production of fiber optic cable.”

fundamentalist: “You seem obsessed with subjective valuation and believe that it’s fickle. That’s not the case. Why did people value fiber optic cable so much one year and so little the next? A change in fashion? I don’t think so. It happened because they saw the mal-investment caused by excessive growth in the money supply.”

Yes, subjective valuation is not only not constant, it’s extremely fickle. Do you eat the same meal three times a day, 365 days of the year?

Why did people not subjectively value the gold buried in the hills of California one year and so much the next? There was a gold rush to supply fiber optic cable. Just like there was a gold rush to supply subprime mortgage loans. In a free trade market of given supply, only changing subjective valuations can cause profit and loss. They signal the wants and desires, and you only profit by serving those wants and desires.

——

fundamentalist: “Nonsense. Austrian econ demonstrates clearly that increases in the money supply by the Fed causes enormous malinvestment. I have even read some Fed economists state that.”

That’s a statement of claim, not a demonstration.

fundamentalist: “And what would cause people to lose confidence in the currency, other than that the Fed was flooding the market with it?”

That question is exactly why the 20th century monetary theorists royally screwed up. That was the status gold rush area of intellectual achievement in economic theory then. Why would people subjectively value money solely as a means of exchange? They failed to realize that money, while useful for economic calculation, is still nevertheless a strict barter good, just like every other good in the economy subject to changing subjective valuation. People don’t supply and demand for the sake of supplying and demanding. They trade, just like they act, for the sake of increasing subjective wealth.

—–

fundamentalist: “It certainly does result in malinvestment. Why did people suddenly value homes less? Could it possibly be that home builders built to many? But why would they do that? Because the low interest rates of the past 7 years encouraged them to build.”

People subjectively valued bigger homes just as they subjectively valued SUVs. They also subjectively valued second homes and condominium complexes as investment properties. There was a super abundance of cheap illegal immigrant construction labor. Oversupply and undersupply are common self-correcting scenarios. They just don’t continue unabated like they would have in the USSR. How many copies of even a book like Harry Potter end up being recycled? There was a lot more competition for raw material resources from the likes of China. Maintenance costs and ever increasing property taxes quelled the appetite for amateur house flippers. Don’t you remember all the realestate get rich quick conventions and infomercials? When that fad ended, that’s why people suddenly valued homes less. And those homes are still sitting there. And even still, many of those owners are still sitting on their properties in denial. Percentage commissions still exist for trading houses even though such styled commissions became outdated in equity markets long ago. And now the housing market is a morass because of changed subjective valuations from the inputs to the final house output. But if the money supply is more inflated and devalued than ever, why would people trade their houses for even less money? Only because subjective value demand for houses dropped even more than the subjective value of money.

Person December 15, 2007 at 8:36 am

newson and fundamentalist: First, its widely accepted, even by Austrians, that the Fed only influences short-term rates, so that’s all I would have to assume relevance of.

Second, I still don’t see why all these ambitious projects are so sensitive to changes in the interest rate. Are you not aware of how projects like these work? Entrepreneurs demand abnormally high rates of return before they start them. For the really speculative ones (that Austrians laugh at when the bust comes), 50-100%. Cost of securing capital substracts directly from that. So 4% vs. 5% vs. 6% seems to be a non-issue.

The only way you could make that claim is if the natural interest rate is some proxy for general level of coming consumer expenditures. But to believe they change *that much* with the interest rate? Enough to make projects that would return 50%, return -50%, because the interest rate cleared the market at 4% when it should have been 5%? Still very hard to fathom.

Oh, and can we ditch the video? It seems to be crashing Firefox.

Alex December 15, 2007 at 11:44 am

Fundamentalist, Anthony, Jesse: (Fundamentalist)If in general Austrians, as you say, don’t believe that only time preference determines the natural interest rate there are sure a lot of them who keep saying just that (Read Jesse’s remark, for example).

So, as someone gaining knowledge in Austrian economics, I think the determination of interest rates is not well explained since it doesn’t seem to be universally understood by those who profess to understand Austrian economics. Perhaps, therefore, someone needs to write an article explaining, in simply English and in unambiguous terms, what the Austrian school believes determines the natural rate of interest. Then everyone can at least argue from the same theory.

(Anthony and Fundamentalist) In my example, the invention would cause a higher natural interest rate. Period. In Polleit’s diagram terms, the “I” curve would shift rightward. The fact that the higher interest rate would increase saving is reflected by a movement up the “S” curve.

Alex December 15, 2007 at 1:27 pm

rtr: Okay, let me see if I’ve got your argument right. One unit of Good A trades for 1 unit of Good B. Suddenly, out of the heaven’s drops lots more units of Good B. At first, those who trade these heaven sent units of Good B can trade each for about 1 unit of Good A. But soon the additional supply of Good B on the market pushes up the price of Good A in terms of B. And this argument holds whether Good B is fiat money or anything else.

At each point, both before and after the heaven sent supply of Good B, when a trade takes place, to each party the subjective value of what they receive in the trade is greater than the subjective value of what they give up in the trade, and so, as usual, each trade benefits both parties. This will be the case for those who trade A for heaven sent B when heaven sent B trades near 1 unit for 1 unit with A and later, when each unit of A trades for more than 1 unit of B. Some of those who traded A for B might REGRET not having waited and traded later when they might have gotten more B, but that’s a natural kind of thing that is always happening in markets, and wouldn’t therefore be peculiar to the fact that Good B might be fiat money.

Some others here are arguing that when this heaven sent Good B is more fiat money created by the Fed, this particular amount of REGRET would have been avoidable but for the actions of the Fed, and therefore it is right to blame this REGRET on the Fed and to urge them cease and desist in such actions.

I realize I am not discussing this in jargon terms of “higher order” vs. “lower order” goods, etc., but I don’t like jargon if it can be avoided.

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