Current distortions in the Capital Structure

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    Hi Dr Herbener,
    The Fed has been keeping interest rates extremely low for some time now. On the one hand, banks have not lent all the newly created money out. On the other hand enough money has been created to keep the stock and bond markets high…

    When interest rates rise (because of Fed tapering, price inflation, low demand for cash or whatever reason) the distortions will be revealed and the capital structure will be “corrected”. The larger the distortions the more severe the correction/recession.

    I’m wondering if it’s possible to measure how distorted the capital structure is right now in order to predict the severity of a coming recession. Some Austrians predict that the following years will look like the 1970s with high unemployment and high inflation. Others like Peter Schiff and Doug Casey think that a huge financial crisis will occur.
    Any thoughts?


    Like your other question about how high interest rate will go when the Fed tapers QE3, this question is a matter of judgment concerning the impact of the causal factors that theory identifies for us. Commentators have different judgments and will therefore have different answers to the question of the extent of mal-investment.

    A few points are in order that concern theory and facts, however, and not judgment on this issue. First, interest rates are low now because demand for credit has collapsed, not because of Fed manipulation of the supply of credit. Everyone agrees that banks are not creating new credit, but holding excess reserves in the wake of the Fed’s expansion of its balance sheet. Therefore, Fed policy is not currently manipulating interest rates significantly. Second, the reason for the delayed recovery is the dearth of investment. Because capitalist-entrepreneurs are sitting on cash and not investing, they are not making mal-investments. It may even be the case that investment is currently insufficient to maintain the capital stock and therefore, we have been experiencing capital consumption. Third, the period of mal-investment occurred during the boom. Unlike during the bust, interest rates are low during the boom because the Fed is generating monetary inflation through bank credit expansion. Mal-investment is the result. Fourth, the size of a financial collapse alone does not determine the impact on the real economy. The financial collapse of 1920, for example, was the same size as the collapse of 1929, but was not followed by a depression. Other circumstances must combine with a financial collapse to generate a depression.

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