Interest Rates

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    Given that Austrian Business Cycle Theory says that interest rates are a signal to entrepreneurs as to the amount of savings available to begin and complete a project, and that artificially low rates of interest give a false signal that there are more savings available than are really the case, I want to ask the following question. Given the system we have where there are no true interest rates and we have fractional reserve banking, do entrepreneurs really look at interest rates as a reflection of the amount of savings? It is obvious to everyone that rates are arbitrarily set and not a reflection of savings in the system. Why then do Austrians say that low rates cause firms to think, for example, they should start a longer term project when rates are low, when firms know the interest rate has nothing to do with the amount of savings available?

    Also, I can see where artificially low rates cause speculating and the inflation of asset prices, etc. but I do not see widespread unfinished projects as the Austrians say should result.


    First, it’s not the Austrian view, or at least the Misesian view, that interest rates are signals. Prices are not signals in the normal sense of the term. There are historical facts upon which people form expectations about the realization of their ends in the future through actions they take starting in the present.

    Second, Austrians do not assume that entrepreneurs understand the economic theory of interest rates or what underlying factors are moving rates. Entrepreneurs neither care to know nor need to know the underlying phenomena, e.g., what’s happening to the pool of saving. They can make successful production decisions by perceiving the array of existing prices for things that affect the outcome of their production and selling decisions and formulating those decisions on the basis of their anticipations of the future. If interest rates are falling, then the calculation by entrepreneurs of the present value of future revenue streams increases. Therefore, more profit can be earned from longer term investments relative to shorter term investments.

    Third, the unfinished projects don’t make the headlines. They will be scattered about the capital structure in various stages and emerge in various geographic locations. The half-finished housing developments in Las Vegas in 2008-2009 were on the news, but many of the partially-finished projects do not grab the attention of the media. Moreover, the conception of production being partially-finished in an economy-wide, not project specific idea. Credit expansion from monetary inflation sets in motion a lengthening of the capital structure of the entire economy that cannot be completed given people’s time preference. This is the import of Mises’s famous “Master Builder” metaphor:

    Finally, Austrian are analyzing the implication for the economy of Fed policy and not just the implications for the entrepreneur. When the Fed inflates the money stock through bank credit expansion, then the supply of credit must be larger than it would be on the basis of saving alone and interest rates must be lower than they would be on the basis of time preference alone. The economist must conceive of these facts in properly analyzing the boom-bust cycle. The entrepreneur does not need to conceive of these facts in running his business.


    Dude, you are wicked smart! Thanks Doc!

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