October 29, 2014 at 7:37 am #21385tomasz.slusarczykkMember
Hello, Mr. Herbener,
I have submitted a question in yesterday’s Q&A about input prices rising in the final phase of the boom. Due to it being 3 a.m. in Poland at that time and with limited possibility to word a more complex question properly in the stream chat, I’d like to follow up on it. Come to think of it, I perhaps shouldn’t have put you on the spot with such a question in a Q&A, as I realized it requires at least a short while to think about it to come up with a more elaborate answer. For that, I apologize. Anyway, here goes:
I specifically have in mind a scenario presented in Mr. Cwik’s paper (https://mises.org/journals/scholar/cwik2.pdf), in which he walks through an hypothetical investment project and how its profitability is affected over the course of a credit-induced boom and bust.
The part where I run into problems is exactly the input prices’ rise. If the credit expansion is halted, interest rates are expected to go up as a result of a free-market social time preference overcoming the credit-fueled one. Consequently, it would entail output prices outpacing the inputs. The example in the paper, however, leaves revenues constant and inputs going up in an environment of rising interest rates.
I instinctively understand why inputs would rise when more investment projects are taken up with an unchanged amount of saved resources, and in turn a growing demand for them by firms, which would then squeeze the profits. Does Mr. Cwik suggest that this is a market signal to sell off inputs in order for the profitability of the said project to get in line with a higher interest rate? I would think so, since I imagine the restored purchasing power of market agents would favour outputs of projects which were genuinely desired at the expense of those produced from malinvestments, and the only way to equalize returns on assets is to bring inputs down in those specific projects, while inputs in other projects may enjoy a rise in prices.
I have trouble plausibly holding constant certain events in those market conditions and would therefore appreciate if you brought some sense into a state of many moving parts seemingly pulling in different directions.
I am looking forward to your answer.
TomaszOctober 29, 2014 at 11:21 am #21386jmherbenerParticipant
Cwik is trying to isolate the effect of the suppression of the interest rate during the boom and its restoration during the bust on the profitability of production and thus, the liquidation of capital investment and reallocation of resources during the bust. In his model, he, therefore, assumes that input and output prices are constant (p. 5) to isolate the effect of movements in the interest rate on the present value calculation of asset prices and input prices. (In his model, the movement in input prices is accounted for in the movement of assets prices. Working capital appears in the numerator of the terms of the NPV equation for the price of fixed capital.) I think the general principle that his example shows is that asset prices must adjust downward relative to input prices to compensate for the rise in the interest rate in restoring profitability to production.
If we relax the assumption that input and output prices are constant, then even in Cwik’s model it is not necessary for input prices to rise. Whether or not they do would depend on output prices. And since the liquidation and reallocation process in the market restores the rate of return both to investment in working capital and fixed capital to the higher market interest rate, we know that at the end of the adjustment process output prices are higher relative to input prices.
Cwik is referring only to the effect of rising interest rates on working capital and fixed capital, others things the same, and he is insisting that this effect be taken into account in analyzing the liquidation and reallocation process.
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