[Joshua.Jaouli]

Hello Professor Herbener,

I have read 16 books on the Austrian school this year and I have some questions that I still find unresolved. I hope you can help me answer them. Please note I am 100% Austrian in my beliefs, I just want to clear stuff up in my head.

Something I don’t understand about the business cycle is the idea of misallocations. If a central bank lowers interest rates by increasing the money supply, let’s say I own an oil company and now I invest in purchasing more drilling equipment (a capital good) in order to drill and produce more oil. Why is that a misallocation because the funds were not saved first? Isn’t that something that we needed/wanted in society, that would have been built lets say in two years anyway and we just built it in advance?

Also I am having a hard time grasping the idea that lowering interest rates (VS saved funds) sets up a situation where the wrong things are built. If interest rates went down from voluntary savings, a moron who wanted to borrow money to build a tanning salon in a tropical climate could get funds that now looked attractive at lower interest rates, the same way that he could get funds when the central bank lowers interest rates. Wouldn’t that be a misallocation still? Why is it lower interest rates make the wrong things built, vs the right things built? Why did low interest rates only stimulate home construction and deficit spending, and not the building of factories, oil wells and other more useful things?

Secondly, when the prices of commodities go up, in response to the inflation, entrepreneurs realize they cannot complete their projects because they don’t have enough funds. Everyone says that the next move is liquidation of malinvestment. What does liquidation of the malinvestment mean?

If I built a factory to make widgets, and I realize the price of lumber and labor has gone up, what if I received another loan in order to complete my project and pay for the higher commodity prices and labor costs? What makes this a wrong idea of how to cure the business cycle?

Thank you very much.

-Josh

[miljacic]

… before prof. Herbener or anyone else replies, since the questions do not seem hard to answer (I think)…

Mr. Josh, if you are an oil company and funds are not saved first, then you should quit your job until more funds are made. If there are no savings in the system (it’s very poor), and so interest is naturally high, you should be doing something else not drill oil, maybe bake bread. If, now, rates get artificially lowered by, effectively, printing money, you will be able to snatch the funds from more currently important tasks (baking bread) into drilling oil.. and that’s bad at this very moment when the system is so poor.. people need bread not oil. The high interest is telling you to feed the people first, not their cars.

A moron who wants to borrow money to build a tanning salon in a tropical climate.. will never get that money from anyone with common sense. But let’s assume he does get it somehow (by being very charming, let’s say, Elvis Presley incarnate). If interest rate is naturally low, then the system is rich, everything is plentiful, so if that money is lost, no big deal. If, however, interest rates are artificially low, the system is poor, people are struggling to survive, and that lost money is a great loss indeed.

Why did (artificial) low interest rates only stimulate home construction and deficit spending, and not the building of factories, oil wells and other more useful things? Because, then, no one knows what is “more useful”. The system is pumped with new money and whoever gets it first will do with it whatever he/she wants without being (quite soon) penalized if the usage is not very efficient one. And what would be really efficient? No one knows because the interest rate is false and conveys no information about reality. Then, also, government may step in and, in various ways, direct this new money into some specific areas, like with “everyone needs to buy a house”. .. then in this areas things bubble up and you get a bubble. But even if the government does not direct things, this new money will gather spontaneously into some random puddles of activity and form the bubble there.

Answers to the rest of the questions go are along these same lines.

[porphyrogenitus]

“If a central bank lowers interest rates by increasing the money supply, let’s say I own an oil company and now I invest in purchasing more drilling equipment (a capital good) in order to drill and produce more oil. Why is that a misallocation because the funds were not saved first? Isn’t that something that we needed/wanted in society, that would have been built lets say in two years anyway and we just built it in advance?”
(Emphasis added)

First it’s worth remembering that money is a medium exchange used to represent resources; it is not, actually, the other resources itself. Thus the problem with tinkering with the money supply – either by printing more, or artificially suppressing interest rates (which is usually done by the former means, but can be done by fiat), which leads people to think there is more of it than there really is. The point is that such artificial methods distort the usual price signals.

Note that ABCT does not claim to know which investments are malinvestments. Now people using ABCT can make a SWAG, informed by other data, as to what the malinvestments might be, but the theory in-and-of-itself doesn’t say “such and such an investment is going to be a malinvestment.”

So you cannot know for sure that the drilling equipment itself will have been a malinvestment. under normal market circumstances, you may have evaluated (as an entrepreneur) that it’s an investment you can’t afford to make at that time, or you may not have.

Note also that ABCT does not claim that only malinvestments will be affected by the market dislocations resulting from artificially low interest rates (or the cycle of fractional reserve banking itself).

The other thing your question implicitly forgets is that we live in a world of scarcity; under perfect circumstances, society as a whole may need/could use more of almost any good – energy, for example. (Note that this is important to remember: in public policy debates, people will often assert that there are “unmet needs” in, say, public education or public health, as if this is a trump in arguing for greater budgets. But scarce resources implies that there are always needs/wants that are unmet, that go unfulfilled. It’s a matter of prioritizing these under the resource constraints; and yes, this includes time-delays awaiting more resource availability).

So it’s not even a question of whether the additional drilling equipment would be, in some general sense, good to have. Just as in the master builder analogy it’s not a question of whether a bigger house would be nicer to have than a smaller house: it’s the fact that the resources implied by the market signal that artificially low interest rates do not actually exist (see also “money doesn’t grow on trees” – real investable resources do not expand simply because someone adds more numbers in a computer implying that they do).

So for example you’ll see a lot of nice buildings that, individually, may be very good buildings – but which aren’t filled because the demand for commercial buildings isn’t as high as people thought. Or you’ll see house construction (and price) simultaneously soar, but then crash, with housing developments going unfilled do to demand actually be insufficient (at a price that justified the initial investments made on the basis of artificially low interest rates), even though it is obvious that “society” “certainly needs” nice new homes. Or you’ll see investments in “green technology” be complete boondogles, even though in a perfect world – we shouldn’t be ideological about this – it would be nice if we had affordable low-emissions/efficient, low-polluting vehicles, energy, power plants, and the like. But the investments (whether made directly through fiscal subsidy or indirectly through low interest rates enticing people into thinking it is worthwhile to go into those fields) are failures on the market because their is insufficient demand for them at the price point that would justify the investment.

Artificually low interest rates imply greater demand than actually exists – both for present consumption (if interest rates are low, people will save less and consume more in the present) and investment (if interest rates are low, people will want to borrow more to invest in long-term projects) – than actually exists. Keynsians and other equilibrium-model/simplified-model economists take this implication of higher demand to mean (or create) actual higher demand. But ABCT, essentially, shows that this is an illusion.

[maester_miller]

Porphyrogenitus’ point about scarcity is an important one, it’s always good to keep the concept of scarcity front and center when dealing with economic issues.

Take your example of a tanning salon in a tropical environment. Such a place would not be TOTALLY useless. It would allow people to tan at night, or during monsoon season. The question isn’t “is this a productive use of resources” but rather “would there be MORE productive uses of resources than this?” The people living in a tropical climate quite likely have numerous more critical unmet needs than a tanning salon. That being said, I wouldn’t be surprised if there WERE in fact many tanning salons in tropical climates, catering exclusively to the wealthy or tourists or what have you. There are some people out there whose priorities are such and whose current level of wealth is such that for them, the best marginal use of funds would in fact be a tanning salon.

[porphyrogenitus]

Let me clarify something, too; it’s not possible to know a priori what the malinvestments will be (as in the example). One often gets a variant of this reasoning from non-Austrians (not JNJ1987), to the effect that “if you guys believe entrepreneurs are so great at forecasting, why can’t they just incorporate the artificial interest rate into their calculations and adjust for it?”

Well, 1) a belief that good entrepreneurs will generally make superior forecasts is not a belief in their infallibility (standard macro “rational actor/rational choice model” style). Absent the market price, there is no way for entrepreneurs to know what the true interest rate would be.

2) we’re all trapped in a “collective action problem” – knowing the interest rate/money supply is being interfered with, people could make no new investments, since they cannot predict which ones will go belly up during the bust. But not making new investments does not affect people or firms from being affected by the bust. Especially since in the meantime competitors are taking advantage of the seemingly cheap credit, which will have market-distorting affects in the short run as well (to their advantage, and your potential & actual disadvantage if you forego it – without much long-term advantage, since you’ll still be affected, in ways you cannot predict in advance, by the general bust that follows any artificial boom). So the only reasonable choice is to make whatever investments you can with an eye towards avoiding the pitfalls as much as you can and hoping to shield yourself as much as possible. but it’s imperfect, which is why everyone would be better off avoiding this whole mechanism to begin with.

[jmherbener]

When people lower their time preferences, they save and invest a larger proportion of their incomes and consume a smaller proportion. Their reduced demand for consumer goods lower their prices, which reduces the demand entrepreneurs have for producer goods used to produce those consumer goods. Losses in these lower- stage production processes are balanced by profits in higher-stage production processes. With the additional investment funds, entrepreneurs will buy capital goods that prove profitable by satisfying the patterns of consumer demands that emerge in the future. Their additional demand bids up the prices of these capital goods making their production more profitable, which makes the production of higher-stage capital goods more profitable. The entire production structure of the economy lengthens in response to lower time preferences.

Monetary inflation and credit expansion increase the supply of credit and push down interest rates, but the proportion of saving-investing to income has not risen and the proportion of consumption to income has not fallen. Any lengthening of the production structure will prove to be malinvestment because people’s time preferences will not make it profitable in the future. Fed monetary policy causes an inter-temporal misallocation of resources.

The further the misallocation proceeds, the greater the divergence between the lengthened production structure and people’s time preferences. That’s why more monetary inflation and credit expansion cannot restore normalcy to the economy. The only way to do that is to adjust production processes to satisfy our preferences.

[ronigafni]

“The further the misallocation proceeds, the greater the divergence between the lengthened production structure and people’s time preferences”

Can you expound on this a little? In such a case, Fed policy made entrepreneurs believe that they should invest in capital goods today in order to profit tomorrow. When tomorrow comes and there is no profit and the prices are all bid up too high, how does further Fed policy necessarily increase the discrepancy between peoples wants and the structure of production?

[jmherbener]

Further monetary expansion during the bust may not increase the discrepancy but instead delay liquidation and reallocation. What I was referring to was further monetary expansion during the boom which lengthens the production structure beyond what less monetary expansion would do.

[ronigafni]

OK, thank you for clearing that up!

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