Interest Rate Coordination and the Austrian Theory of the Business Cycle

[This short article can be better understood if one precedes it by reading Why Socialism Must Fail and the Necessity of Privatization(8 mins)]

Thanks to the banking/finance industry entrepreneurs/orders have access to other people’s saved wealth and can thus create large companies or restructurings of the social order that would be otherwise impossible if they were limited to the savings of friends and family. One of the vital functions of the interest rate is to encourage and coordinate the pairing of savings with the best ideas. People who have bad ideas or no interest in going into business lend their saved wealth to superior businessmen which brings great benefits. Let’s briefly discuss how this works.

Let’s assume that the current interest rate is at around 10%. This means that millions of minds/computers in the social order can be divided into two categories 1) Those who contain knowledge/ideas that can grow the economic pie by greater than the current 10% interest rate and decide to become borrowers in order to acquire the necessary wealth with which to nourish their consumption as they produce their product/service. For example, Mike borrows $1,000,000 from a bank which charges him 10% interest on the loan, implements his business idea which has sales revenue of $1,500,000 thus growing the economic pie by about $500,000 or 50%, pays back the loan with interest and keeps $1,500,000(revenue) — $1,100,000(loan+interest) = $400,000 as profit. And there are also 2) those who contain knowledge/ideas that can grow the economic pie by less than the prevailing interest rate and will prefer to lend their savings to banks in order to earn interest, say 8%. Banks will lend the money to borrowers like Mike at a higher interest rate, say 10%, and keep the difference as profit (borrowers like Mike pay 10% on a million to the banks ($100,000), while lenders get 8%/$80,000 from the bank which keeps the difference of 2% or $20,000 as profit). So…Thanks to the banking/finance industries and the key role that the interest plays we can see that 1) Superior ideas can immediately access the necessary wealth needed to bring about their rearrangement of society, and 2) Savings and the wealth they can acquire are going from minds that have inferior knowledge (can grow economic pie from 0–10%) to those that have superior knowledge (can grow pie greater than 10%). It is important to realize that, as the great economist/journalist Henry Hazlitt writes in his classic “Economics in One Lesson”:

“ “Saving,” in short, in the modern world, is only another form of spending. The usual difference is that the money is turned over to someone else to spend on means to increase production”,

and that this increase in production has to be large enough to pay back the loan with interest. The aforementioned benefits, along with economic competition, help the market process turn the social order into a sort of supercomputer that is constantly growing and morphing the social order in increasingly productive and technologically advanced ways.

Having discussed various aspects of the market process like profit/loss economic calculation, competition, and interest rate coordination, we can begin to get a feel for how the world really works, with its billions of minds acting as computers, each using monetary profit/loss calculation in its own local section of the world to manage the never-ending cycle of production and consumption which happens at the cellular, individual, household, corporate, and global level. If one looks at the Social Organism from high above it looks like a human ant-farm made up of mini social orders which are constantly producing, trading with other orders, consuming, learning from each other via competition, coming together and apart as businesses emerge and dissolve in everchanging conditions. Entire cities morph themselves in specialized ways as complementary pieces of knowledge and orders/businesses segregate themselves in distinct geographical locations like the software industry in Silicon Valley, California, manufacturing in Guangdong, southern China, and finance in New York City and London. The market process is inadvertently uniting mankind as it evolves the Social Organism.

The “Austrian Theory of the Business Cycle”

With our rudimentary understanding of money/inflation/banking/lending and interest rates, we can very briefly go over one of the hallmarks of economic thinking. The so-called ‘Austrian Theory of the Business Cycle’, originally developed by quite possibly the greatest economist ever, Ludwig von Mises, and to a lesser degree his most famous pupil and 1974 Noble laureate in economics F.A. Hayek. The theory explains why the economy seems to go in cycles from boom to bust/depression to boom to bust, etc. Most people and clueless mainstream economists (as will be discussed later) believe that such cycles are inherent in a free economy/Capitalism yet as we will see they are the inevitable outcome of misguided central bank policy. It is very easy. The more people save and make their money available for banks to lend out to borrowers, the lower the interest rate will be as banks compete with each other by offering a lower interest rate to lure borrowers. The lower interest rate is partly reflective of the fact that savers have refrained from consumption, thus making the wealth they would have consumed, available to borrowers. If interest rates are at 10%, it does not make sense to borrow/consume to implement a business idea that will have a return on investment less than 10%, but if they go down to 3%, then it does make sense to borrow and carry out an idea which will yield 10% ROI to pocket the 7% difference. So the lower the interest rate, the more profitable ideas/plans can be carried out which motivates entrepreneurs/companies/orders to borrow the saved wealth in order to fund/nourish/sustain their productive activities. We now come to the essence of the problem. What happens if interest rates are lowered, not because savers refrained from consumption thus making wealth available for borrowers, but because central banks simply increased the money supply so there really has not been an increase in wealth available to borrowers? Businesses/orders must consume real wealth/goods as they go about production, not pieces of paper or more zeros in a digital bank account. Imagine 10 men tasked to build a mansion which will take them 6 months. During this time they obviously need food, materials, energy to consume/use in order to produce the mansion. If they have this unconsumed/saved wealth great, but creating pieces of paper with 0s on them is not the same thing. Again, businesses/orders need real engineers/labor/materials/food/energy/etc., the wealth that would have been available had people really increased savings by reducing their consumption, but obviously this is not what happened. So what happens is that when interest rates are “artificially lowered” by the central banks’ money creation (credit expansion) you get an initial surge in new businesses or expansion (the ‘artificial boom’), but the new money coupled with the reality that the needed wealth/goods simply does not exist ultimately causes prices of factors of production to go up more than expected as entrepreneurs use the new money to compete for the limited existing wealth, causing the original profit/loss calculations and plans to eventually reflect the reality that there just isn’t enough wealth for all the newly attempted businesses/expansions to really produce more than consume. Let’s quote the great Mises:

“A lowering of the gross market rate of interest as brought about by credit expansion always has the effect of making some projects appear profitable which did not appear before.” (Mises, p. 558)

“However conditions may be, it is certain that no manipulations of the banks can provide the economic system with capital goods[wealth]. What is needed for a sound expansion of production is additional capital goods[wealth], not money or fiduciary media. The boom is built on the sands of banknotes and deposits. It must collapse.” (Mises, p. 559) (words between [brackets] added by me)

Mises sums up everything beautifully when he wrote:

“Credit expansion cannot increase the supply of real goods. It merely brings about a rearrangement. It diverts capital investment away from the course prescribed by the state of economic wealth and market conditions. It causes production to pursue paths which it would not follow unless the economy were to acquire an increase in material goods. As a result, the upswing lacks a solid base. It is not real prosperity. It is illusory prosperity. It did not develop from an increase in economic wealth. Rather, it arose because the credit expansion created the illusion of such an increase. Sooner or later it must become apparent that this economic situation is built on sand.” (Mises L. v., 2006, p. 162)[i]

As signs of trouble inevitably surface in the economy, banks and clueless politicians will have two options, they can either lower interest rates again by adding more money to the banking system which will eventually lead to hyperinflation and people eventually abandoning the money for a foreign currency or something else, or they can stop the money creation and let various businesses fail and let the social order realign itself to reflect reality (the bust). This bust, as people lose their jobs and eventually find others, seems like chaos to the economically ignorant public and politicians who will erroneously try to prevent it with more disastrous government action, yet it is precisely what is needed. This time we quote Hayek:

“And, if we pass from the moment of actual crisis to the situation in the following depression, it is still more difficult to see what lasting good effects can come from credit-expansion. The thing which is needed to secure healthy conditions is the most speedy and complete adaptation possible of the structure of production … determined by voluntary saving and spending. If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand, it must mean that part of the available resources is again led into a wrong direction and a definite and lasting adjustment is again postponed. And, even if the absorption of the unemployed resources were to be quickened this way, it would only mean that the seed would already be sown for new disturbances and new crises. The only way permanently to “mobilize” all available resources is, therefore, not to use artificial stimulants — whether during a crisis or thereafter — but to leave it to time to affect a permanent cure by the slow process of adapting the structure of production to the means available for capital purposes.” (Hayek F. A., 1932, pp. 86–87)

Sadly, even though Mises and Hayek had the economic world completely worked out by the 1930s, mankind continues making the same mistakes, especially the disastrous desire to bring about prosperity via central bank manipulations of interest rates. A perfect example of an economoron at his best when it comes to messing around with interest rates was president Lyndon B. Johnson who in his State of the Union message in January 1967 put it bluntly :

“Given the cooperation of the Federal Reserve System, which I so earnestly seek, … I pledge the American people that I will do everything in a President’s power to lower interest rates and to ease money in this country. The Federal Home Loan Bank Board tomorrow morning will announce that it will make immediately available to savings and loan associations an additional $1 billion, and will lower from 6 percent to 5 3/4 percent the interest rate charged on those loans.”

[i] Available here http://mises.org/books/causes.pdf