I understand the Austrian idea that fractional reserve banking(FRB) and artificially low interest rates(ALIR) create malinvestment which fuels the business cycle. This comes about because entrepreneurs are directed into longer stages of production (i.e. businesses that take a longer time to show returns).
I have a question though. Is it possible that the same FRB and ALIR colud cause entrepreneurs to instead "over invest" in short stages of production? Interest rates still guide the investment decisions and I can't see a reason why someone wouldn't just borrow more money and increase their short stage investments.
To illustrate, consider the following example. An entrepreneur is offered two investment choices 1.) opening a hotdog stand or 2.) developing a new computer chip. Lets say, that both businesses require a $100,000 investment. Lets also say that the hotdog stand takes 1 year to turn a profit and the computer chip plant takes 5 years.
Now if interest rates are 10% APR the entrepreneur decides that the hot dog stand is the more profitable venture and if interest rates are 1.5% APR then the entrepreneur decides that the computer chip factory is more profitable.
If the free market sets the interest rate (there is no Fed) at 10%. The entrepreneur will certainly invest in the hot dog stand.
If however, the Fed introduces an ALIR of 1.5% then what happens? Austrians say the entrepreneur will switch and invest in the long run, computer chip factory. But because the future demand for money was really higher (10% according to the free market), the entrepreneur's investment won't be worth what he thought it was and his investment will have been a bad decision.
I'm wondering isn't it also possible that with an ALIR, the entrepreneur will simply increase his investment in short stage investments? Isn't it possible that he'll simply open two or three hotdog stands instead of one? He can now "afford" to borrow more money. Three hotdog stands may not be sustainable where one hotdog stand is sustainable.
Or am I missing something?
I think you're spot on.
Im guessing that the lucky hot dog guy will finish his three stands on time and on budget and live happily ever after.
But he's not the only one out there. There will be plenty of people that go for the computer chip factory, and they will be in trouble eventually. Enough of them and they will drag down the economy with them.
My humble blog
It's easy to refute an argument if you first misrepresent it. William Keizer
OOOps, I missed the heart of your q. Is the guy foolish for building 3 hot dog stands instead of one? I think that's what you are asking.
Well there are dumb guys and smart guys. There will be people who build the 3 hot dog stands when they shouldn't have. Easy money brings the stupid out of their caves, absolutely. They too will contribute to the crash.
Mises didn't mention them, I think, because he was trying to get a mathematically rigorous explanation for booms and busts, independent of relying on human stupidity in his explanation. He managed to build a beautiful construct where the low interest rate results in even the best and the brightest wasting their money. A Greek tragedy at its best.
But in the real world the picture is simpler. Stupid people usually don't have the money to try out their stupid money losing schemes. But with ALIR, they have their big chance.
It reminds me of Mises' critique of Socialism. Some idiot criticized him because Russia didn't collapse from the reason Mises invented [that they wont know how to use their resources without a price system]. Like criticizing a doctor for diagnosing cancer because the patient dies a few minutes later in a car crash. Mises was showing an insurmountable problem every socialist system must have, even if we assume all its leaders are brilliant saints and all its citizens Mother Teresa. Russia died because it had cruel foolish leaders and normal citizens. So?
Similarly here, Mises wrote why there is a fatal flaw in ALIR that will ruin an economy even if all its people are brilliant. That it will collapse sooner because there are in fact dummies out there is something he didnt bother with.
tir38: I'm wondering isn't it also possible that with an ALIR, the entrepreneur will simply increase his investment in short stage investments? Isn't it possible that he'll simply open two or three hotdog stands instead of one? He can now "afford" to borrow more money. Three hotdog stands may not be sustainable where one hotdog stand is sustainable. Or am I missing something?
No, you've independently hit on a crucial distinction: between lateral and longitudinal expansion. As Mises puts it in Human Action, Chapter 20, Section 6:
"When under the conditions of credit expansion the whole amount of the additional money substitutes is lent to business, production is expanded. The entrepreneurs embark either upon lateral expansion of production (viz., the expansion of production without lengthening the period of production in the individual industry) or upon longitudinal expansion (viz., the lengthening of the period of production). In either case, the additional plants require the investment of additional factors of production. But the amount of capital goods available for investment has not increased. "
I would contend that, while the period of production hasn't been lengthened for the individual industry, it has for the economy as a whole. The capital that is now allocated toward the new hot dog stands that aren't actually viable, has been directed away from branches of production elsewhere in the economy with even shorter periods of production.
But that's my own reasoning, and not what I've found in the AE literature yet: although I've been looking.
is a single hot-dog stand a relatively less roundabout way of making and selling hot dogs than three hot dog stands?
(is a small bucket a less relatively roundabout way of fetching water than a bucket that is three times as big?)
if so, maybe the categories of higher and lower order are still good.
anyhow,...ABCT is characterised not just by malinvestments in longer term projects, but in overconsumption during the boom. i.e. consumption of hotdogs...
Mises:Conditions are different under a credit expansion which first affects the loan market. In this case the inflationary effects are multiplied by the consequences of capital malinvestment and overconsumption
props to lilburne on his post. I better get lateral and longitudinal into my vocab
Where there is no property there is no justice; a proposition as certain as any demonstration in Euclid
Fools! not to see that what they madly desire would be a calamity to them as no hands but their own could bring
Well I'm saying that three stands might still be a malinvestment.
one stand might be. malinvestments are identified by the losses they incurred and how the entrepreneurs that engaged in them went on to abandon them
nirgrahamUK:props to lilburne on his post. I better get lateral and longitudinal into my vocab
Thanks nir. Have you seen my thread Feedback request for Economics Piece? You being a student of ABCT, I'd particularly appreciate your feedback.
@ Lilburne
I'm not so sure. Wouldn't higher order entrepreneurs tend to outbid lower order entrepreneurs for the new funds available since their investments appear more profitable?
Stephen:@ LilburneI'm not so sure. Wouldn't higher order entrepreneurs tend to outbid lower order entrepreneurs for the new funds available since their investments appear more profitable?
Yes, but that would actually seem to fit what I'm saying. If the following were true...
Lilburne: I would contend that, while the period of production hasn't been lengthened for the individual industry, it has for the economy as a whole. The capital that is now allocated toward the new hot dog stands that aren't actually viable, has been directed away from branches of production elsewhere in the economy with even shorter periods of production.
... then that would mean the capital for the new hot dog stands was bid away from away from lower order entrepreneurs (say some other entrepreneur who would have liked to use metal components in the grill to make silverware for retail sale): thus a longer period of production is substituted for a shorter one.
I understand the Austrian idea that fractional reserve banking(FRB) and artificially low interest rates(ALIR) create malinvestment which fuels the business cycle
do you believe it to be true? or false?