The question sounds simple, yes. Ceteris paribus, when the supply of loanable funds increases, the interest rates drop (basically because supply increases while demand stays constant). Now merge this with the Austrian capital theory which says that as savings increases (which conversely means final consumer demand decreases) more roundabout methods of production become more profitable than less roundabout methods of production. Shouldn't this increase in the prospects of profitable investment in more roundabout methods of production actually cause an increase in the interest rate? I mean, an increase in economy's savings causes the need for a change in the structure of production giving an opportunity for entrepreneurs to gain profits from the allocational disequilibrium and hence cause their ability to pay higher interest on loans. PS: I'm taking the Misesian approach of profits being a phenomena of disequilibrium in the allocation of resources.
Prashanth Perumal:and interest rates depend on profits (because interest is basically paid out of profits),
Interest rates and profits are entirely seperate components that do not depend on each other. The entiere question in the OP is based on this false premise. Understand the concept of "originary interest" as Mises called it (or "natural rate of interest" as others call it) and you will answer your own question.
Why does this feel like deja vu? Oh wait. That's right.
John, I am not sure if that answers my question. Those two threads talk about the interest rate sensitiveness of projects. Yes, at lower interest rates longer term projects become more feasible. I kind of know that, I guess. For instance, a $10,000 investment that promises $10,302 at the end of three years would be feasible when the interest rate is 1%, but the same investment wouldn't be possible if the interest rate is 10% unless the return is at least $13,310 at the end of 3 years (note the huge gap in returns required to break-even). So a higher interest rate cuts down a number of less-profitable business projects, more the time it takes to complete those projects.
I hope I'm not missing something else that's relevant that you wanted to get my attention onto. If I'm looking at something else, please be more specific. My question has more to do with the Misesian approach towards profits. If I'm not wrong, Mises says profits are about disequilibrium in the allocation of resources in an economy. So if there is a sudden change in consumer preference (like, for instance, when people suddenly become more oriented towards the future, so they value producer goods more than consumer goods; or more roundabout producer goods over less roundabout producer goods), then there would exist a greater disequilibrium, which would mean higher profits for entrepreneurs who take advantage of the "allocational" disequilibrium. If that's the case, higher savings would mean a greater disequilibrium in allocation, which should lead to higher interest rates.
You've used this term twice now...yet I have no idea what it means...what is a "roundabout method of production" and a "roundabout producer good"?
More roundabout method of production (or more roundabout producer good) = more time it takes to break-even on investments (made on the method of production/producer good). Does that make things clearer?
people suddenly become more oriented towards the future,
Profits are not the only that is in equilibrium in the ERE, so if people's demand schedules suddenly shift, you need to explain what caused this.
I don't have time to go into depth answering your specific question so let me just give the very high-level view and hopefully you can work out your own answers.
The interest rate is like any other price, it is the price of borrowed funds. The more "borrowable funds" (savings) there are, the lower the interest rate and vice-versa. The higher the demand for borrowable funds (investment demand), the higher the interest rate, and vice-versa. And just like any other price, the interest rate is locked in a circular causation with supply and demand - the higher the interest rate, the more savers will want to save and the less investors will want to invest, and vice-versa.
If we are talking about a fiat money economy, that's the end of the story (except that central banks are constantly price-fixing the interest rate, thus discoordinating savings and investments). However, in a natural money economy where there is no central bank and, therefore, the interest rate really does coordinate savings and investment, you also have to look at the supply and demand for money (purchasing power of money) and how this is affected and affects the interest rate.
Clayton -
roundabout method of production
This is standard Austrian terminology and Prashanth is using it correctly. Higher-order goods are defined as goods that require more roundabout methods of production. A consumer good is something that people directly consume. It is the first order good. The second order goods are those which are directly used in the production of consumer goods. The third order goods are those that are used in the production of second-order goods and so on. It is the use of the good which determines its order, not its SKU. For example, an automobile can itself be a consumer good (used to take a pleasant evening drive) or as a higher order good (to deliver pizza). The attributes of the material object itself are not what determine its order.
Prashanth Perumal:More roundabout method of production (or more roundabout producer good) = more time it takes to break-even on investments (made on the method of production/producer good). Does that make things clearer?
Not really...I don't understand why something simply having a longer production process makes it a more "roundabout" good. But I guess the nonsensical nature of the term is irrelevant for this discussion. Clayton pretty much answered your question (as far as I can tell.)
Ok. I think I need to get my question across first. I'll try to explain it in a better way.
Initial consumer allocation of income towards Consumption and Investment = $20 vs. $80. In this case, it would take four rounds of consumer spending of $20*4 to get $80 worth of returns.
Lets say people now decide to save more, and the C-I matchup becomes $10 vs. £90. In this case, it would take 9 rounds of consumer spending of $10*9 to obtain break even returns of $90.
The return from each round of consumer spending narrows (from $20 to $10), but the production process lengthens (from 4 to 9). Basically, the production process has become more roundbout but narrower. Note: the lengthening and narrowing happens because there won't be profits unless it happens. That's what pushes entrepreneurs to take up longer projects. (All this is explained in Hayek's ''Paradox of Saving", in tables named "scheme A" and "scheme B")
Now, getting down to the point on profits, Mises says profits are about "allocational" disequilibrium. If entrepreneurs are going to adapt instantaneously to longer production methods in response to higher investment (savings), then there would be no profits at all. But we know that's not how things happen in the real world. Entrepreneurs who first adapt to the changed fundamentals will gain profits, while others would make lesser profits, or no profits or outright losses (depending on when they adapt to new economic conditions).
So my point is, if profits are mainly about disequilibrium, and interest rates depend on profits (because interest is basically paid out of profits), shouldn't the disequilibrium caused by higher savings (which requires that the production process adapt to the new fundamentals) actually cause a temporary (is that the crucial word I've missed?) increase in interest rates?
If we did not have central banks and we had a free market in banking. Would we have a centralized interest rate? Would not each bank independently set its own interest rate on savings and loans based on the product/service that the bank offers the specific individual?
edit: What I mean is to say is the bank's then would have to consider all factors, from the supply of its own loanable funds to the availability of loans in the market to the credit worthiness of the individual and other factors.
Ok. I think I need to get my question across first. I'll try to explain it in a better way. Initial consumer allocation of income towards Consumption and Investment = $20 vs. $80. In this case, it would take four rounds of consumer spending of $20*4 to get $80 worth of returns.
You're mixing incompatible methodologies. There are no "rounds" of investment/consumption in the ERE.
Now, getting down to the point on profits, Mises says profits are about "allocational" disequilibrium. If entrepreneurs are going to adapt instantaneously to longer production methods in response to higher investment (savings), then there would be no profits at all. But we know that's not how things happen in the real world. Entrepreneurs who first adapt to the changed fundamentals will gain profits, while others would make lesser profits, or no profits or outright losses (depending on when they adapt to new economic conditions). So my point is, if profits are mainly about disequilibrium, and interest rates depend on profits (because interest is basically paid out of profits), shouldn't the disequilibrium caused by higher savings (which requires that the production process adapt to the new fundamentals) actually cause a temporary (is that the crucial word I've missed?) increase in interest rates?
Either you or we are completely misunderstanding the other. Why don't you link to the specific passage you have a question about. In the meantime, take a look at this which explains Hayekian means-ends analysis and the theory of production-possibility frontiers from an Austrian perspective.
Clayton:roundabout method of productionThis is standard Austrian terminology and Prashanth is using it correctly.
I don't think I had ever heard that term before. On its face it wasn't obvious to me what was meant by it. I see Shostak (twice) quotes von Strigl using it here and here, but I'm not sure I'd come across it in Austrian text. Probably because I'm behind on my old school scholars. Especially Böhm-Bawerk.
In light of those readings it makes more sense.
@JJ: Bob Murphy lays out the concept here in a very accessible way, though he uses the term only once.
Clayton:The interest rate is like any other price, it is the price of borrowed funds.
Nothing could be further from the truth. http://wiki.mises.org/wiki/Interest#Interest_is_not_a_price