Hello to everyone! It's my first post here, and I'm glad this forum exists.
I'm familiar to Austrian Economics for some time and have read several "Austrian" books. Today, all of a sudden, the following thought crossed my mind: Why is it, actually, that in a free market economy interest rates would go up when people save less? Until today, it seemed obvious to me: Less savings means less to lend out for the banks (supply of savings goes down, price goes up). But now something bothers me: When people trade with each other, the money simply goes from one bank account to the other. So the amount of available money seems to stay the same for the banks...
I tried to solve this puzzle by thinking: When people save more, prices fall and the value of their money rises. That could be the same as if there were just more money. But that thought doesn't help, because the amount of money still stays the same, so interest rates are nominally the same as well...
I would be very glad if someone could help me with this. It's sure some sort of fallacy of mine, but yeah... Thank you in advance.
The money on your checking account is not exactly available for the banks to lend out...
If on average people start spending more and therefore saving less, and they withdraw money from their bank accounts for this purpose, there are less funds available to the bank to be loaned out, and so interest rates rise. As long as this more spendthrift tendency remains, the higher interest rates will remain. If people revert back to their original frugality, interest rates will fall accordingly as bank deposits increase.
While true that money withdrawn by Jones and spent will ultimately end up in Smith's bank account, remember that the premise of this hypothetical is that people on average have become more spendthrift; i.e. Smith will also have already reduced his bank deposits, and any income from selling something to Jones will be allocated according to the new more spendthrift consumption-savings ratio. In other words, even though the spent money might flow through the banks briefly in the transaction between buyer and seller, the stock of bank-deposited money relative to the stock of circulating money will be smaller than it was before. And if there's no change in total money supply, this means an absolute decline in loanable funds and higher interest rates, all else being equal.
Under the situation you are talking about banks would either have to artificially create the money, and then lend it, in which case it wouldn't be dissaving which is happening but rather credit expansion, or the money would have to come from reserves like checking accounts, which would indeed count as dissaving and it would have the affect of raising current spending relative to current investment, shifting the factors of production to a more current use.
Eliminate the bank and what you have is a bunch of people trying to fund projects that will pay more than what they need to start, call them entrepreneurs, and another group of people who have wealth and are planning to spend it, call them consumers. The consumers want to consume some of their wealth and they want to save some. The entrepreneurs want to entice the consumers to save their wealth with them and not consumer. The entrepreneurs do this by paying interest on the the money consumers save with them. So if consumers adjust their behavior by consuming more and saving less, then less money is available to the entrepreneurs. So to keep the same amount of savings available the entrepreneurs will have to increase the payouts to consumers by increasing the interest rates.
Even if the amount of money stays the same, consumers adjust their consumption decisions not only to savings versus consumption, but on what products and services they consume to satisfy their preferences. And in a free economy entrepreneurs are always looking to get the wealth of consumers by trading for wealth through interest or by trading goods and servcies. So if the consumer with a constant amount of money can increase their wealth by either having a large set of things to buy or by having cheaper prices for those things.
Now as the consumers see ever expanding values of their money, the money becomes so valuable that it becomes hard to trade so there will be entrepreneurs who jump in to the market in several ways: Cut the amount of gold in the money, Mine new gold, start new forms of money (A person may want 10 ounces of gold for a car or 600 ounces of silver or 6000 ounces of copper, etc, or offer a paper or electronic contract for money.) or get more money by giving users of the metal alternatives. (An entrepreneur could give dentists a ceramic cap instead of a gold one for instance.)
Think for a moment how advantageous it is to have a precious metal with alternate uses for money. Dentists, jewelers, circuit builders, etc all use gold and silver. When the value of these metals as money goes up they use other things, and when the value of gold as money goes down they switch back to the monetary metals. Compare this to the ever decreasing value of paper money.
people have to pay more for scarcity.
Why is it, actually, that in a free market economy interest rates would go up when people save less?
On the simplest level, interest rates are the price paid for borrowing money. If supply of money available to lend goes down and demand remains the same, there will be more people chasing a smaller pool of funds, meaning the price, the interest rates, would naturally rise.
I see. So it's the money in circulation that is of course not available for the banks... But does this really matter so much? I mean, exchanges don't take that much time, so the money will quite quickly be on the other person's account again. So is that really such a big loss to the banks? This short time the money is not available?
"I see. So it's the money in circulation that is of course not available for the banks... But does this really matter so much? I mean, exchanges don't take that much time, so the money will quite quickly be on the other person's account again. So is that really such a big loss to the banks? This short time the money is not available?"
That's meant to be an answer to "Minarchist".
In a free market interest rates on savings would represent the market rate for interest on savings. Ideally from the bank's perspective the interest rates on savings would be low and the demand high. The consumer preference is obviously high interest. The bank then would have an incentive to raise the interest rates in order to get customers.
By way of analogy, suppose there's a waterslide, where the water collects in a pool at the bottom and gets pumped back up to the top, so that it flows in a loop. The pool is the bank, the rest of the circuit is the path of the money through the economy outside the bank. When the savings rate goes up, the circuit gets longer. Instead of a 100 foot slide, it becomes 120 foot slide, but the total amount of water remains the same. So what happens? The pool loses water, since more water is in the rest of the circuit. Yes, the water that leaves the pool might quickly return to the pool, it could even return more quickly than before, doesn't matter - the pool still has less water in it at any given time than it did before.
@Minarchist: Great analogy, thank you! One last question: What about an economy where everything is like in the US except for the FED leaving the interest rates alone? Would interest rates still go up if people saved less and go down if people saved more? Even though there's online banking, for example, so the money changes bank accounts extremely quickly and is thus almost always available for the banks?
By the way: Would online banking exist under a gold standard?
Leon Wolf: By the way: Would online banking exist under a gold standard?
Sure. You'd just use information as credits to each bit of gold. There's still the possibility of issuing more credits than you have gold, so it needs to be tightly controlled and periodically audited so that confidence remains high.
After WWII, the US gave gold to our allies for decades. They never took it out of Fort Knox, we just change who owned it. Thus, exchange requires exchange of title only, not the physical asset necessarily. Which is one of the reasons why fiat money works without a commodity backing, and also one of the reasons why bitcoin functions as money.
I think that's a bit glib. Money substitutes - hell, banking itself - only work if there is some kind of securitization of the assets held. It doesn't have to be government doing it (in fact, one could argue that the breakdown of the global financial system is naught else but the result of governments securitizing financial instruments) but, somehow, there has to be securitization. Look at Hawala to see a system of distributed securitization.
Clayton -