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On Malinvestment, How? and Why?

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David Z posted on Wed, Dec 17 2008 3:13 PM

A lot of people are unclear on the concept of "malinvestment."

I'd like to start with an expanded version of a response I posted earlier in order to try and clarify the concept.  Intelligent comments and constructive criticism appreciated.

Begin by considering two concepts:

  1. An interest rate is fundamentally an inter-temporal price: present goods in terms of future goods.
  2. Consumption is always the destruction of previously accumulated wealth.

The value of a prices, no pun intended, is that they provide signals to market participants: when, where, in what quantity, and towards what ends should investments be directed. These signals are valuable information that market participants use in directing the resources at their disposal, whether they be cash, credit, finished products, works-in-progress, etc. Any interference with prices, therefore sends inaccurate signals to investors, entrepreneurs, consumers, borrowers, and lenders.

When money is injected into the system, it causes prices to change without a corresponding change in time preference which would be necessary to meet the "demand" contrived by the inflation. The takeaway here is that if time preferences haven't changed, fiat injections cause a disconnect between prices and time preference.

New money, especially fiat money, typically manifests itself as demand for consumption goods. Keeping in mind that "consumption" is just a polite and roundabout way of saying that you're destroying something valuable, since this consumption wasn't matched with a previous investment in productivity, it's likely to be a net value destroyer.

What happens when new money is introduced, is that demand appears to have increased, manifested by higher prices. These prices tell people "make more stuff", this is how it works: People see a higher price being paid for certain goods, and this appears to indicate that there is perhaps profit to be made in that market. Responding to the apparent signal, they begin now to overwork their assets, or perhaps to invest in assets that will enable them to be more productive tomorrow.

What has not changed is the present productive capacity.

Prices rose, however, because of the money; the higher prices being merely reflections of the increased money supply, and not of any fundamental change in consumer preferences. This money eventually works its way through the system, and people discover that they over-utilized their productive assets yesterday (and therefore can't produce as much today) or that they invested in assets in an attempt to match increase capacity to accommodate a phantom increase in demand. When this fact is eventually revealed, many investments are revealed as unprofitable and must be liquidated, and in either case we are worse off.

It requires previously accumulated capital (higher order goods) to facilitate the production of more consumer products (lower order goods) without depleting the existing capital stock. In order to have more today, it is imperative to have invested in productivity, made some sacrifice towards that end, yesterday.

This process does not work in reverse.

Without that previously accumulated capital, a boom/bust phase is inevitable.

 

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David Z

"The issue is always the same, the government or the market.  There is no third solution."

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Prashanth Perumal:

What about this actually makes it an unsustainable boom? Or am I failing to find something obvious here?

Prices need to convey meaningful information about the relative availability of goods & services. By increasing the money supply (whether in the hands of a single individual or many), the resultant prices convey less-accurate information. 

How do others in the economy respond?

  1. Higher relative prices signal "shortage" which may cause businesses to increase production when it's not really justified (per Say's Law).
  2. Other individuals no longer buy at the higher prices, choosing instead to buy something else less satisfying to them (per the principle of revealed preference).
  3. Profits in certain industries most impacted withdraw productive talent and capital from other, otherwise profitable ventures (there isn't any more to go around, so prices for all factors increase...
  4. If the interest rate decreases, individuals contribute less to savings (investment in productivity) and more to consumption which exacerbates the problem.
  5. The productive capital necessary to sustain this level of consumption needs to have been put in motion ex ante.  It's too late, now.

etc.

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Artificially loweing an interest rate is like a Communist taking a pool of capital and saying we're not going to have a free market price anymore - it's going to be lower for the greater good.  Ok, but then supply of the capital falls because people get less of a return and demand increases. Now you have shortages of capital.

Why do people get less of a return? I mean, sure, I understand why people lending money get less of a return, but I don't understand why businesses get less of a return in profits. They shouldn't have trouble borrowing money since money is created out of thin air especially for them.

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Oh, bobbo kind of answered that question. I'll get to his post tomorrow.

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bobbo: when long-term investments start, they pull in labor from other areas in the production structure, many of which were previously working closer in time (further down the production structure) to producing finished consumer goods.  to do this, they must offer higher wages. [...] the laborers for the 5 year project come from other sectors of the economy.  to lure them away from their current occupation, the 5 year project offers them better wages.

Why are long-term investments able to pay higher wages? Couldn't the short-term investments borrow money as well to outbid them for labor?

I think I understand most of what you're saying. I just don't see how the control of the interest rate relates to the ratio between long-term and short-term investments. None of the resources I've come across have explained this either.

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Andrew replied on Thu, Mar 22 2012 9:29 PM

Just because a project will take longer doesn't mean it will have a higher ROI.  However, some ventures that are long term projects are more profitable than your average short-term project.  Think of creating a business - you could become Warren Buffett - or you could invest your money you were going to spend on the business in 30 day Treasury bills and make a small, yet relatively immediate return.   

Entrepreneurs and businessmen who bid up labor in this example are speculating or expecting their returns to be higher from these longer term projects than shoter term ones they could otherwise do.  The artificially lower interest rate simply encourages them to pursue these longer term projects - it doesn't force them.  It allows for the possibility of these investments - when before, the cost of capital was too prohibitive.  

 

 

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But wouldn't there also be people who wouldn't normally have pursued a short term project but decide to when the interest rate is lower?

Also, I'm not sure there is a necessary connection between the length of a project and the amount of investment. For example, it might cost me $100 million to buy and run a used factory building, but I could start producing and selling consumer goods immediately. On the other hand, I could buy a plot of land for $1 million and start a Christmas tree farm, where I might have to wait 20 years before I can sell anything. It might take me a long time to pay-off the factory building, but that doesn't mean its a higher-order good (if I understand that term correctly). The investment is going to satisfy consumer demand immediately. It doesn't involve the creation of new resources that won't be used for a number of years.

Additionally, the bulk of the costs of long-term projects often doesn't come until near the end of the project. It takes a long time to design a building, find a location, and assemble potential financiers, but the main costs (I imagine) come in the actual construction which takes a relatively short amount of time. While I'm sure there are a number of incomplete buildings, the bigger problem we are facing is the number of empty complete buildings and houses.

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Well we might as well talk about commercial real estate, and for that matter residential.  Let's start with the latter.

Although residential real estate is a consumer good, it is durable good financed over a long period of time.  Lower interest rates make these goods seemingly more affordable.  Demand for housing goes up.  More labor and resources are drawn into businesses that help houses get built - ie lumber, carpentry, stone-work.  This extends far beyond construction and contracting.  It affects trucking - new trucks may be built to handle getting more construction materials to where they need to be.  It changes the property taxes - governments hire more for their new streams of revenue.  There is a ripple effect that alters the entire structure of production.  While elongation of the production structure would be more feasible from low interest rates, it doesn't necessarily mean such must occur to create a business cycle.  It is not the only form of malinvestment.  We may have cases where less high order capital of one type is being produced in favor of another.  Consider a factory converted from making coffee cups to making granite counter-tops.

The credit expansion is putting upward pressure on prices - not only home prices, but all consumer goods, as well as interest rates.  When rates rise, it will make homes more expensive.  It will also arrest price increases.  Speculative assets bubbles will pop.  All the changes aligning more resources towards home construction will be shown to be unprofitable and unwarranted.  The glut of homes and lumber cannot be easily liquidated, at least not at a price that incurs heavy losses.  Banks have heavy losses, and cannot afford to make new loans.

As shown in the Sushi example, workers cannot simply move right back into retail and other sectors close to end consumption, because those businesses rely on finished products from an earlier stage of production, which ultimately rely on some form of capital that was consumed.  This capital needs to be rebuilt or worked around to provide those goods.  In the meantime, many workers have no work.

The same thing goes for commercial real estate - it's just one step back from final consumption - rather than being a final good itself, it provides final goods.

So in your example, you are assuming that there are idle capital goods laying about.  Let's assume that's true for some intermediate capital.  Well how does this factory get the refined materials it will use to produce more consumer goods?  It would increase demand on refiners, who increase demand on miners or chemical factories, etc.  Expanding production in one area will make it more profitable for others to expand further back to higher-order capital goods.  If there is no idle capital goods that can be used for say mining and refining, they must be built, which is often a long-term investment.

Given the choice entrepreneurs will buy idle capital before constructing new capital, provided the idle capital costs the same as constructing new capital, simply due to time preference.  The interest rate has no bearing on this.

The ROI isn't necessarily what the interest rate changes - it's the time factor that's most constricting.  Using your example, let's assume the Christmas tree farm has a ROI of 4% and the factory 3%, no matter what the interest rate is.  At a 3% interest rate, the Christmas tree farm starts earning profit after 40 years.  At a 6% rate, it's 120 years.  Comparitively, the factory can earn income after 2 years at 3% and 3 years at 4%.  So the interest rate makes a difference of 80 years vs. one year for the respective investments.

Would you make an investment that wouldn't show a profit until after you were dead, even if it had double the profit margins of any existing business?

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In the second of last paragraph there, I mean 6%, not 4% for the interest rate.  I can't edit my post with the backwards-a$$ browser I have...just wanted to point out I'm not changing the numbers.

I also want to point out not to compare business cycles to depressions like the Great Depression and the current one.  In a normal business cycle, unemployment goes down once the interest rate regains stability around its natural rate, the capital structure is repaired, and resources are allocated back to where they can maintain a sustainable profit.

What we are experiencing is regime uncertainty.  Investors know that interest rates are being held below the market rate.  They also fear how Obamacare when fully implemented will affect profits, as well as pending schemes such as environmentalist regulation/taxes.  They also know the US is fiscally imbalanced and don't know whether the ground will be recouped with gov't spending cuts or tax hikes, but they probably figure tax hikes since gov't spending has almost never been cut, except after major wars.

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Although residential real estate is a consumer good, it is durable good financed over a long period of time.  Lower interest rates make these goods seemingly more affordable.  Demand for housing goes up.  More labor and resources are drawn into businesses that help houses get built - ie lumber, carpentry, stone-work.  This extends far beyond construction and contracting.  It affects trucking - new trucks may be built to handle getting more construction materials to where they need to be.  It changes the property taxes - governments hire more for their new streams of revenue.  There is a ripple effect that alters the entire structure of production.  While elongation of the production structure would be more feasible from low interest rates, it doesn't necessarily mean such must occur to create a business cycle.  It is not the only form of malinvestment.  We may have cases where less high order capital of one type is being produced in favor of another.  Consider a factory converted from making coffee cups to making granite counter-tops.

But wouldn't this be true in reverse as well? If the interest rate rose, then people would buy less houses and more coffee cups. So investors would invest in more higher order goods to produce coffee cups since the increased demand means a higher ROI. As resources are tied up in producing higher-order goods, the supply of current goods is diminished. This leads to price increases in coffee cups as well as houses. The high profits the increased prices induce will lead to higher investment--raising the interest rate even higher. These long-term projects now have to refinance at higher rates. This extends the time needed to become profitable--causing them to fold.

As shown in the Sushi example, workers cannot simply move right back into retail and other sectors close to end consumption, because those businesses rely on finished products from an earlier stage of production, which ultimately rely on some form of capital that was consumed.  This capital needs to be rebuilt or worked around to provide those goods.  In the meantime, many workers have no work.

But if capital needs to be rebuilt, doesn't that mean an increased demand for workers to rebuild that capital? It doesn't seem like there should be a lack of work because of that. I didn't understand that part of Murphy's article. If the boats and nets were in such ill repair, why wouldn't the islanders use the idle workers to fix them and then transfer them to another task once capacity has been increased?

The ROI isn't necessarily what the interest rate changes - it's the time factor that's most constricting.  Using your example, let's assume the Christmas tree farm has a ROI of 4% and the factory 3%, no matter what the interest rate is.  At a 3% interest rate, the Christmas tree farm starts earning profit after 40 years.  At a 6% rate, it's 120 years.  Comparitively, the factory can earn income after 2 years at 3% and 3 years at 4%.  So the interest rate makes a difference of 80 years vs. one year for the respective investments.

Would you make an investment that wouldn't show a profit until after you were dead, even if it had double the profit margins of any existing business?

No, probably not. I don't think anyone answered this question: Would the interest rate not change at all in a free market? And if the interest rate was always 6%, does that mean we would never get any Christmas trees, or more importantly, any new trees for construction?

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I think you're trying to put my example into the wrong paradigm.  Yes, houses and coffee cups need higher-order capital to be more efficiently produced.  Yes, if there is less demand for housing and more for coffee cups, then you'll see the shift.  The reason there is a cyclic activity here is that when the interest rate is lowered via credit expansion (ie - money creation), it induces TEMPORARY changes to the price structure.  The more money that is borrowed and invested puts more pressure for the interest rate to move back towards the natural rate.  So the changes in demand are cyclic.  Much of the shift in production is malinvestment.

You are indeed correct that such a shift would be hard to do profitably at the higher interest rate.  Indeed what we often see after a bust is a shortening of the production structure.  It must adapt to the lack of higher-order capital that was consumed during the low-interest rate period.  The economy must stabilize and get back to full capacity, and this might be less efficient/productive than the situation before the boom/bust cycle.  Before the production structure can be lenghthened to return to its pre-cycle productivity, there must be a change in saving/consumption ratio to allow the interest rate to naturally lower and allow investment that does not have the risk of rising prices and interest rates to reveal it as malinvestment.

Murphy explains why this the bust causes unemployment.  Part of it is because of the opitimal combination of factors of production.  Let's say one net is most efficiently made by two workers.  Each additional worker adds little to no productive value to the process.  For example, consider 100 cooks trying to make a single hamburger.  So the unemployed workers could make additional nets.  But this has no value, since the sushi production structure only requires say 5 nets, not 50.  The extra 45 nets made would go idle.  They could perhaps be used as spares, and it would make more sense in a communistic setting, but in a capitalist environment, no entrepreneur is going to spend capital to soak up idle labor by making idle capital.

The other reason is that labor is not a homogeneous blob of goop that can be redirected anywhere in the production structure willy-nilly.  If McDonald's is forced to lay off 10% of its workforce, and there's a shortage of neuro-surgeons, we can't just move the idle labor from fast food service to surgery.  Probably less than 1% of that labor pool actually has the potential to be compentently-trained in surgery.  But back to the current example, if we were to train the idle labor to work efficiently in a different sector of the production structure, the time and energy it takes to do so may be unwarranted by the time they are actually ready to begin production.  For instance, if a factory needs to be converted from making granite counter-tops to coffee cups, it might take a year to do so given the current labor available.  It could be done twice as fast with twice the labor, but it takes 1 year to train such labor.  By the time that labor is trained the job is already done.

On final reason is that during the boom, entrepreneurs are expecting larger profits and believe they can afford to raise wages.  Thus, they are bidding up labor.  When the bust hits, this process is driven in reverse.  Laid off workers who may be able to return to their former jobs may need to take a pay cut to do so.  They are reluctant to accept, instead choosing to search for a higher paying job for a little longer, rather than immediately accepting a lower wage.  Remember, due to capital consumption and a shortening of the production structure, labor is made less productive, and thus cannot afford to be paid as large of a wage as before, relative to price inflation.

To answer your last question, the interest rate does change in the free market, but not in the same manner as a boom-bust cycle.  It generally moves lower and lower.  As productivity increases material well-being, people can afford to save more and more; and in general they do.  The history of interest rates show it decreasing on average from the middle ages all the way to WWI.  The age of fiat currency and gov't financing via massive debts has pushed this in the opposite direction.

But the main thing to pick up on is that the boom-bust cycle is a temporary interest rate change.  The more money that is borrowed at artificially low rates, the more pressure there is to increase the rate.  Wages and other prices will increase exponentially, and as investors tug-o-war for labor and resources, they will have to borrow exponentially more and more to afford it.  The only way to maintain the interest rate is to add exponentially more and more new money into the economy, which eventually results in hyperinflation and complete economic breakdown as it destroys economic calculability and long-term planning.

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Before the production structure can be lenghthened to return to its pre-cycle productivity, there must be a change in saving/consumption ratio to allow the interest rate to naturally lower and allow investment that does not have the risk of rising prices and interest rates to reveal it as malinvestment.

Consumption in this sense just means spending? If I take out a loan to spend on a personal house or a long-term business project, I'm expressing a preference for consumption in either case?

Murphy explains why this the bust causes unemployment.  Part of it is because of the opitimal combination of factors of production.  Let's say one net is most efficiently made by two workers.  Each additional worker adds little to no productive value to the process.  For example, consider 100 cooks trying to make a single hamburger.  So the unemployed workers could make additional nets.  But this has no value, since the sushi production structure only requires say 5 nets, not 50.  The extra 45 nets made would go idle

He says that it takes 25 workers to maintain them under normal conditions. After they fall into disrepair, I imagine the process could accommodate more workers. If a hurricane struck a city, I'm sure it could accommodate more construction workers than it could under normal conditions.

The other reason is that labor is not a homogeneous blob of goop that can be redirected anywhere in the production structure willy-nilly.  If McDonald's is forced to lay off 10% of its workforce, and there's a shortage of neuro-surgeons, we can't just move the idle labor from fast food service to surgery.

I actually made this point in another thread in relation to the affect of technological development on employment.

To answer your last question, the interest rate does change in the free market, but not in the same manner as a boom-bust cycle.  It generally moves lower and lower.  As productivity increases material well-being, people can afford to save more and more; and in general they do. 

Does that mean the rate of profit declines as well?

The history of interest rates show it decreasing on average from the middle ages all the way to WWI.  The age of fiat currency and gov't financing via massive debts has pushed this in the opposite direction.

And yet the 1800's were characterized by more booms and busts than the fiat era. Do Austrians have a separate business cycle theory pre-fiat?

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"Consumption in this sense just means spending? If I take out a loan to spend on a personal house or a long-term business project, I'm expressing a preference for consumption in either case?"

No sir.  A consumption good is one that is used to directly satisfy a human want.  Consumer spending is spending on consumer goods.  In contrast, a capital good is used to help produce consumer goods or other capital goods.  Someone may purchase capital goods for their own personal amusement, in which case they could be regarded as consumer goods, just like someone might enjoy his job, regardless of his pay.  But these cases are a small sample, and they are only a fraction of the value.  Most investments only satisfy the investors desire by making him a profit - the goods themselves are only useful in that they produce other goods, that are valued by other people.  Eventually, the value of all these goods is derived from how much consumers value the final consumption goods at the end of this chain.

Saving is a difficult concept to grasp.  Obviously saving money is considered saving as well as making loans.  Investment is trickier.  Sometimes this take the form of not making capital goods, but simply holding speculative assets like gold and silver.  One could even hold consumption goods like cigarettes.  Usually saving is defined as deferred consumption, so as long as you're not consuming whatever you have earned or bought, you are saving.  Of course, when we think of saving for the investment process, we are talking about making resources available for entrepreneurial activities.  This means corporate bonds and time deposits in banks, or in our fractional-reserve banking system, simply making deposits in the bank.  Or it could mean directly saving capital then investing it into an entrepreneurial venture, like starting a business.

Perhaps Murhphy's example overstates the bust's unemployment, but as I said, there's no point in making nets that will remain idle.  And in a capitalist society, no entrepreneur is going to spend his savings or take a loan to hire idle labor to make what will likely be idle capital goods.  Of course, the gov't might.

I am not sure about the interest rate's affect on the profit rate, but I would assume not.  It would encourage more investment, so in the sense that the supply goes up, the price goes down, profits would shrink; but there's not a fixed demand in investment.  Some investments create brand new technology, creating new demand where it didn't exist before.

Austrian Business Cycle is not dependent on fiat currency, or technically even central banking, although both these conditions can worsen the severity of business cycles.  Keep in mind the 1800's had two national banks, and the post-civil war era to the creation of the Federal Reserve was known as the national banking era.  All of these encouraged fractional reserve banking from a top-down scheme.  The national banks WERE central banks.  In the nat'l banking era, the large New York banks were virtually a cartel central bank.

A better comparison would be the Free banking era to the others, and it actually has a good history.  moreover, business cycles during the 1800's were not as severe, long, and perhaps even as frequent as the 1900's.  Rothbard's History of Banking is a must read on this account.  For instance, some 19th century "depressions" according to economic history actually show low unemployment with average income increasing year over year.  In comparison, average worker income has stagnated in real terms since 1970, when our currency was made fully fiat.

The root of the business cycle is lowering of the interest rate by the creation of new money originating into circulation as bank loans.  In short, fractional reserve banking.  To the extent a free market allows this, the business cycle is part of the market economy.  However, the main problem with business cycles has always been government endorsement, subsidy, or direct practice of fractional reserve banking.

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No sir.  A consumption good is one that is used to directly satisfy a human want.  Consumer spending is spending on consumer goods.  In contrast, a capital good is used to help produce consumer goods or other capital goods.  Someone may purchase capital goods for their own personal amusement, in which case they could be regarded as consumer goods, just like someone might enjoy his job, regardless of his pay.  But these cases are a small sample, and they are only a fraction of the value.  Most investments only satisfy the investors desire by making him a profit - the goods themselves are only useful in that they produce other goods, that are valued by other people.  Eventually, the value of all these goods is derived from how much consumers value the final consumption goods at the end of this chain.

You implied that the interest rate was determined by the consumption/saving ratio. I don't see how this can be true. I would think the level of borrowing to buy productive goods would also affect the interest rate.

I am not sure about the interest rate's affect on the profit rate, but I would assume not.  It would encourage more investment, so in the sense that the supply goes up, the price goes down, profits would shrink; but there's not a fixed demand in investment.  Some investments create brand new technology, creating new demand where it didn't exist before.

Then I'm not convinced that the interest rate would have a natural tendency to go down over time. High profits would increase the demand for credit, driving the interest rate up.

Austrian Business Cycle is not dependent on fiat currency, or technically even central banking, although both these conditions can worsen the severity of business cycles.  Keep in mind the 1800's had two national banks, and the post-civil war era to the creation of the Federal Reserve was known as the national banking era.  All of these encouraged fractional reserve banking from a top-down scheme.  The national banks WERE central banks.  In the nat'l banking era, the large New York banks were virtually a cartel central bank.

But the impression I got from your previous arguments was not that fractional reserve banking causes the business cycle in itself, but that the manipulation of the interest rate by a central authority causes it. In addition, you said that the interest rates gradually went down throughout the period preceding WWI. The first graph here seems to indicate that that is not true. Now we could acknowledge that the interest rate was manipulated during that period, but then I'm not sure what the deal with the Fed and fiat currency is.

A better comparison would be the Free banking era to the others, and it actually has a good history.  moreover, business cycles during the 1800's were not as severe, long, and perhaps even as frequent as the 1900's.  Rothbard's History of Banking is a must read on this account.  For instance, some 19th century "depressions" according to economic history actually show low unemployment with average income increasing year over year.

Hmm, this isn't the impression I've always gotten. First off, I'm not sure how good a barometer the unemployment rate is for an era that was much less capitalist. According Wikipedia, the US labor force was 80% agricultural in 1800 and 50% in 1850. Considering that this was made up of mostly small independent farmers with their own land and slaves, it would be pretty hard for them to ever become "unemployed." So in 1850, an estimated 5% of the workforce was unemployed. That's 1/10th of the people that could be unemployed. So the rate is fairly comparable to today. In addition, Wikipedia notes that during the 1800's "unemployment outside of agriculture was as high as 80%." Then there were depressions like the Panic of 1893 where the overall unemployment rate reached as high as 18%. As far as length, the Panic of 1837 during the Free Banking Era was the second longest depression in American history.

In comparison, average worker income has stagnated in real terms since 1970, when our currency was made fully fiat.

Some people here on this site disagree with that. Still, I'm not sure why you mention fiat here and then say that fractional reserve banking is the real issue.

The root of the business cycle is lowering of the interest rate by the creation of new money originating into circulation as bank loans.  In short, fractional reserve banking.  To the extent a free market allows this, the business cycle is part of the market economy.  However, the main problem with business cycles has always been government endorsement, subsidy, or direct practice of fractional reserve banking.

So in a free market with fractional reserve banking and no central authority dictating the interest rate, the interest rate would still fluctuate?

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Yes, "the" interest rate is simply of an average of many interest rates, which are simply prices accepted by borrowers and lenders.  If the demand for borrowed capital rises while the supply remains the same, the price should go up.  So yes, interest rates are determined by both borrowers and lenders and capital is subject to the laws of supply and demand.  Where consumption/saving falls into this simply has to do with the supply of capital.  It's quite possible that entrepreneurs attempt to increase borrowing at the same time as saving rates rise and rates remain neutral.

I see your point about how profit opportunity would try to push up the interest rate.

The major question of the business cycle is why there are clusters of business errors that all occur at roughly the same time across a large area and why these clusters of errors occur repetitively.  If one bank engages in large-scale fractional reserve lending, they are able to be bankrupted by a smaller bank run than a bank that engages in small-scale fractional reserve lending. The most extreme case is 0% reserve, where any demand deposit withdrawal bankrupts the bank.  In a free banking environment, there is no central mechanism so that all banks engage in fractional reserves at the same proportions and times.  In fact, because banks often end up with their competitors' notes, they can attempt to orchestrate runs on rival banks.  So in a free market (to the extent fractional reserve banking isn't treated as fraud), banks would maintain higher reserves, and reserve levels would be highly unlikely to be coordinated over large areas or time.  So business cycles would be very small and have little affect on the whole economy.  They would not appear as the business cycles we currently have.

Where business cycles are more noticeable is when many banks are encouraged to lower their reserve levels simultaneously, lowering interest rates over a large area.  What is needed is to reduce the risk bankruptcy in the case that a fractional reserve bank is exposed to a lack of capital needed to satisfy demand deposits.  Central banks serving as lenders of last resort, or gov't schemes to dispel bank runs like deposit insurance reduce this risk.  Fiat currency gives more power to both these backstops.  Then the lender of last resort or gov't deposit guarantor cannot run out of emergency funds itself.  Notions like "too big to fail" and prior bailouts are further moral hazard for banks to mismange risk.

When I was talking about interest rates falling, I was talking about the average macro rate trend, not a perfect line, which clearly falls from 1860-1915.  But I was talking more like 1600-1900.  After the creation of the Federal Reserve and the era of strongly manipulated interest rates, looking solely at the rate is meaningless.  It needs to be indexed against price inflation to get the real rate, in terms of goods.  It should be indexed as such for all periods - I'm not saying there was never inflation until the Fed came around.  But it'd be more clear that you'd see a different story.  Of course, the real rate still isn't the natural rate.  The real rate would still be held below the natural rate by credit expansion - the creation of currency issued into circulation in the form of bank loans.

The 1873 and 1893 panics were both a result of gov't interference with monetary policy.  The greenback issuance during the Civil War and the change to the National Banking system encouraged credit expansion and malinvestment.  

The 1837 depression is inaccurately attributed to the Free Banking Era, when in actuality it was the inevitable consequence of the excesses of the 2nd National Bank, and various government meddling with money affecting strong flows of gold/silver.  This is documented in Rothbard's History of Banking.  He points out in the book that many economists overstate how bad the bust was, as both real production and real consumption increased rather largely during the 4 year bust, contrasted to the 1929-1933 bust period in which both fell tremendously.

It's pointless to compare statistics today to statistics over 100 years ago, unless there is a reason to think they have relevance in comparison.  If unemployment was high in your opinion during the 1800's, was that due to economic policy or in spite of policy?  The bigger point is to look at how the business cycles affected unemployment, not whether unemployment is higher during the 1800's or 1900's.  AND if we were to want to compare unemployment rates, we should want to make sure we're comparing the same thing.  IE - comparing the rate as definied by some economic historian for the 1800's is probably not the same way the BLS calculated U-3 or U-6, etc.

Also, be wary of how certain things are described according to economic history.  Somehow the 1870-1890 period is regarded as a long depression, when it actually shows the highest rate of economic growth in American history - the 1880's.  At the same time, the banking system was centralized by the gov't.  While it didn't have the cartelization features of a true central bank and the endless backstop of fiat currency, it did encourage fractional reserve lending, and there were numerous banking panics.

The biggest point I was trying to make was the severity and frequency of 1800's busts, particularly look at the "best" periods during free banking and the federal reserve.

As for the stagnating real wages, that's still true.  benefits, perhaps not.  and i'm not going to argue everyone is just as well off today as 1975.  clearly things have improved in numerous ways.  but also keep in mind that many more households have both man and woman in the workforce.  so while household income goes up, a lot.  but i believe without the massive erosion of purchasing power to the currency and the numerous business cycles we've experienced, we'd be better off.

and yes, in a free market, interest rates would definitely fluctuate.  but there would be no indication of cyclic clusters of business errors.  there would be less malinvestment.  there would be less fractional reserve lending and more banking stability.  i think the free banking era demonstrates such fairly well.

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I expressed skepticism earlier over whether a low interest rate would increase the level of investment in long-term projects. I just came across a post on a Marxian blog that said the following:

Finally, another dig at Austrian Business Cycle Theory, one of its precepts is that an increase in the money supply will lead to an unwarranted increase in “roundabout” methods of production. But there’s actually no evidence that this is the case. Instead, what happens with lots of cheap credit is that money pours into short-term investments in securities. The “structure of production” is not lengthened (ie made more “roundabout”) at all.

Two questions: Is this true? And if it is, would that invalidate the ABCT?

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"there’s actually no evidence that this is the case"

So I guess we recently didn't get a glut of houses, and correspondingly a glut of businesses and capital goods created to help produce houses?

I guess skyscraper theory is just a phenomenon.

Perhaps what's confusing them is that short-term interest rates fall too.  But that doesn't mean that long-term rates are at their natural level.  The short-term borrowing rate being lower than it should doesn't help the economy either.  It may help keep afloat businesses that should fail.  At the least it causes price inflation and leads to economic forecasting difficulties.

The whole point of ABCT is that the interest rate structure is not in line with society's overall time preference.  Unsustainable investments will occur all over the time horizon.  Long-term ones usually cause worse damage because they leave behind a lot of work that cannot be liquidated.  The size of the recession following the bust is determined by how difficult it is to reestablish the structure of production that is in line with consumer demand.  IE - if it just means some labor needs to be retrained and employed elsewhere, it can happen relatively quickly, given no severe barriers, such as union regulations, are in the way.  If it means that a capital goods structure that was consumed during the boom needs to be rebuilt, that can take years, and most of the labor that is now unemployed has to find jobs that pay far less than their potential productivity, until those capital goods are ready to be used.

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