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:
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."
Prashanth Perumal: What about this actually makes it an unsustainable boom? Or am I failing to find something obvious here?
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?
etc.
Both the decision to lend and borrow are determined by the interest rate. At a lower rate, profitable businesses may choose not to lend their profits but to expand their business or speculate on commodities. Entrepreneurs will borrow more to invest.
Makes sense.
You ignored my point about adjustable-rate mortgages, which exploded in volume during the housing boom and which were the majority of the delinquent loans as the bust came in.
Oh, sorry. I guess I didn't realize the mortgages had adjustable rates. Does this mean that existent borrowers had to pay more as the rate went up?
I never said most business expenses are financed by loans. Long-term investments often are, especially when there are low interest rates.
Know where I could find empirical data on this?
It borrows $1,000,000 every month to meet these costs. Well, then B comes on the scene. It has to offer more to convince labor to leave A for B. So it borrows $1,005,000. Now A is short labor. It has to borrow $1,010,000 to get the labor back. So then B outbids, etc etc. Notice the loan volume is increasing each time, putting UPWARD pressure on the interest rate. The bank(s) can only maintain the interest rate if more and more individuals increase their savings rates and inject more and more capital into the bank(s) OR if the bank(s) increase the amount of money created out of thin air each time.
I think I follow. If there were 100% reserves, then B would have to pay a higher rate of interest than A and thus would be less likely to take the loan? What (eventually) prevents the banks from increasing the money indefinitely?
Roundabout processes are assumed to be more productive. This means the same amount of materials or labor can produce more goods or services. IE - given the same amount of labor, a factory can produce the far more of some good as can be made using hand tools. Another way to view this is that roundabout processes have a far lower cost per unit, and thus a much higher profit margin.
Makes sense, at least with the factory example. Could we say that lower interest rates increase investment in more fixed capital instead of roundaboutness? (I'm think especially of Marx's definition.)
At 7.5%, the INTEREST alone on that debt may out-strip your annual profit. So it is IMPOSSIBLE to pay it down - the whole investment is insolvent. At 4%, it is possible to pay it down, with the same annual profits. If you started a project at 4% but had to roll the debt over to 7.5%, you may end up insolvent. Even if the project is solvent at both rates, it will still take exponentially longer to pay off at 7.5% vs. 4%. The principal is larger on the day you start actually paying it down, and the interest rate is higher. This means the interest paid is much larger, and it continues to grow and grow until it is fully paid off. So even if a project is solvent, an entrepreneur may not be willing to wait so long into the future to actually have a net positive asset.
At 7.5%, the INTEREST alone on that debt may out-strip your annual profit. So it is IMPOSSIBLE to pay it down - the whole investment is insolvent. At 4%, it is possible to pay it down, with the same annual profits. If you started a project at 4% but had to roll the debt over to 7.5%, you may end up insolvent.
Even if the project is solvent at both rates, it will still take exponentially longer to pay off at 7.5% vs. 4%. The principal is larger on the day you start actually paying it down, and the interest rate is higher. This means the interest paid is much larger, and it continues to grow and grow until it is fully paid off. So even if a project is solvent, an entrepreneur may not be willing to wait so long into the future to actually have a net positive asset.
This is assuming the mass of nominal profits for the investment doesn't increase above expectations, right? If the mass of nominal profits increased enough, that would negate the extra time needed to pay off the loan. Of course that wouldn't help to pay the interest before the project is completed, and I do mean to say nominal profits would necessarily increase ... just trying to include all of the possible counteracting factors.
Short-term investments are generally not to expand the production structure to make it more roundabout. For instance, rather than build a new factory, you might hire a crew for an extra shift or make small alterations to allow more workers to operate on the line without necessarily increase the productivity of each laborer. Because these costs must be paid to make a product before you can earn revenue from your additional output, you must either invest savings/profit to do this, or borrow short-term.
Are there examples of this in the present crisis? You chose factories as your example of increased roundaboutness. Did factories experience an unsustainable boom?
As regards the housing crises, all that you've said about roundaboutness would lead me to predict that a housing crisis would develop in the following way. The low interest rate would cause the producers of houses to invest in machines that would make it more efficient to produce houses in the long term. This would be at the expense of hiring more construction workers to build the houses on site. Once the interest rate goes up, the house producers' investments in the new machines would no longer be profitable. Thus, resources would have to be reallocated, etc.
Do you see why I'm still having trouble connecting the ABCT to the housing crisis? It doesn't seem to have predicted it in quite the right way.
Thanks a lot for your post though. It was helpful.
...and I do mean to say nominal profits would necessarily increase...
Should be "don't."
Yes, in some cases their monthly payment more than doubled. Consider an "interest-only mortgage" (otherwise known as rent) when the interest rate goes from 2% to 5%. The payment could go from $2,000/mo to $5,000.
Unfortunately, no. Most statistics lump investment together. The best proxy we may be able to find is the average maturity length of corporate bonds. As the interest rate goes down, we should see corporations issue longer-term bonds, extending the average maturity of their debt. I'd normally be happy to research such but I'm too busy to do so.
Correct - for the banks to attract the capital to lend to businesses, they would have to offer higher interest payments for time deposits, and they would have to charge even higher rates to businesses wanting to borrow. There is another possibility, but it is highly unlikely, which is that a large amount of individuals suddenly change increase their time preference, saving more of their income and lending it to the banks at the banks' current interest rate.
The second question is actually kind of a laugh. Since we have a fiat currency, and deposit insurance pretty much dismisses the possibility of bank runs, the banks have no real liability they have to meet that they can't simply create out of thin air. The true limitation upon them is actually government regulations. The capital and reserve requirements are regulations, and if they breach such, they get taken over by the government and shut down. So it is actually a political policy that both allows banks to create money out of thin air, and prevents them from lending "too much" money out of thin air.
Ultimately, government backs this limitation to basically cartelize the banks and preserve their control over money. If each bank could engage in as much FRB as they wanted without limitation, it would be a race to the bottom. There would be massive price inflation, bubbles, etc. and the currency would get destroyed. Then the public would start using an alternative currency, and it would be harded for the government to finance itself.
Yes, I think I would agree, at least in the modern sense. But think of being stranded on a desert island. You may produce a net to catch fish that is consumed over 2 days. It allows you to catch more fish in a given time period than you could by hand, but it also took a certain amount of time to make that could have been spent catching fish. The net is a more roundabout method of production, but it isn't permanent - it doesn't last longer than how we think about an accounting period. But it did require a lower time preference to produce, which would be reflected in an economy that uses money by the interest rate.
I can't really think of a modern piece of capital that is consumed within a single accounting period that a lower interest rate would stimulate the production of. If it is consumed that fast, it seems like it would also not take very long to produce, thus not requiring a long-term loan to finance. So on the whole, I would definitely agree that lower interest rates increase fixed investment.
Just keep in mind that fixed investment can mean expansion in scale rather than increasing the productivity of a production process. For example, a store expansion is a fixed investment, but that's not usually going improve the store's profit margin, only its absolute return.
That is a good point, and it should indeed be taken into consideration. The crazy thing about price inflation is how unpredictable it is. If anything it adds uncertainty to business forecasting, increasing the risk of any long-term undertaking. A forecasted sale price of the final merchandise may go from a range of $1.05-$1.08 to $1.30-$1.60. In the first range, it just affects how profitable the business is. In the second range, you might be quite profitable or you might be going bankrupt.
You have to think back to everything that goes into building houses all the way to raw materials. I would imagine timber companies wanted to add more tree-cutting and chopping machines/vehicles into their fleet. This requires more refined rubber and steel, etc. They also needed to distribute such, so more 18-wheelers were built, more belts or pallettes or whatever is used to bundle shipped wood was produced. Also, bricks, cement, glass, tar, granite, etc. etc. All of these industries likely added long-term investments to increase the efficiency of how these intermediary goods could be provided to construction companies who actually turn them into a house. It might be additional mines or refineries. If intermediary goods were produced overseas, companies may have produced more ships to transport them across the ocean.
None of these things are at the expense of construction workers. It actually increases their productivity, allowing them to build more houses in the same amount of time for less cost, causing their wages and employement rate to rise. Similarly, the industrial revolution RAISED the real wage rate for workers.
The investment in capital is one aspect of the housing boom and bust. The other is the actual financing of the final product. As mentioned above, banks were putting people in mortgages that couldn't afford to pay them. Perhaps they believed that if they had to foreclose then they assume possession of the collateral, the house, which still increased in value, so they still make were making a net positive return on their investment. IE - the banks were acting as virtual landlords. They did not anticipate that the rise in houses were temporary, and that when the loans eventually went delinquent they would be stuck with an asset far less valuable than the loan used to pay for it. When this happened the banks were essentially bleeding capital, requiring them to stop lending and/or dramatically increase rates.
ABCT is not the only explanation of the housing boom and bust. I do not believe it directly attempts to explain asset bubbles; however, such as logical behavior when an asset class is rising in price at a greater rate than the interest rate, so much that the risk in the investment seems minimal, which is often caused by massive credit expansion from thin air, which lowers interest rates as it puts upward pressure on asset prices. The process reverses as rates rise and money supply growth diminishes.
There's the gov't regulations designed to boost housing. There's also the implicit guarantees of bailouts and the roles of the GSE's Fannie and Freddie. All of these things at least help start blowing the bubble. The Fed's easy credit policy allowed it to reach absurd heights.
The current downturn has very little to do with ABCT. The bust for ABCT is the realization of the business errors that were committed from the mismatch in time preferences and interest rates. The bankrupt investments get liquidated, prices are reestablished and business moves on. There is temporary unemployment as prices adjust and clear profit signals reemerge.
What is actually happening in this bust is that there is extreme regime uncertainty. Potential employers and investors know that the government has a debt it cannot afford and is doing nothing to arrest it, which signals that it will eventually need to dramatically raise taxes, likely on their future profits. They do not know how Obamacare is going to affect their bottom line. They know the government is trying to recreate the housing bubble, but they've already seen how that ended and don't want to end up on the chopping block. They know the current state of the economy is marked by severe gov't intervention, which is unsustainable in nature and could reverse course after ANY election. So they're sitting out. That's why we have a prolonged bust. Just like in the Great Depression, private net investment has dramatically fallen and will not return until there is a business environment that has more certainty of long-term stability.
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OK, so when A borrows $1,000,000, the interest rate goes up. What about C who started before A and is using a series of short-term loans to fund a long-term project? When A starts borrowing money and raising the interest rate, doesn't that mess up C's plans--extending the amount of time it will take for C's business to be profitable?
And if businesses are willing to get into a bidding war over labor, then why wouldn't they also get into a bidding war over credit? In fact, if they're borrowing more each month to bid up labor costs, they are already taking on a larger amount in interest, if not a greater percentage, given a constant rate of interest.
My understanding is that the government doesn't actually have the ability to limit the amount of money that the banks create. The money ends up back in the system, so the requirements don't prevent the banks from lending money. In fact, some countries, such as Canada, don't even have any reserve requirements. So something else must prevent the banks from expanding the money supply indefinitely and keeping the interest rate constant.
What about building a second factory? Does the first factory that one builds increase roundaboutness, but the second one doesn't? It seems like a store expansion could be a candidate for a long-term loan (or series of loans) as well as a factory could be.
Considering the amount of money being added to the economy is proportional to the amount the interest rate is being artificially lowered, it might not be too unreasonable to expect businesses to experience a likewise proportional increase in their nominal profits. On the other hand, this wouldn't help someone who purchased a home with such a loan, as houses don't make profits.
I'm sure a lot of these higher order goods were expanded for the production of houses. However, I think a lot of that could be explained as a result of the increased demand for houses rather than the low interest rates on capital loans.
That's why I currently find the Financial Instability Hypothesis (FIH) more appealing. It attempts to explain asset bubbles in relation to the interest rate and credit expansion.
OK, so when A borrows $1,000,000, the interest rate goes up. What about C who started before A and is using a series of short-term loans to fund a long-term project? When A starts borrowing money and raising the interest rate, doesn't that mess up C's plans--extending the amount of time it will take for C's business to be profitable? And if businesses are willing to get into a bidding war over labor, then why wouldn't they also get into a bidding war over credit? In fact, if they're borrowing more each month to bid up labor costs, they are already taking on a larger amount in interest, if not a greater percentage, given a constant rate of interest.
First, if there is a long-term investment, it's not going to be a series of short-term loans. It's going to be a series of long-term loans. Let's assume your first loan can be paid off the first month your factory goes online and is producing goods, and it affords the first month of labor and materials to build the factory. If that's 7-10 years away, that's a long-term loan. Your second loan covers the 2nd month of labor and materials and gets paid off the second month the factory is online. So you have a series of long-term loans with virtually the same maturity. If you simply borrowed everything up front, the loan-term would be longer, and the interest paid on it much greater. You'd be sitting on a pool of cash, slowly spending it down each month. If you were to do that you could put the unused cash right back into rolling CD's, and the effect would be relatively the same.
Yes, everyone (even C) with long-term investments is going to get hurt by an unexpected rise in the interest rate or in other costs. Both of these typically happen in ABCT, which explains why there is a cluster of business errors. Remember that the business cycle is not simply an inevitable force of nature but defined by why many trained businessmen simultaneously make large-scale business errors and such events repeat cyclically.
As far as a bidding war, again, the investments themselves are not highly liquid. If you don't produce a finish product, you are likely bankrupt. ABCT predicts that the sooner businessmen recognize their error and abandon the investments and liquidate what they can, the sooner recovery can occur. Some businesses might realize their error and wisely not get involved in a bidding war, either for credit or factors of production. Others may blame the rises in temporary anamolies or seasonal conditions, etc. Some may think that it makes the project potentially less profitable but not unviable.
Also, consider that my example was clearly a hypothetical. In real life, the factor of production in question would not be bid up uniformly and not all of them would move in lockstep. One month labor costs may go up, whereas gasoline might go down. The next month is the opposite. If B or C abandon their investment, A will perhaps see several months of stable or diminished costs, leading him to believe previous rises were similar temporary trends.
Like the stock market, the trends in the long-term only become clear far past the date when action could have been taken to take advantage of gains or avoid losses.
Also keep in mind that as knowledge of ABCT becomes more widespread, the extent of business cycles will diminish as investors take the additional risks (or impossibilities in some cases) into account.
Reserve requirements are only one kind of regulation. There are still capital adequacy ratios and leverage to capital ratios that need to be met. In fact, Mish (an economic blogger) was arguing that the Fed's infusions of cash into the banks would not result in anything resembling hyperinflation partially because it was reserve ratios that prevented them from loaning but capital adequacy ratios.
You show me a banking system that lets freely competitive banks lend fiat currency out of thin air without any form of government regulation, and I'll show you hyperinflation.
If it's the exact same factory then right, it would be no different than a store expansion. It wouldn't decrease the cost of each unit produced but increase it, because the supply of that good would be higher and price pushed lower. But usually newer factories have newer technologies and production techniques and are more efficient. Or they are not duplicating an existing factory's output but producing intermediary capital. For instance, let's say some of the parts in an existing factory naturally wear out relatively quickly without maintenance (1-2 years), so they require stringent maintenance, as reproducing them would be very time-consuming and costly. Well another factory could be made that exclusively produces these parts, with a cost less than current maintenance.
Think about an automobile factory, with all the robots working on the line. The tools used to make those robots may not be very specific to them or efficient. So maybe there's a profit opportunity in making a factory that produces robots.
So your point is indeed valid in some cases, but in many cases a new factory replaces a less efficient older one, or it adds more steps to the production process, more efficiently making capital goods that makes capital goods....and eventually we're more efficiently producing consumer goods.
Sure it could - rent the house. If other prices are rising, surely rents are as well. He could increase the yearly rent he collects in step with the rising value of the home.
Again, there are two things to consider. Price inflation increases the uncertainty in business forecasting. This means things become more risky. If an investor may potentially bankrupt himself but knows he can bail out now and take the losses on the chin, he may choose to do so rather than enter riskier waters. Secondly, because the interest rate is higher, the growth rate of the debt is faster. Even if nominal price increases rose in lockstep with the cost increases, the growth rate of the debt is still higher, and thus it will take longer to repay the debt. Imagine a house taking 30 years to pay off versus 60, BUT no one is willing to buy it. You're 1 year into your mortgage. Do you stop paying it, and start over, or do you stay in debt for the rest of your life?
Well certainly that's part of it, but the interest rate corresponds to the time aspect. The higher demand for houses will see more workers move into construction and related industries. We will see more housing materials being supplied, etc. But will we see long-term investments designed to make houses ultimately cheaper to produce? That is the role of the interest rate.
For instance, let's say a timber company wants to cut down more trees. It can either work existing machinery harder and longer, creating greater need for maintenance, or it can purchase new machinery. The new machinery may take a long time to produce. Or maybe they even decide to create a factory or other dedicated capital to producing such machinery. This would add even more roundaboutness to the production process, and require even more time to produce a marketable product.
FIH fails to explain why the financial system moves cyclically and why scores of businesses would make business errors all at the same time. It is no different than Keynes' animal spirits argument.
FIH seems an extension of Keynesianism, which should have been thoroughly discredited by the stagflation of the 70's, not to mention the countless examples of "stimulus" failing to arrest economic declines. Read Murphy's critiques of Krugman in the Mises Daily articles. Krugman always says that there wasn't enough stimulus. But it's a logical error. Anytime the economy does not recover, Keynesians will say there wasn't enough stimulus. It is baked into their theory that stimulus will revive the economy. Yet that has never happened. Murphy puts the stimulus numbers into perspective. We've spent so much and pushed interest rates so low this time, it's starting to beg the question - shouldn't we be analyzing the cost of stimulus? It may just be that "stimulus" is pushing us deeper into recession.
Again, the biggest statistic is private net investment. It has declined and it hasn't come back. This is despite a huge rise in the savings rate. So what gives? Interest rates are at all time lows. Everything is stimulated, according to the Keynesian playbook. Their only retort is reverse animal spirits. That investors have become fearful fools - where they once invested whimsically and carelessly now they are afraid to make sure bets.
No, a much more plausible explanation is Higgs regime uncertainty explanation. Again, there are numerous possible government regulations/taxes that will potentially make investments unprofitable. From "green" policies to the gov't's spiraling debt, Obamacare, and the massive intervention in financial markets, investors are wisely awaiting a more stable long-term environment to invest in.
As for the boom and bust itself, you should read Tom Woods' Meltdown. It's a very simple-to-read, yet powerful explanation of all the various forces at play in the housing boom and bust. ABCT plays a part, but Fannie and Freddie, and implicit bailout policies are technically not part of ABCT.
So why housing? As I explained about bubbles, when the interest rate is far lower than the average price increase in some relatively liquid asset, you will get a bubble in that asset. Housing's price increases started back in the late 90's when Clinton removed taxes on first home sales and pushing for more aggressive enforcement of the Community Reinvestment Act. Bush continued this trend by making homeownership a national goal. Many of these policies were implemented through the GSE's Fannie and Freddie, who had implicit gov't backing, which proved to be correct when they went bankrupt. The big banks took the same risks on the "too big to fail" mentality, and most of them were rewarded for it.
For the few banks that did get burned, their executives still made a bundle in the good times. None have been investigated and convicted of any crime or been found to be derelict to shareholders. We could further the case against gov't intervention for the big banks. Gov't tax, lobbying, and regulatory policy (not to mention bailout policy) rewards size, creating an artificial economy of scale. The SEC is incompetent or even supportive of big companies using questionable accounting practices. The credit-rating agencies have perverse business models but they are endorsed by SEC rules. Size, just like in a nation, makes effective control over the business and executives more difficult for each shareholder. This combined with the leniency of the law in the wake of what happened are a moral hazard that encourages executives to behave in an extremely risky manner.
"In fact, Mish (an economic blogger) was arguing that the Fed's infusions of cash into the banks would not result in anything resembling hyperinflation partially because it was reserve ratios that prevented them from loaning but capital adequacy ratios."
Should read "In fact, Mish (an economic blogger) was arguing that the Fed's infusions of cash into the banks would not result in anything resembling hyperinflation partially because it was not reserve ratios that prevented them from loaning but capital adequacy ratios."
I wanted to point out one more thing. Keynesians rely on empiricism to "prove" their hypotheses. Austrians base economic knowledge on deduction from a priori statements that are universally valid. I find it strange that the Keynesians hold so strongly onto the idea that stimulus can cause an economy to recover when the empirical data suggests otherwise.
Their reply reveals exactly what is wrong in using empiricism to develop macroeconomic theory. They say that it is not stimulus causing further decline but the extent of the bust. But how do we isolate the variables? It's impossible. Empiricism cannot tell us whether a current recession is an extension of a bust or actually caused by stimulus and other measures designed to "fight" it.
The best we can do empirically is compare a no-stimulus response versus heavily stimulus. The two heaviest stimulus responses were the Great Depression and the current recession. The clearest case of the hands-off approach was 1921. If you're basing your economic theory on empirical study, I don't understand how you can conclude the Keynesians are correct...
On that last point I'd just like to note that Keynes was not an empiricist and his 'general theory' is in fact a priori and praxeological (and would be correct if his concept of the 'propensity to consume' was accurate).
Keynes' influence was highest in the 20s and evolved into the 30s. General Theory was an apology for the depression, a lame explanation as to why policies based on his teaching culminated so badly, and a clutching at straws as to what to do next. What the politicians did that led to the end of the depression was learned to ignore him and and all of his theories. Wish that lesson learned had had some staying power. Government has no money to spend but our money! They do not spend our money better than us. Stimulus is bogus.
Statements that are widely accepted are not proven valid. All economists work from models based on scarcity, while reality is of limited surplus. Those models point towards importance of increasing productivity, while the world production is already more than sufficient. Equitable distribution is the key for widespread affluence, not economic growth. Increasing the wealth of the world means nothing to anyone if all of the production growth goes into the coffers of the people who already have more than they know how to consume.
As far as a bidding war, again, the investments themselves are not highly liquid. If you don't produce a finish product, you are likely bankrupt. ABCT predicts that the sooner businessmen recognize their error and abandon the investments and liquidate what they can, the sooner recovery can occur. Some businesses might realize their error and wisely not get involved in a bidding war, either for credit or factors of production. Others may blame the rises in temporary anamolies or seasonal conditions, etc. Some may think that it makes the project potentially less profitable but not unviable. Also, consider that my example was clearly a hypothetical. In real life, the factor of production in question would not be bid up uniformly and not all of them would move in lockstep. One month labor costs may go up, whereas gasoline might go down. The next month is the opposite. If B or C abandon their investment, A will perhaps see several months of stable or diminished costs, leading him to believe previous rises were similar temporary trends.
But your explanation of the business cycle implied that A and B would keep bidding each other up and that this would increase the upward pressure on the interest rate. If--as you say now--there are other counteracting factors and one month might be the reverse of the previous, then it doesn't seem like the pressure on the interest rate would necessarily increase. It seems to me that there are two possibilities all else being equal: (1) under a fractional reserve system, the artificially lowered interest rate exerts a constant amount of upward pressure; and with 100% reserves, the interest rate remains constant. (2) under a fractional reserve system, the artificially lowered interest rate exerts an increasing amount of upward pressure; and with 100% reserves, the interest rate gradually rises. Am I missing something?
Reserve requirements are only one kind of regulation. There are still capital adequacy ratios and leverage to capital ratios that need to be met. In fact, Mish (an economic blogger) was arguing that the Fed's infusions of cash into the banks would not result in anything resembling hyperinflation partially because it was reserve ratios that prevented them from loaning but capital adequacy ratios. You show me a banking system that lets freely competitive banks lend fiat currency out of thin air without any form of government regulation, and I'll show you hyperinflation.
I'm not really sure how those other ratios work, but my question pertains to what makes the bubble pop in the ABCT. Are you saying that the banks reach the legal limit to what they can lend, and thus the interest rate finally goes up? Or does the government change their mind and enforce stricter limits?
I see. Roundaboutness and fixed capital are definitely different in that case. As a consequence, the claim that a lower interest rate increases roundaboutness seems less plausible. I don't see why someone would choose to buy a second factory when interest rates are high but choose to upgrade the machinery in his current factory when interest rates are low. Just because something increases efficiency doesn't mean it takes longer to get a return on an investment.
Well certainly that's part of it, but the interest rate corresponds to the time aspect. The higher demand for houses will see more workers move into construction and related industries. We will see more housing materials being supplied, etc. But will we see long-term investments designed to make houses ultimately cheaper to produce? That is the role of the interest rate. For instance, let's say a timber company wants to cut down more trees. It can either work existing machinery harder and longer, creating greater need for maintenance, or it can purchase new machinery. The new machinery may take a long time to produce. Or maybe they even decide to create a factory or other dedicated capital to producing such machinery. This would add even more roundaboutness to the production process, and require even more time to produce a marketable product.
And? Is that what happened?
FIH fails to explain why the financial system moves cyclically and why scores of businesses would make business errors all at the same time. It is no different than Keynes' animal spirits argument. FIH seems an extension of Keynesianism, which should have been thoroughly discredited by the stagflation of the 70's, not to mention the countless examples of "stimulus" failing to arrest economic declines. Read Murphy's critiques of Krugman in the Mises Daily articles. Krugman always says that there wasn't enough stimulus. But it's a logical error. Anytime the economy does not recover, Keynesians will say there wasn't enough stimulus. It is baked into their theory that stimulus will revive the economy. Yet that has never happened. Murphy puts the stimulus numbers into perspective. We've spent so much and pushed interest rates so low this time, it's starting to beg the question - shouldn't we be analyzing the cost of stimulus? It may just be that "stimulus" is pushing us deeper into recession.
I don't know enough about the FIH to endorse it or even to explain it well, but it does claim to describe the business cycle and stagflation. I was just reading this (PDF) paper by Steve Keen that addresses those two issues. Krugman doesn't subscribe to the FIH.
I believe the FIH explanation is that the level of private debt is too high. People are using their incomes to pay down their debt rather than to spend. Thus, demand has fallen. If demand hasn't fallen and investment has decreased, wouldn't we be seeing a lot of shortages right now or increasing prices?
" But your explanation of the business cycle implied that A and B would keep bidding each other up and that this would increase the upward pressure on the interest rate. If--as you say now--there are other counteracting factors and one month might be the reverse of the previous, then it doesn't seem like the pressure on the interest rate would necessarily increase." The long term trend is that factors of production will be bid up until there is a bust. I was simply saying that the upward pressure won't perfectly fit a curve and can even act contrary to the long-term trend in the short-term. Costs may also become more volatile. This adds to uncertainty. If entrepreneurs saw in the first 2-3 months that their costs were uniformly rising smoothly along a curve, they could easily predict alternative costs for the entire project and perhaps abandon it early-on. It may be only after a year or two of investment that the trend became clear, when they carry greater debt. The only things that could prevent rising costs (in the long term) including the interest rate are if entrepreneurial ventures were halted (or never started), or if for some unknown reason there was a mass-shift in people's time preference and they began to save more. We tend to see the first of these happen when the bust phase sets in. It generally occurs alongside a drop in incomes (layoffs and unexpected losses) which to some degree prevent savings rates from rising. However, the interest rate can be held constant, even with increasing loan demand, by creating more and more funds from thin air - ie engaging further in fractional reserve banking. In a free banking system, this makes the bank more and more vulnerable to bankruptcy from normal redemption demand or bank runs. In our fiat, gov't backed system, it pushes banks closer and closer to capital adequacy and reserve ratio regulations. It's important to realize that even without regulatory requirements, the boom cannot be permanent. Because maintaining the interest rate requires greater and greater funds created from nothing, it will eventually result in hyperinflation, essentially driving the economy back to barter and making long-term calculability in a common unit impossible. But also keep in mind that as business ventures go bankrupt, this hurts banks' balance sheets as they have to write down losses. This is especially true for investments that are mostly illiquid, like a half-finished factory or mine - the bank cannot recover much if any of its lent funds. So while business ventures no longer demanding bank funds would normally drive rates down, banks need to raise capital to repair their balance sheets, which actually forces rates upwards. Also, banks generally try to make a positive real return on their loans. Thus, they are unlikely to push the interest rate too low, although they will occasionally accept negative real rates of return (which are still better than no return at all, ie - sitting on cash). So in the hypothetical world, where A, B, and C all start their investment at relatively the same time due to artificially lowered interest rates and everything else remains constant, yes, there is a constant upward pressure on the interest rate that the bank can only prevent by engaging further and further into fractional reserve banking, until it hits regulatory limitations or redemption demand greater than its reserves. " It seems to me that there are two possibilities all else being equal: (1) under a fractional reserve system, the artificially lowered interest rate exerts a constant amount of upward pressure; and with 100% reserves, the interest rate remains constant. (2) under a fractional reserve system, the artificially lowered interest rate exerts an increasing amount of upward pressure; and with 100% reserves, the interest rate gradually rises. Am I missing something?" Honestly, I'm not sure how to answer this question. As time progresses everything cannot remain equal. In theory, the interest rate should find an equilibrium where the supply of loanable funds clears the market. I would have to imagine that if costs of production went up or demonstrated a trend of going up exponentially, entrepreneurs would not increase their loan demand in lockstep forever. Some would eventually abandon their investments. If we accept that they absolutely refuse to give up and continue to bid up costs, then yes, there is increasing pressures to raise rates from the factors I mentioned above - either risk of bankruptcy or breaching regulatory requirements or further and further negative real returns. In such a hypothetical case but using full reserve banking, loan demand would outstrip loan supply, causing the bank to raise rates to keep them in balance. If entrepreneurs chose to continue borrowing at any rate, then yes, there would be constant upward pressure on rates. However, higher interest rates should cause less loan volumes to be demanded. I suppose the tendency in FRB would be for banks to try to get as close as possible to violating regulations or having regular redemption demand cause them to go bankrupt without actually doing so, maxmizing loan demand and manufacturing whatever loan supply is necessary. " I'm not really sure how those other ratios work, but my question pertains to what makes the bubble pop in the ABCT. Are you saying that the banks reach the legal limit to what they can lend, and thus the interest rate finally goes up? Or does the government change their mind and enforce stricter limits?" Thinking of it as a pop is incorrect. You have to think of it as a cluster of errors. The "pop" or bust is the realization of the errors, and the decision to abandon them or declare bankruptcy, etc. This isn't a single event or multiple occurring simultaneously. It's more of a chain reaction. Also keep in mind, Austrian Economics does not view the bust as harmful to the economy - it views it as essential to reestablishing prices that reflect the realities of available resources and time preferences, allowing the economy to start producing the most desired goods at a stable growth rate. Rather, it is the boom that is the problem, where errors are committed and resources are wasted. As mentioned earlier, there is developing "pressure" to push rates upwards. The event that actually FORCES the rates upwards could come in many forms and it can be different for different banks. It could be reaching a regulatory limit, or a change in regulations. It could be an unexpected bankruptcy, forcing a bank to recapitalize. It could be an accounting error. There's also political pressure due to consumer price inflation. Rather than change regulatory requirements on reserves or capital adequacy, the central bank will raise the federal funds rate, which it enacts by reducing the amount of base money available to banks (M1). The banks have debts too and to meet them with cash, they occasionally need to borrow money. While they can create loanable funds from thin air, they cannot pay down debts by creating money from nothing. If the interest rate at which they borrow rises, then they start expending more capital on interest costs. So they need to borrow more and more. And eventually they hit their regulatory limits on reserves or capital. Whatever the cause of rising rates, they cause investments to realize they are unprofitable or are profitable but not until exponentially farther into the future than expected. Thus, investors abandon the investment. The effect this has on bank's balance sheets and how they have to raise capital puts more upward pressure on rates. So then why is the case of ABCT so different from the normal economy? In other words, what if in full reserve banking an unexpected bankruptcy were to happen, forcing banks to raise rates? Would there be a similar chain reaction? Potentially there could be, but there are several factors in heavy fractional reserve banking that need to be considered. There's the inflation factor - fractional reserve banking clouds forecasting by causing inflation. The more stable the money supply, the easier it is to forecast, since all prices are denominated in that unit. Then there's bank risk. FRB manipulates the interest rate, leading to a greater amount of long-term investments. Where unexpected events affect the interest rate, they do not do so as strongly as such events in FRB. FRB essentially makes banks less stable. Central banking was designed to reduce this risk, and to some degree it does for individual banks. But then banks as a whole can take on too much risk and the central bank cannot bail them all out if a bust occurs. In short, FRB makes economic activity have more uncertainty and thus risk, introducing greater volatility in all prices and the interest rate. This can be confirmed through statistical data. "I see. Roundaboutness and fixed capital are definitely different in that case. As a consequence, the claim that a lower interest rate increases roundaboutness seems less plausible. I don't see why someone would choose to buy a second factory when interest rates are high but choose to upgrade the machinery in his current factory when interest rates are low." I think you may have misinterpreted my example. I was saying that a lower interest rate may prompt the creation of a factory that creates parts for a different factory. In this case, you have both more roundaboutness and fixed capital. Whereas before, you had a few engineers maintain the capital with wrenches and hammers and welding torches, now you have an entire other factory that makes those parts. " Just because something increases efficiency doesn't mean it takes longer to get a return on an investment." I agree, but in general the more efficient and less roundabout production processes are easier to discover and implement. Also, such discoveries are relatively random, and are not dependent upon the interest rate to implement. So there's no boom associated with them, whereas there is with a lowered interest rate. "And? Is that [, investing in long-term roundabout production processes,] what happened?" http://wiki.mises.org/wiki/Great_Recession This is a good account of the recent boom/bust. The ABCT is mainly a theory of how there are cyclical clusters of business errors, revolving around long-term assets and the use of monetary policy or fractional reserve banking to artificially reduce the interest rate. Keep in mind that it does not exclusively deal with extending the production structure, although that was its normal expression in the past. One example of the capital goods side of this is the number of leveraged corporate buy-outs that occurred. As for the housing/construction side, I'm not sure if construction companies extended their production structure or simply expanded their quantity of capital goods. It seems like they invested in long-term assets that did not pay off, as houses were sold to individuals that ultimately could not pay for them. I do not think the ABCT as normally constituted regarding more roundabout production processes neatly fits the last boom/bust cycle. The monetary policy, maturity-mismatching, and excess financial risk part of it does, but there's less evidence of extending the capital structure. The essential question is whether manipulation of the interest rate prompted more long-term lending than was ultimately sustainable. The answer is yes. As the wiki post above mentions, real-estate loans are longer-term than most business loans, and banks shifted lending from construction/manufacturing towards real estate. There were certainly other factors pushing credit towards housing. But if you include asset bubbles in ABCT, then the housing bubble was a good example of ABCT. If you simply view it as unsustainable attempts to extend the capital goods structure, it does not fit as nicely. Also, part of ABCT is that there weren't enough real resources to complete an investment profitably. This was the case with the housing boom. Although plenty of houses were completed, they weren't able to be financed at a profitable price. Those who bought them at such prices often were delinquent on the mortgage. When the bank foreclosed and put them up for auction, the houses were sold at a loss. Comparitively, less durable consumer goods, such as food, have consistently been paid for profitably the entire boom/bust cycle. " I don't know enough about the FIH to endorse it or even to explain it well, but it does claim to describe the business cycle and stagflation. I was just reading this (PDF) paper by Steve Keen that addresses those two issues. Krugman doesn't subscribe to the FIH." I am definitely no expert, but from what I've read it seems to base business cycles upon group psychology and animal spirits. I cannot endorse that. Successful businessmen are often the complete opposite. Yes, they are willing to take risks, but any idiot can do that. The successful ones are generally patient, smart, and hard-working, doing a lot of research before investing. They are basically the opposite of the instinct or mania-driven fools Keynesianism or FIH makes them out to be. Even if most investors were such idiots, the smart ones would end up on the better sides of trades with them, and eventually the smart investors would have far more resources than the idiots, and the smart investors would steer prices and the economy. Mania cannot describe why lots of businessmen all make errors simultaneously and this process repeats cyclically. If FIH, etc. were correct and people are simply idiots, I fail to see how a government or other centrally-planned policy can overcome this and keep the economy stable. Rather I see it as the opposite - government tries to centrally plan the economy such as promoting home ownership and "encouraging business" by artificially lowering interest rates. And the central plan's failure hurts economy-wide. " I believe the FIH explanation is that the level of private debt is too high. People are using their incomes to pay down their debt rather than to spend. Thus, demand has fallen. If demand hasn't fallen and investment has decreased, wouldn't we be seeing a lot of shortages right now or increasing prices?" Well I would agree that private debt levels are too high to sustain the kind of consumption the government wants us to in order to "help the economy". But where does debt come from? If some people have too much debt, does that mean others have too much credit? Not in our system - the credit came from thin air, created by the banks. The banks made errors, just as did individuals who took on too much debt. Now the banks aren't getting repaid and can't lend further. The source of all this error - manipulation of the interest rate as well as moral hazards from gov't, such as implicit bailouts. There has been plenty interest rate manipulation since the bust has hit. This is evidenced by the growth in money supply measures. Prices ARE increasing, even in the items that should have been hit hardest by the bust: housing and rent. http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[1][id]=M2&s[1][range]=5yrs http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[1][id]=CPIAUCSL&s[1][range]=5yrs http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[1][id]=CPIHOSNS&s[1][range]=5yrs http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[1][id]=CUUR0000SEHA&s[1][range]=5yrs The government can't consume its way out of the recession. The only way it could bring down private debt levels is to dump the debt on the taxpayer or destroy property rights and the banking system. Dumping on the taxpayer is only going to hurt net investment. It's not as if producing things has become unprofitable - there are plenty of profit opportunities out there. Unemployment and underemployment are potential profit opportunities. What is holding back investment is regime uncertainty. Why risk your savings or years of work when the government might tax away all your gains or otherwise make your business unprofitable by making labor and energy more expensive? The Keynesian argument that a fall in demand causes less investment seems plausible. If no one is buying anything, then it doesn't make sense to produce anything. But a fall in demand does not mean that investments are unprofitable. Costs can fall too, or maybe it's just profit margins shrunk. Actually looking at "demand" shows very clearly that demand has NOTHING to do with the current lack of investment in the economy and the high unemployment nubmers. I'm sure FIH and Keynesians have some trifles, but the basic story is the same: unfettered market causes business cycles, government solution prevents them.
Here's my little summary of the business cycle:
This in a nutshell explains the business cycle, I believe.
Yet I said nothing about demand for consumer goods increasing (the necessarily corollary of the savings rate decreasing resulting from lower interest rates), nor did I say anything about how low interest rates effect high and low order production differently.
Now, here's my question (aside from: does my above summary make sense?): does the greater sensitivity of high-order production to interest rates actually need to be cited in order to explain why there is a sudden cluster of errors at the end of a boom, when rates rise to their market level? It's necessary to explain why high-order production suffers more than low-order, but that's incidental, a feature of actual modern business cycles, but not an essential feature of the business cycle as such, isn't it? If there were a fairly primitive economy with nothing we would call high-order production, inflation through the credit market would still cause the business cycle. The really important concepts to grasp are simply that 1) the suppression of the rate makes fundamentally non-viable businesses appear viable, and 2) this is unsustainable.
I'm not saying that talking about the structure of production is unimportant, just that it doesn't concern the essence of the business cycle.
...or maybe I'm missing something.
i agree. the main thing to take away from higher-order goods is that they generally take longer to start earning revenue and are more difficult to liquidate. to the extent the boom spurs such investments, it will likely make the bust that much more painful. also if existing higher-order goods are allowed to be consumed rather than maintained based on planning to be replaced by new investments, this will cause issues in the production structure during the bust, which can explain unemployment, as in Murphy's sushi island example.
Sorry, kind of forgot about this thread and lost track of the discussion. I think I'll have to check out that wiki link and read up more elsewhere on the ABCT.
I am definitely no expert, but from what I've read it seems to base business cycles upon group psychology and animal spirits. I cannot endorse that. Successful businessmen are often the complete opposite. Yes, they are willing to take risks, but any idiot can do that. The successful ones are generally patient, smart, and hard-working, doing a lot of research before investing. They are basically the opposite of the instinct or mania-driven fools Keynesianism or FIH makes them out to be.
I have not read Keynes's own explanation of "animal spirits," but if it's what I think it is, then I might agree with you. I've so far been disappointed with the way I've seen the FIH presented--as if everyone becomes enraptured with deluded expectations. Personally, I am a big fan of the prisoner's dilemma and similar insights from game theory. I think the FIH could potentially be explained in those terms. Maybe I'll try to work such a version out once I understand it better.
I'm sure FIH and Keynesians have some trifles, but the basic story is the same: unfettered market causes business cycles, government solution prevents them.
Though I find the FIH appealing as an explanation, I am a bit skeptical of the government's ability to prevent business cycles. I'll read the Keynesians soon enough.
Anyway, thanks for the interesting discussion. I think I understand the ABCT a bit better now.