The question sounds simple, yes. Ceteris paribus, when the supply of loanable funds increases, the interest rates drop (basically because supply increases while demand stays constant). Now merge this with the Austrian capital theory which says that as savings increases (which conversely means final consumer demand decreases) more roundabout methods of production become more profitable than less roundabout methods of production. Shouldn't this increase in the prospects of profitable investment in more roundabout methods of production actually cause an increase in the interest rate? I mean, an increase in economy's savings causes the need for a change in the structure of production giving an opportunity for entrepreneurs to gain profits from the allocational disequilibrium and hence cause their ability to pay higher interest on loans. PS: I'm taking the Misesian approach of profits being a phenomena of disequilibrium in the allocation of resources.
Prashanth Perumal:and interest rates depend on profits (because interest is basically paid out of profits),
Interest rates and profits are entirely seperate components that do not depend on each other. The entiere question in the OP is based on this false premise. Understand the concept of "originary interest" as Mises called it (or "natural rate of interest" as others call it) and you will answer your own question.
@DD5: I think that entry is incorrect because it does not discuss the market (real) interest rate. I'm not sure if Mises is distinguishing between originary interest and real interest but the fact is that increases in the real interest rate result in increases in investment. Perhaps it's more accurate to say it's a ratio of prices but it acts like a price in the sense that it alters people's calculations.
Investment increases can occur as a result of savings-depletion, consumption-deferral or both. The individual's propensity to defer consumption is, in fact, affected by what he expects he can enjoy in the future as a result. If I forego eating 2 out of 3 tarts in the expectation that eating the remaining two after dinner will result in greater satisfaction than eating them presently, I am calculating that a better expected future state is worth giving up present consumption. The same is true of investments - if I expect to have a higher total income as a result of deferring present consumption, the amount of that future higher income matters in deciding how much present consumption to defer.
Mises: "People do not save and accumulate capital because there is interest. Interest is neither the impetus to saving nor the reward or the compensation granted for abstaining from immediate consumption. It is the ratio in the mutual valuation of present goods as against future goods."
Clayton -
Ah, I found the issue: "The granting of credit is necessarily always an entrepreneurial speculation which can result in failure and the loss of a part or of the total amount lent. Every interest stipulated and paid in loans includes not only originary interest but also entrepreneurial profit."
When we speak of "interest", we ordinarily mean "the interest stipulated and paid in loans" which includes both the originary interest Mies describes in HA.XIX as well as the entrepreneurial profit (the profit that incentivized taking the risk of giving a loan in the first place). Mises's point is that you cannot reduce the "stipulated interest" to originary interest because the latter is an expression of purely psychological factors, like an individual's preference of oranges to bananas.
There is a market interest rate for loanable funds and this is a major factor in determining the stipulated rate of interest in a particular investment - for a given entrepreneurial risk for project A and a group of savers with a given risk-tolerance, I will sign the loan contract with the saver who has the lowest time-preference, that is, who will agree to the smallest ratio between future and present funds. This is the portion of the stipulated interest rate that has only to do with originary interest and not the entrpeneurial risk component which varies depending on the nature of the specific investment project and also on the risk-tolerance of investors generally.
Clayton: I think the Wiki page has a fundamental misunderstanding of what Mises is saying in HA.XIX though I don't have time right now to try to root cause the problem.
I'm afraid you have completely misunderstood the Austrian time preference theory of interest rate. The problem is not your lack of "time right now" but that you probably never took the time in the past to really study this stuff in depth. You have it all backwards and your analogy with the price of apples fails for precisely the reason that interest rate is not a price.
@DD5: Yes, I've studied it in some depth and Mises is not beyond question - please see Hulsmann's Mises daily which actually disagrees with Mises on the interaction of interest rates with the money supply.
Prashanth's question was about interest as generally understood which is not originary interest, it is the interest stipulated and paid on loaned funds in Mises's terminology. Note that the portion of this rate that is due to originary interest cannot be separated from the whole interest rate itself, so originary interest is a wholly theoretical discussion of the interaction between time preference and consumption-deferral.
Clayton:the market interest rate absolutely affects the propensity to invest
This is basically the Keynesian theory of interest rate. Is this news to you? People like Mises, Hayek, and later Hazlitt worked very hard to refute this nonsense and to show why this is exactly backwards, i.e., the "propensity" to invest affects the market rate of interest , or for better words, time preference affects the maket rate of interest. If it was your way (or the Keynesian way), then people would indeed adjust their "propensity to invest" (as you call it) to whatever the new arbitrary rate set by some dictator and you would never really have a problem with malinvestments because the funds would increase (or decrease) accordingly.
Clayton, is the use of the word "round" the problem here, or something else? I am not sure if Hayek uses the word "round" or not (does he use stages instead?), but what he tells is pretty much the same, I guess. He addresses Fosters and Catchings who say savings would cause production costs to be too high to be compensated by the little consumption spending made on the products manufactured. Hayek says savings would be used to produce capital goods that would be capable of producing consumer goods over a longer period of time (what he calls a lengthening in the production process is nothing but a longer period of time to break-even) to help compensate for the investment made. Am I getting Hayek wrong on this?
Regarding the nature of profits, I am talking about this quote from Mises (see chapter 15, sub-sections 8 and 9 in "Human Action"): "There is nothing “normal” in profits and there can never be an “equilibrium” with regard to them. Profit and loss are, on the contrary, always a phenomenon of a deviation from “normalcy,” of changes unforeseen by the majority, and of a “disequilibrium.” They have no place in an imaginary world of normalcy and equilibrium."
My question has to do with how well entrepreneurs anticipate the "disequilibrium". If profits are about disequilibrium, and if increased savings aggravates the disequilibrium (thus incentivizing entrepreneurs to correct the disequilibrium), then the chance to make profits would cause an increase in the interest rates, no?
Clayton:please see Hulsmann's Mises daily which actually disagrees with Mises on the interaction of interest rates with the money supply.
His disagreement has nothing to do with what you claim. Hulsmann would certainly not claim that the causation is from market rate of interest to investments.
@DD5: So you think that Austrian theory states that the interest rate does not affect the amount of investment??
Clayton, is the use of the word "round" the problem here, or something else?
Well, we have to have conceptual clarity regarding what we're talking about - the Austrian model is the Evenly Rotating Economy. The idea of "rounds" suggests that there's some kind of collective or aggregated action taking place. In the ERE, there is no collective or aggregated action, there is just an artificially constructed "ceteris paribus" situation, so it doesn't really make sense to speak of "rounds" to me. Perhaps there is an Austrian that uses this terminology but I would be curious to see his definitions.
(what he calls a lengthening in the production process is nothing but a longer period of time to break-even)
I'm pretty sure this is incorrect, can you provide the quote? Break-even has to do with a specific firm whereas a lengthening of the production process has to do with all firms. Specifically, a lengthening of the time-structure of production is evidenced by the emergence of entirely new types of firms or services from existing firms that serve ever more roundabout production processes.
He's just saying that you can't conceive of a "regular profit" in a thought-experimental ERE. This is because all events within the thought-experiment are periodic and known from the outset so anyone charging a profit would simply be undercut by someone else not charging a profit.
I don't like the word "disequilibrium" here, I would prefer to use the word "uncertainty" because the difference between the ERE and the real economy is precisely that, uncertainty. There is no uncertainty in the ERE. Everything that happened before will happen again and all is known and predictable.
And yes, all entrepreneurial profit is the result of uncertainty. Because no one knows for sure what the future will be, the possibility of profit arises. You seem to be reversing causality and want to talk about a "chance to make profits" in a perfectly certain world (the ERE) which is absurd. You have to have uncertainty in order to have the possibility of profit or any action at all.
I'm pretty sure this is incorrect, can you provide the quote? Break-even has to do with a specific firm whereas a lengthening of the production process has to do with all firms.
Can you then tell me what Hayek is talking about in the schemes A and B in Paradox of Saving? My conclusion is based on what he is aiming to debunk: Foster and Catchings' theory that savings would cause investment in production to be more than the money spent on buying the produced consumer goods. Hayek replies by saying that the savings would be used to improve the capital efficiency of the production in such a way that goods are produced with those capital goods over a longer period of time and thus help in breaking-even.
See what Hayek says:
"The allocation of the additional means of production has been effected by maintaining the equilibrium between costs of production and the prices of consumption goods in such a way that the money stream has been lengthened and narrowed down correspondingly, i.e., the average number of the successive turnovers during the productive process has risen in the same ratio as the demand for means of production in relation to the demand for consumption goods has increased."
@Prashanth: To be honest, I haven't read any Hayek to speak of so I really can't answer that question. I also don't own the book so, unless the passage is available online, I can't take a look to try to see if I can make out what he's saying. There are some lurkers here who might be able to answer your question... folks, can you help Prashanth?
I might not be correct. But I don't realy see how increases in savings would cause investment in production to cost more than the produced goods could sell for, ie how increases in savings could make production non viable.
Increases in savings within the market could have the potential to lower interest rates on loans because the more people that have savings the less demand there would be for loans and thus could cause a lowering of the interest rate. ie the less demand for money (loans) the lower the interest rate.
To be honest, I haven't read any Hayek to speak of so I really can't answer that question. I also don't own the book so, unless the passage is available online, I can't take a look to try to see if I can make out what he's saying.
I just quoted Hayek in my previous (edited) post :)
The book is available online: http://mises.org/books/hayekcollection.pdf
DD5: Clayton:please see Hulsmann's Mises daily which actually disagrees with Mises on the interaction of interest rates with the money supply. His disagreement has nothing to do with what you claim. Hulsmann would certainly not claim that the causation is from market rate of interest to investments.
faber est suae quisque fortunae
JackCuyler: DD5: Clayton:please see Hulsmann's Mises daily which actually disagrees with Mises on the interaction of interest rates with the money supply. His disagreement has nothing to do with what you claim. Hulsmann would certainly not claim that the causation is from market rate of interest to investments. Are you saying that this quote is false, then? "The rate of originary interest directs the investment activities of the entrepreneurs. It determines the length of waiting time and of the period of production in every branch of industry."
Of course it is absolutely correct. But what determines the interest rate? Time preference, purely and simply! The Gross rate of course is the orginary rate + premiums of all kinds (inflation, risk of borrower, etc....) but saying that interest rate affects time preferece (what can "propensity to invest" possibly imply?) is sheer fallacy.