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.
re: Dave's two posts
I must admit, I'm not as well versed in time preference theory as I'd like to be, but from where I sit right now, that sounds pretty good to me. I especially like the summation
"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."
as well as
"those are consequences, not defintions."
I'd be interested to hear from Danny and Jonathan on this.
I don't think there is any contradiction in Mises' explanation of interest formation and how it decides the supply of and demand for capital goods. The originary rate of interest is a function of a change in time preference; as society sacrifices present consumption for future consumption — a lowering of time preference — the originary rate of interest lowers, precisely because the discount between the valuation of future goods against present goods lowers (see page 521 of Human Action, where he discribes interest as the difference between the value of present goods and the value of future goods, where the latter are always worth less than present goods of the same quantity and kind [n.b.: this is also why Mises believes originary interest is always positive]). The sacrifice of present consumption, which is an act of setting aside capital (i.e. saving), decides the supply of capital. Neither does the demand for capital determine the rate of interest, given that the latter is only a price ratio; the demand for capital is constrained by its availability.
Why doesn't the rate of interest act as an inducement to save? Because, if this were true then an increase in savings would cause a fall in the rate of interest, which in turn would cause an inducement to consume, or a rise in the rate of interest. This implies that there is an "equilibrium," for lack of a better term, between a rate of interest that induces consumption and one that induces savings. I think it's clear enough that this can't be how interest is formed; no, changes in preference between present and future consumption decide the rate of interest.
I also broadly agree with Ensuric, although I think one needs to eventually evolve past Prices and Production, given that Austrian capital theory moved on since 1931. With regards to Smiling Dave's request for a page number, I suggest reading the entire book. It is all a very good introduction to the basic idea behind Austrian capital theory: price formation of higher order goods and how these determine the shape of the structure of production. Like I said — and Ensuric may disagree —, I think it is fruitful to move beyond Hayek, but Prices and Production serves as an excellent introduction to the nature of the topic.
TY Jonathan.
Can you spot where in Prices and Prod. Esuric's point is discussed, that "the decision to employ more/less capitalistic methods of production is not an entrepreneurial decision that any individual firm makes. It's not like businessmen say to themselves, "there's a lower time preference, I can now employ more roundabout, profitable methods of production!"
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It's easy to refute an argument if you first misrepresent it. William Keizer
Smiling Dave,
I don't think he writes that explicitely (I would use the more confident "he doesn't," but I don't remember each and every word of Prices and Production; but, "he doesn't" is more accurate). It's a paraphrasing of a point you take away from the book. I suggest pp. 256–258, to get a glimpse. Hayek's essential point in the book is that it is the pricing process which guides shifts in the use of capital goods. Hayek uses a lot of those 'archaic' words terms like "more capitalistic" "method of production," or production that is more "roundabout." Moving away from these terms is, partly, what I mean when I suggest evolving "from Hayek" (although, Hayek's continued work on capital theory — Prices and Production was only a 'rough draft,' so to speak — matured throughout the 1930s and early 1940s; he even went back on some of the ideas in The Pure Theory of Capital). The real point is that the supply of capital goods grows (the rate of interest lowers), inspiring changes in the prices of goods of earlier stages. These price changes will influence the shape of the structure of production, since price divergences create profits that entrepreneurs might choose to exploit.
Jonathan M. F. Catalán:Why doesn't the rate of interest act as an inducement to save? Because, if this were true then an increase in savings would cause a fall in the rate of interest, which in turn would cause an inducement to consume, or a rise in the rate of interest. This implies that there is an "equilibrium," for lack of a better term, between a rate of interest that induces consumption and one that induces savings. I think it's clear enough that this can't be how interest is formed; no, changes in preference between present and future consumption decide the rate of interest.
This kind of bothers me. I have a really hard time accepting the idea that propensity to save is not influenced by the going interest rate. I agree it's not where the rate comes from, but all the real world evidence I've experienced points to rates influencing saving/borrowing behavior. More so, the latter. I wouldn't feel very confident in arguing that the rate of interest acts as an inducement to save, necessarily, as I think people tend to have higher priorities that determine whether and how much they save. In other words, I don't see a lot of people basing their decision to save on the rate they would allegedly get. (But that also doesn't mean it doesn't happen.)
However from the other side of the coin I think a much easier case is made...I would think a lower rate of interest certainly acts as an inducement to borrow, does it not?
JackCuyler: But the quote you just said was "absolutely correct" specifically says that interest directs investment activities. If you can tell me how a can direct b, yet not have an effect on b, I'll be pretty amazed.
Where have I ever said that interest rates do not direct investment activities? Please provide a quote.....
But to answer the question anyhow, this is how:
Esuric: The economy employs more technically efficient, capitalistic ("roundabout") methods of production as a result of a lower time preference (higher savings rate) precisely because the interest rate falls. In other words, the shift towards a different method of production is the result of changes in interest rates. Also, and I just want to make this clear, the decision to employ more/less capitalistic methods of production is not an entrepreneurial decision that any individual firm makes. It's not like businessmen say to themselves, "there's a lower time preference, I can now employ more roundabout, profitable methods of production!" The structure of production (macro-economy) is forced to expand as a result of a lower time preference.
The same amount of producers cannot produce goods of lower orders and remain in business; again, they are forced to redirect towards remoter productions.
JackCuyler:How exactly does a tampering with the interest rate cause distorion in capital structure if the interest rate has no effect on investment levels?
The tampered interest rate can affect the amount of savings but that's due to the distorted component of the interest rate and not to the market rate of interest. The business cycle occurs not due to this change of savings if occurs, although it can make things worse. The Austrian Business Cycle occurs because the distorted intrest rate no longer reflects the true time preference of the consumer. Time preference and amount of savings need not even change.
John James:This kind of bothers me. I have a really hard time accepting the idea that propensity to save is not influenced by the going interest rate.
It is enough to adopt the confusing Keynesian terminology such as "propensity to save" to begin to start mixing everything up again.
propensity to save is not influenced by the going interest rate
I don't have time to dig into it right now but I think there is some serious confusion in this thread. It's easy to see that propensity to save is influenced by profit opportunities (of which the opportunity to earn interest on a loan is just one type) - let's say I have $100 in my pocket and I am driving to the grocery store to buy dinner, I have no food at home. Lo and behold, I come across a man trying to sell a gold coin for $100. It's late at night, would I buy it even though I will have to go hungry? Of course I would buy it, who can pass up 1,600% profit? But I wouldn't do the same if he was offering me $110 in silver coins, even though it would be profitable. The psychic cost of foregoing short-run consumption cannot be made up for the opportunity for just 10% profit.
I think the problem is partly related to the use of percentages for a variety of things - this makes them look superficially the same even though they are in fact different things. I believe Mises' point in HA.XIX is that originary interest is purely psychic and is a reflection only of dearness with which one holds the present over the future value of consumption. But this is a "price" in the sense that if you have in front of you a secure profit opportunity in excess of that "price", that opportunity exceeds every possible consumption or savings end to which the money could be put and you will accept the profit opportunity, cf the gold-coin vs. silver-coins example above. It's a reserve price, not a market price.
But then there is also a market for loanable funds and the prevailing interest rate there is best thought of as a market price. Just because you won't loan me money for less than 100% compounded daily doesn't mean I can't find someone else who will loan me money for a more reasonable rate. When people like the OP ask about the effect of "the interest rate" on investors, they have in mind the prevailing interest rate in the market for loanable funds, not the originary interest rate, that is, the internal "reserve price" of an individual which is purely psychic.
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Clayton -
With regards to Smiling Dave's request for a page number, I suggest reading the entire book.
Exactly.
"If we wish to preserve a free society, it is essential that we recognize that the desirability of a particular object is not sufficient justification for the use of coercion."
Clayton,
An individual abstains from present consumption under the expectation of thus being able to consume more greatly in the future. There is a sense of profit, but this is between the relative valuation of future consumption v. present consumption. So, you have causality backwards: it is not the rate of interest that decides the rate of profit, but the change in time preference (change in valuation) that decides the rate of interest.
@JMF Catalan: I'm not disagreeing with that, I'm simply saying that doesn't answer OP's question which is not about the psychic originary interest rate that emerges from the instantaneous time-preference of the individual but, rather, the going rate in the market for loanable funds.
Let me ask what I asked DD5 (and received no reply) again - does the interest rate (in the market for loanable funds) affect investment? Is there a cause-and-effect relationship between the interest rate and investment?
There is a supply and demand for loanable funds; demand can be increased, for example, by a natural disaster, which can raise the interest rate which can, in turn, increase the supply of loanable funds. This is the case because people do not only either consume or invest, they also hoard. Hoarded money is money that can be instantly released into new investments if the interest rate increases. This is precisely the mechanism which the central bank is constantly frustrating because this natural mechanism is in competition with the central bank. The central bank seeks to centralize all hoarding in itself.
Anyway, I need to brush up on this topic, it's clear there's some basic miscommunication occurring here and I want to understand what it is.
Here's a quote from HA.XX:
There prevails upon the loan market a tendency toward the equalization of gross interest rates for loans for which the factors determining [p. 546] the height of the entrepreneurial component and the price premium are equal. This knowledge provides a mental tool for the interpretation of the facts concerning the history of interest rates. Without the aid of this knowledge, the vast historical and statistical material available would be merely an accumulation of meaningless figures.
So, Mises at once says that the loan market is non-homogeneous (earlier in the same para) and yet, "the loan market a tendency toward the equalization of gross interest rates for loans for which the factors determining [p. 546] the height of the entrepreneurial component and the price premium are equal." This is the key point because it is within a given "tranche", "risk-class" or whatever-you-want-to-call-it, that a meaningful "market interest rate" emerges. Lenders are in competition with one another for the opportunity to lend to borrowers of similar creditworthiness and the deciding factors in this competition are the same as with any good: the quality of service of the lender (the terms of the loan, such as late fees, bankruptcy deadlines, procedures etc.) and the price at which the lender is offering this service.
Anyway, the point of saying all that is simply to say that the loan market is a market and, therefore, there is something which is being supplied and demanded (sold and bought).
Clayton:Let me ask what I asked DD5 (and received no reply) again - does the interest rate (in the market for loanable funds) affect investment? Is there a cause-and-effect relationship between the interest rate and investment?
Dishonest debate tactics is why I hardly ever post here.
You are a confused. That's according to the pure time preferece theory of the interest rate. Not ABCT.
So we get different kinds of interest depending on what theory we start from?
ABCT describes the intertemporal distortion in the capital structure that occurs as a reult of tempering with this rate. It is precisely because the natural interest rate is determined by the amounts of investment (and never the other way around) that the distortion in the capital structure occurs. If it was your way, then the Kenyesians would be correct with their "gas and brake" view of the economy.
No, the problem arises because Keynesian theory does not take into account the time-structure of production - they are absolutely correct that the interest rate affects investment levels. The "gas and brake" theory doesn't work because you can't magically convert farms into automobile factories into computer databases or vice-versa just by moving the interest rate up and down. Every order of good is affected by the interest rate in a different way... investment in production of lower order goods increases and investment in production of higher order goods decreases when interest rates are high and vice-versa when they are low.
So what do you think Mises in that quote meant by "amount of savings are NEVER determined by the interest rate but the other way around....." Do you think he had a typo (in so many places) and actuall meant "always" or "sometimes"...? and then Rothbard carried over all those typos into his writings also? Just curious..
Well, I think he's not talking about the market interest rate, he's talking about an imaginary component of the real interest rate which he is calling "originary interest." The reason for talking about this imaginary component of the real interest rate is to provide an explanation for the discount rate. He is asserting that the discount rate is not objective, that is, there is no fixed amount of dollars one year from now which is considered the same as $100 right now by everybody. Each individual has his own originary interest rate, that is, his own ratio by which he discounts the future against the present.
This "subjective discount rate" is a symptom of the fact that everyone has non-zero time-preference. From HA.XVIII:
What restricts the amount of saving and investment is time preference.
In other words, because you must act to survive (have non-zero time-preference) you cannot defer all consumption indefinitely. Hence, the amount which you may save and invest is restricted by the fact of time-preference.
People eager to embark upon processes with a longer period of production must first accumulate, by means of saving, that quantity of consumers' goods which is needed to satisfy, during the waiting time, all those wants the satisfaction of which they consider more urgent than the increment in well-being expected from the more time-consuming process.
That last phrase is another way to say "expected profit." Obviously, the higher the profit, the higher the time-consuming process will be ranked against consumers' goods in one's own schedule of wants. Interest earned from loaning money is just another kind of profit. A higher interest rate on a loan constitutes a larger profit from the loaned money (which wil, in turn, be invested in time-consuming processes). This is precisely how more profitable industries attract capital... by offering to pay higher interest rates on loans in this industry versus other industries.
And please explain where I've been dishonest... rather than answering my question, you just claimed I'm "confused." I understand you've spent some time studying this issue but you come off awfully dismissive and from the looks of it, I don't think you actually have the most solid grasp of it yourself.
HA.XIX.3:
People often raise the question of which rate of interest, a "high" or a "low," stimulates saving and capital accumulation more and which less. The question makes no sense. The lower the discount attached to future goods is, the lower is the rate of originary interest. People [p. 533] do not save more because the rate of originary interest rises, and the rate of originary interest does not drop on account of an increase in the amount of saving. Changes in the originary rates of interest and in the amount of saving are--other things, especially the institutional conditions, being equal--two aspects of the same phenomenon. The disappearance of originary interest would be tantamount to the disappearance of consumption. The increase of originary interest beyond all measure would be tantamount to the disappearance of saving and any provision for the future.
Here we are into the meat of it and this is precisely where Hulsmann has footnoted Mises. The value of money affects how much people save or spend. When the purchasing power of money increases, people spend more and save less. When it decreases, people spend less and save more. It is through this link that savings are in fact connected to the interest rate. Hulsmann explains that, as the purchasing power of money in a natural money economy (e.g. gold economy) increases, the interest rate rises as the factors of production are bid away from non-money-production industries into the money-production industry and the opposite occurs when the purchasing power of money decreases. Hence, the link between the interest rate and the propensity to spend or save is the money production industry itself.
This is an original contribution of Hulsmann, so we can debate Human Action all day long and we'll never get anywhere on this point. Hulsmann argues that Mises's theory is completely correct for the special case of a fiat money system where increases and decreases in the money supply are essentially costless - in this case, changes in the interest rate have no connection to changes in the propensity to save or consume. But the general theory makes the connection between interest rates and the purchasing power of money (hence, the propensity to save or consume) through the money-production industry itself.