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.
Clayton:And please explain where I've been dishonest...
Why don't you also quote my direct response to the queston you asked me (and Jon) in which you claimed that I didn't reply.
Clayton: When the purchasing power of money increases, people spend more and save less. When it decreases, people spend less and save more.
When the purchasing power of money increases, people spend more and save less. When it decreases, people spend less and save more.
Y'sure? Always thought it was the other way around?
The Anarch is to the Anarchist what the Monarch is to the Monarchist. -Ernst Jünger
The simpler answer to the OP is that savings are used to loan out money to businesses and consumers, in fact quite a bit more than was saved (via the bank's reserve multiplier of 10%, meaning it can loan 10 times reserves).
With more savings, there's more money available for loan, meaning supply of available capital increases. If demand for loans stay the same, supply and demand says the price of loans will tend to drop, and the price in this case is interest rates (IR). Of course, that depends on price elasticity.
However, in our modern US economy, the Fed has a host of ways to manipulate IR, so IR are not determined by a free market and thus there's quite a bit of price distortion there. This occasionally leads to weird situations where no matter what the fed tries to make happen, the opposite happens.
Jargon: Clayton: When the purchasing power of money increases, people spend more and save less. When it decreases, people spend less and save more. Y'sure? Always thought it was the other way around?
Clayton?
When the purchasing power of money increases, people spend more and save less. When it decreases, people spend less and save more. Y'sure? Always thought it was the other way around?
Increased purchasing power -> Goods appear to be getting cheaper, thus spurring demand across the board; this is visible when a country's money appreciates and its citizens become tourists.
Decreased purchasing power -> Goods appear to be getting costlier, thus slowing demand.
Note that this is relative to a ceteris paribus condition on cash balances (constant money supply) but I think we can treat incomes as variable with the price level, in other words, it doesn't matter that incomes go down along with prices because the cash balances themselves become more valuable vis-a-vis non-cash goods. So people who have cash balances are more tempted to spend their savings when money becomes more valuable.
This is precisely the opposite of the conclusion that Keynesian fairy-la-la-land theory reaches but this is why the Keynesians believe in the silly "paradox" of thrift... they neglect the fact that cash balances do not decrease even as all other asset prices and incomes fall during deflation. Because cash balances retain their nominal value (and are increasing in real value) during deflation, this naturally spurs consumer demand among savers.
And their scare-mongering about the dreaded "deflationary spiral" is also rubbish. I don't know of any economist who argues that a past market trend dictates the future market behavior but that's precisely what the "deflationary spiral" argument does ... because cash balances are becoming valuable, therefore, everyone begins saving even more on the expectation of ever more valuable savings accounts! Nonsense. Savers begin spending more of their now-more-valuable cash savings than they otherwise would have while non-savers who try to begin saving to take advantage of the increased value of cash will likely miss the boat, just like stock-traders who buy into or sell out of a trend. To get the advantages of the increased purchasing power of money, you have to have money already saved under the mattress (investments go down during deflation). If you start saving once the value starts to increase, it will be too late by the time you're into cash because those who were holding cash all along began spending and drove the value of cash back down.
Increased purchasing power can be the result of either:
Decreased purchasing power is vice-versa.
If I thought through that all correctly, I think my original assertion is correct.
Clayton -
Didn't you exclude expectations from this analysis?
That when consumers expect their purchasing power to increase they will abstain from consumption in the hopes of obtaining an even cheaper good in the future and may hoard to do so, and oppositely that when consumers expect their purchasing power to drop soon that they will spend where prices are low instead of where they will be high in the future.
And also that when purchasing power is increasing, a real cash yield is to be acquired simply by hoarding, and oppositely that a cash loss is to be incurred by hoarding.
Isn't this exemplified in all the talk about the "Flight into Real Values" when inflation hits a point wherein everyone spends a lot to get rid of their currency?
EDIT: In regard to the "deflationary spiral" it is indeed nonsense but for more than the reason that you listed. One being that nominal prices are entirely inconsequential in regard to consumer spending. What is, is the ratio between all the relevant prices, including wages. The second being that demand is not stalled indefinitely due to a raise in the value of cash balances. Goods are still demanded throughout the deflationary price movement. If they weren't, it would imply that the the general time preference had become zero, which would not be reflected in the asset structure, as there would be higher hoarding.
I edited it in later, sorry. I think that expectations must be excluded from the analysis for the same reasons they are in price theory. We don't see a "flight out of apples" when the price of apples goes down, we see people buying more apples because apples are cheaper.
Well, I think that if the central bank came out and credibly stated a schedule on which it would be printing or destroying money then, yes, this would happen. But that has never happened and never will happen because the central bank would be frustrating its own efforts to do such a thing.
Again, there would have to be a systematic and certain movement in the money supply for this to hold.
Well, I think that is a separate topic - here we're really talking about Gresham's law and the search for the best liquidity available both in terms of non-devaluation (non-inflation) and widespread acceptance. You can buy gold but you won't be able to buy groceries with it, for example. Or you can hold dollars but maybe in 20 years you won't be able to buy groceries with that either (pun). ;-)
So, the movements in and out of weaker/strong currencies are just a reflection of the expected relative stability and liquidity of the respective currencies.
demand is not stalled indefinitely due to a raise in the value of cash balances.
But note that cash balances do not actually have to rise in order for there to be deflation! All that has to happen is an increase in the demand for cash balances. For example, imagine you live in an area where there are lots of hurricanes and this time, there is an unprecedented monster hurricane coming 10x the strength of Katrina. Everything will be flattened. The demand for cash would skyrocket, while the prices of real goods would plummet. This would be a buyer's paradise and anyone with cash savings and a pickup (which would also get cheaper) could leave town with a gold mine's worth of goods for a low price.
Clayton,
I see what you're saying and I think you've made a good argument for the case that with the rise of purchasing power, ceterus paribus, people will spend more on consumption goods. I don't know price theory so I don't know whether expectations play in or not. The extent of my knowledge is the theory of marginal pairs. Anyways, those buying consumption goods and not, directly, capital goods are not so concerned with anticipating the future. With a higher purchasing power it is likely that consumers will spend more, taking advantage of a new advantage. Most do not engage in speculative games.
The entrepeneurial class however is different. As Mises says (paraphrasing here), the function of the entrepeneur is profit and profit is the successful anticipation of future wants. So it is the duty of any entrepeneur, as investor, "mover" of capital, to be predicting/envisioning the future. Of course these visions will ultimately be subjectively determined, but based on more than the immediate price information. Price information is a guide for actions that have been committed but cannot direct future decisions (unless we're talking about the futures market which does a good deal to homogenize and stabilize opinion on commodity futures, but is no guarantee of anything either). Entrepeneurs have to be attuned to things like monetary policy and geopolitik. Thus the entrepeneur's response to a certain change in purchasing power may well be very different from that of the average consumer.
Entrepeneurs wield a significant amount of the wealth in society and the "shape" of prices will be significantly impacted by their decisions. Producers whose production goods are not employed or are employed to the detriment of other producers are affected by the entrepeneur's expectations.
Basically I think that the relationship between monetary policy and demand for cash are too multifaceted and determined within a wide margin of judgment for there to be a general rule on the psychology of those within the sphere of a certain monetary policy.
Sorry for the delay in replying, this thread was showing up as "read" in my thread view... not sure why.
I see what you're saying and I think you've made a good argument for the case that with the rise of purchasing power, ceterus paribus, people will spend more on consumption goods. I don't know price theory so I don't know whether expectations play in or not.
Well, future expectations do factor in but the key thing to realize is that price history has no systematic relationship to future price movements. In my opinion, it's actually very dangerous to look at stock price charts if you are engaging in stock speculation because there are patterns there and the brain is an extremely powerful pattern-recognition device... the only problem is that a pattern in past price history still has no systematic relationship to future price movements. If you look around almost any stock-investing site, you will see people talking about W price movements, inverted-W price movements, "price shoulder" and so on. This is all 100% pure, mumbo-jumbo, voodoo nonsense. It may have a thymological use in interpreting why events happened as they did (and this, in turn, may make you a better entrepreneur) but it has no a priori use in predicting future trends.
The extent of my knowledge is the theory of marginal pairs. Anyways, those buying consumption goods and not, directly, capital goods are not so concerned with anticipating the future. With a higher purchasing power it is likely that consumers will spend more, taking advantage of a new advantage. Most do not engage in speculative games. The entrepeneurial class however is different. As Mises says (paraphrasing here), the function of the entrepeneur is profit and profit is the successful anticipation of future wants. So it is the duty of any entrepeneur, as investor, "mover" of capital, to be predicting/envisioning the future. Of course these visions will ultimately be subjectively determined, but based on more than the immediate price information.
The entrepeneurial class however is different. As Mises says (paraphrasing here), the function of the entrepeneur is profit and profit is the successful anticipation of future wants. So it is the duty of any entrepeneur, as investor, "mover" of capital, to be predicting/envisioning the future. Of course these visions will ultimately be subjectively determined, but based on more than the immediate price information.
In the language of Markov chain probability theory, the price is a "memoryless" magnitude... in terms of cause-and-effect, the only price the matters is the present price. Price history is of no importance whatsoever either to entrepreneurial or consumer decisions.
Price information is a guide for actions that have been committed but cannot direct future decisions (unless we're talking about the futures market which does a good deal to homogenize and stabilize opinion on commodity futures, but is no guarantee of anything either). Entrepeneurs have to be attuned to things like monetary policy and geopolitik. Thus the entrepeneur's response to a certain change in purchasing power may well be very different from that of the average consumer. Entrepeneurs wield a significant amount of the wealth in society and the "shape" of prices will be significantly impacted by their decisions. Producers whose production goods are not employed or are employed to the detriment of other producers are affected by the entrepeneur's expectations.
True but note that the reverse does not hold... the "shape" of prices has no impact whatsoever on decision-making - or, to say it another way, any influence that historical prices do have is in direct proportion to the existence of a mania. To decide to buy something on the basis of its average price over some time period rather than its present price only is delusional. It is an act of self-delusion in that you are pretending to yourself that the price is really higher or lower than it actually is.
*shrug - all that matters to the theoretical issue is that past prices have no systematic relationship with the future price. Hence, the present purchasing power of money can not be said to have any systematic relationship with the future purchasing power of money and claiming that the purchasing power of money must continue to increase in the future because it has been increasing in the recent past is like saying that the price of oranges must continue to increase in the future because it has been increasing in the recent past.
I'm confused as to why you think that I was referring to price histories rather than present prices. Wherever you assumed me to be speaking of historical prices, I meant 'present' prices. It's all a matter of degree but I think we both get the distinction. For example with the 'shape of prices', I'm not referring to a stock index charts ups and downs with the shape being chronologically denominated, I mean 'shape of prices' in a time-instance in the market, the allocation of resources and assets towards and away from certain industries/businesses.
Pardon if I've misread your post but from what I'm reading of it, I don't think you're addressing my point.
In response to the assertions that "interest is not a price", Bob Murphy says here QUOTE, "Interest rates are prices, and as such they convey real information about scarcity in the world." [Emphasis original]
I'm reading HA XVIII-XX to try to rectify this. I think the answer has to do with the decision whether to consume or defer consumption; deferral of consumption can consist either of simple saving (stuffing money under the mattress) or capital investment (buying a piece of capital equipment, employing certain kinds of labor, or lending or all of these). Only when the discounted expected profit from a choice to defer consumption exceeds the satisfaction that would have been derived from present consumption will the individual choose to defer consumption and this psychological "discount rate" is precisely the originary interest rate.
The market interest rate that Murphy is talking about changes the expected profit from a choice to defer consumption. When that increases, the choice to consume in the present becomes less attractive, ceteris paribus. In this regard, cash savings as against capital investment (purchase of capital equipment, labor or lending) should be viewed as a form of speculation on the future purchasing power of money itself. This form of entrepreneurial speculation is no different than any other; the tendency of the rate of interest in this industry is to reach equilibrium with that of all others and this is Hulsmann's point in this article.
Changes in the structure of consumption versus non-consumption (saving, investment) are solely a consequence of originary interest (a purely psychological factor). But changes in the expected profitability of investments alters the attractiveness of investment itself, that is, it increases the amount of future reward to be had by deferring the same amount of consumption, thus making it more attractive than it otherwise would have been. Hence, for a given originary interest rate, a greater investment interest (greater entrpreneurial profits from lending) will result in greater deferral of consumption.
To specifically deal with the issue of cash balances, increases in cash balances are a function of the speculators' belief that the purchasing power of money will be greater in the future than it is in the present (cash has become a more attractive investment versus other alternatives). Contrary to Keynesian theory, this expectation is not mechanistic or inherently self-reinforcing. It is no different than any other kind of speculation. As the profitability of cash-hoarding increases, interest rates will rise in the money production industry and investment will flow into it, increasing money production and driving the profitability of cash-hoarding back down and bringing the industry into equilibrium with all lines of production (I'm just restating Hulsmann). Also, as cash flows out of non-hoarding investments into cash-hoards, the interest rates in those lines of production will increase until they are brought into equilibrium.
DD5 had the clue to my answer. Took me two weeks to get over this doubt, but it's well worth it. Thanks to everybody, and especially to DD5.