The Austrian Business Cycle Theory states that entrepreneurs are not able to distinguish between money that comes from genuine savings and money created through credit expansion by the Fed. But surely the Fed keeps track of how much money they loan into existence.. If entrepreneurs know this, shouldn't they be able to adjust the interest rate appropriately and not be fooled into malinvestments?
I know there are holes in this argument, but I'm having trouble putting together a cohesive counter-argument in my head..
The most they could know is how much money exists above what existed before. This does not tell them what the interest rate should be. Also, remember that an interest rate bring supply of credit and demand for loans into equilibrium (it's a type of price, which always brings things into equilibrium). Even if they were somehow able to determine what the market interest rate should have been, this will reduce the demand for loans leaving them with Fed inflation sitting in their accounts. They must pay the Fed interest for these securities, and indeed the Fed operates off of these interest payments. Furthermore, each bank faces a dilemma: hold onto the inflation, pay the interest and become less profitable, or jump out and make loans quickly and try to grab market share, which is almost certainly is what the competitors would do?
In practice, even knowledge of the ABCT would not prevent it. Inflation will distort the market, and the correction will inevitably come.
Every decent man is ashamed of the government he lives under - Mencken
There was a business cycle, and malinvestments, but a bit different from how Mises mapped it out, I believe.
You believe wrongly.
Hard to say that a dot.com stock or a house is a high order capital investment.
Houses are durable consumer goods, and the dot.com stock fits right in with what he was saying.
There was a business cycle, and malinvestments, but a bit different from how Mises mapped it out, I believe. You believe wrongly. Hard to say that a dot.com stock or a house is a high order capital investment. Houses are durable consumer goods, and the dot.com stock fits right in with what he was saying. Are you unacustomed to supporting your assertions with facts and such like? It's a usefull habit to get into. To get you started, show me where my mistake lies, to back up your first claim. And for your second, quote me where Mises says there will be malinvestments in durable consumer goods. Also, for completeness, where he says entrepeneurs will invest in companies that pay no dividends and sell no products, and in companies that have the brilliant idea to charge shipping and handling for every individual item, instead of having people pick it up in a store. Or where Mises writes they will do anything remotely similar in level of stupidity. 3 simple things, beneficial to us both, and to the readership at large, if you can do them.
Are you unacustomed to supporting your assertions with facts and such like? It's a usefull habit to get into.
To get you started, show me where my mistake lies, to back up your first claim.
And for your second, quote me where Mises says there will be malinvestments in durable consumer goods.
Also, for completeness, where he says entrepeneurs will invest in companies that pay no dividends and sell no products, and in companies that have the brilliant idea to charge shipping and handling for every individual item, instead of having people pick it up in a store. Or where Mises writes they will do anything remotely similar in level of stupidity.
3 simple things, beneficial to us both, and to the readership at large, if you can do them.
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It's easy to refute an argument if you first misrepresent it. William Keizer
Hayek, Mises, and Wicksell all explicitly say it. I'm not going to go quote mining now, and it's unreasonable for you to expect one to do this, but here's Wicksell:
"An abnormally large amount of investment will now probably be devoted to durable goods (a result of an artificially reduced rate of interest). There may result a relative overproduction of such things as houses and a relative underproduction of other commodities" (Interest and Prices, pp. 96)
I don't know why you're fixated on the stock market. Stock market bubbles are the result of malivestments. There were far too many tech companies taking vital resources from other, more warranted economic activities. The tech bubble is a classic example of the ABC. (1) Economy is hit with a technological innovation; (2) banks don't elevate the rate of interest, and central bank actually lowers interest rates; (3) too much investment in technology and media, and (4) interest rates rise, bringing about a correction (recession).
"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."
TY for the Wicksell quote.
Stock market bubbles are the result of malivestments. There were far too many tech companies taking vital resources from other, more warranted economic activities. The tech bubble is a classic example of the ABC. (1) Economy is hit with a technological innovation; (2) banks don't elevate the rate of interest, and central bank actually lowers interest rates; (3) too much investment in technology and media, and (4) interest rates rise, bringing about a correction (recession).
There is, however, a huge difference. The dot.com bubble was not a case exclusively of higher order capital goods being invested in. In many instances none of Wicksell's durable consumer goods were there either. The companies invested in existed on paper. Some paid no dividends and made no profits. Their essential premise was absurd. How does a low interest rate "mislead" the entrepeneur into an "honest error" of thinking that to charge shipping and handling for every individual item, instead of having people pick it up in a store, is a money maker.
I'm not sure how your 4 step summary is relevant to the point I was raising. I'll make myself very clear. The quibble I have with the classic ABCT from the dot.com bubble is this: Mises says that low interest rates "fool" the normally sophisticated entrepeneur, who has gotten to where he is by his business acumen, into acting upon misinformation. Given his acceptance of the wrong facts through no fault of his own, he acts sensibly.
However both of our two recent bubbles had people acting foolishly, not wisely. The housing bubble was predicated on an assumption in most people's minds that houses only go UP in price, never down. That idea is foolish. it is not the result of a message from low interest rates that people are investing and are interested in higher order goods.
Same thing with the dot.com bubble. The mistakes made were not of misinformation, but of foolishness, as I explained above.
One more point. A house may be a durable good, but many people were not buying houses because they needed one. They were buying second and third houses TO SPECULATE WITH. Because they believed a house is not a place to live in. It is an investment that will never go down. These aren't wily ole entrepeneurs. These are people making a foolish mistake.
The point to remember is that after a bubble bursts, the first question asked is "What were they thinking?" Is a TULIP really worth 10 years of income? And those stocks people bought in the 20's, NOT KNOWING ANYTHING ABOUT THEIR TRUE VALUE because the paperwork was a secret?
I think the reason there is such resistance here to this very obvious historical fact [that given cheap money, people will do stupid things with it], is because is doesn't follow from any praxeological axiom. It will have to be thrown in as a seperate postulate. Is this a bad thing? I don't think so. It is akin to the motivation [not calculation] problem of Socialism. But I've written about this before.
People bought the houses with money and expected to make a profit from selling the house later. We can agree this is an investment. Whether it can be considered capital or not depends on what makes something capital. Is it necessary to mix labor with the durable good in order for it to be capital, or could they just do nothing with it for 6 or 12 months and sell it later, and still consider it capital? Either way, there were people who bought the houses, performed work on them, and expected to get a positive return from them. I suppose one could argue that since they were treating houses as capital, the houses were capital.
As for the .com boom, companies were created on paper, but they were also using a large portion of new credit and money to start up and grow. They still bought computers, offices, hired employees, etc. If a dump truck from a mining operation could be considered a higher-order capital good, couldn't new tech companies (or a part of those new companies) be considered the same?
CaptainMurphy. Two questions.
1) Do you know what the important roll interest plays in time coordination on the market?
2) Even if business men could anticipate mal-investment by witnessing tampered interest rates, how would they know what interest rates SHOULD(So that they could plan their future expansions on the time schedule most compatible with consumers) be at? And how could they remain competative if they chose not to participate in the easy credit.
You are concentrating on the interest rate effect alone, which is not exactly the primary problem. The primary problem lies with the relative prices.
When the Fed prints new money and lends it to businessmen, the interest rate plunges down (just another example of diminishing marginal utility). Note that the change in the interest rate is only the effect of new money entering the system. The new money then is used by businessmen to bid up the prices of capital goods. So, you see, the relative prices (of capital and consumer goods) change. This higher price paid for capital goods when compared with consumer goods can only continue until new money keeps coming from the Fed. When it stops, the bust follows.
Prash your above response just points to a symptom of the inter-temporal disruption caused by manipulated interest rates. A rise in capital goods pricing(And not just capital goods alone) is a symptom of the problem. It is also a key element which will later explain the crack-up boom but the cause is originally from a inter-temporal imbalance between consumers and producers. Interest rates offer a coordination mechanism for the timing of lateral production expansion.
Obviously when resources become even more scarce, and there are more agents making claims on them the price for those resources and capital goods will be bid up. Perhaps we are just both saying the same thing in a different light.
Consider the following 3 drawings.
Notice they both say good, and the resource pool has remained stable. Prices will have for the most part also remained stable. And now finally back to our issue.
Both present and future consumption have risen. Typically if one rises the other must fall, but since interest rates have been distorted this economic calculation does not occur correctly. Interest provides a calculation feedback mechanism to business's on when they can expand. It tells them that consumers have begun withdrawing present consumption into savings, offering available resources during the expansion period. Instead, since interest rates have been manipulated business's are tricked into thinking consumpers have restricted their consumption (Which is what low interest rates usually means, excess savings). What results is a depletion of resources and the costs which get bid up in the process are one of the results.
Eventually as that pool of "generic resources" gets bid up in price the consumption for future and present goods will have to be curtailed to compensate. This will be the bust.
Back to the original post. The question is why can't entrepreneurs anticipate these changes on the market and prepare themselves accordingly to avoid upcoming business cycles.
The problem with that question is
Hopefully with those two questions left un-answered the original poster will find resolution to his original question.
There is, however, a huge difference. The dot.com bubble was not a case exclusively of higher order capital goods being invested in. In many instances none of Wicksell's durable consumer goods were there either. The companies invested in existed on paper. Some paid no dividends and made no profits.
First, inflation (low interest rates) doesn't necessarily lead to exclusive investment in either long term durable goods or capital goods; it could also flow towards consumers. There's just a propsenity towards investment because the funds usually take the form of producer credits, and because lower interest rates allow for investment in more profitable, longer-term projects. But the nature of finance has changed over the years, and a lot of funds now flow to consumers. But this still arbitrarily alters the structure of production away from actual preferences, which is the ratio of demand between current goods and future goods.
The alteration in the nature of finance is also a direct result of artificially low interest rates. The return on deposits is often below the rate of inflation and individuals chase higher yielding assets in order to protect their wealth (bonds, stocks, commodities) which fuels asset bubbles. Either way, those dot.com and media companies didn't "just exist on paper." They drew labor and resources away from other activities.
How does a low interest rate "mislead" the entrepreneur into an "honest error" of thinking that to charge shipping and handling for every individual item, instead of having people pick it up in a store, is a money maker
Next, the economy is not guided by extremely intuitive entrepreneurs. It is guided by the price mechanism and the profit/loss constraint. Good entrepreneurs are able to interpret the price mechanism and act accordingly; but interpreting prices correctly assumes that prices are actually revealing preferences, as opposed to arbitrarily changing because of alterations in the money supply and interest rate. When the price mechanisms are arbitrarily altered, people invest and consume resources that they shouldn't (insatiable demand). When funds are available to all, you get all sorts of investments which seem ridiculous ex post (or maybe ex ante in some cases). The fact that the dot.com bubble now appears absolutely ridiculous is immaterial.
But you're oversimplifying the matter at hand. Low interest rates do fool the masses, but the important part is how they fool the masses. It tells actors that there are additional resources available, that is, that time-preferences have fallen. This is not to say that investors go, "oh look, time preferences have fallen, let's extend the structure of production!" But rather that their ideas (many of which are terrible) are now possible, or so they think. Every shmuck borrows and invests in some "great idea" until the correction reveals to them that they were mistaken. But more than this, the inflation actually changes consumer desires (income and substitution effects) due to the nature of marginal utility (leads to Cantillon effects).
The housing bubble was predicated on an assumption in most people's minds that houses only go UP in price, never down. That idea is foolish. it is not the result of a message from low interest rates that people are investing and are interested in higher order goods.
And higher interest rates would tell them that it's foolish. Kind of hard to flip houses when the interest rate is at 25%.
One more point. A house may be a durable good, but many people were not buying houses because they needed one.
Immaterial. The question is not why they wanted houses, or what they were going to do with them, but why they were able to invest in real-estate and drag away resources from other economic activities.
You need to read Hayek's Prices and Production.
filc, the artificial interest rate is the symptom of new money being poured in into capital intensive projects. The interest rate plunges down because the new loans (that are created out of thin air) are used to fund business projects with progressively lesser returns(as supply of a product increases, marginal units of the product go into satisfying demands of progressively lesser importance). Just like any other market mechanism.
And as you must be knowing, lower interest rates can help fund projects which take a lot of time to complete, and still promise profits.