Interest Rates and the Business Cycle

by Glen Tenney 

The cause of the business cycle has long been debated by professional economists. Recurring successions of boom and bust have also mystified the lay person. Many questions persist. Are recessions caused by underconsumption as the Keynesians would have us believe? If so, what causes masses of people to quit spending all at the same time? Or are recessions caused by too little money in the economy, as the monetarists teach? And how do we know how much money is too much or too little? Perhaps more importantly, are periodic recessions an inevitable consequence of a capitalist economy? Must we accept the horrors associated with recessions and depressions as a necessary part of living in a highly industrialized society?

Concerns about aggregate money supply levels and aggregate spending might make for interesting conversation, and a discussion of these matters might even reveal certain threads of truth, but they are inadequate in arriving at the cause of the boom and bust cycle that seems to pervade the economy in modern times. Economists in the Austrian school of thought have provided an explanation that bases economic fluctuations on microeconomic theory that is firmly grounded in principles of human action. These economists have pointed out that macroeconomic fluctuations, or what have come to be known as business cycles, are caused by extraneous manipulations of interest rates in the economy.1 This manipulation of interest rates might entail conscious actions by governmental authorities or merely the result of governmental actions taken with other goals in mind.

Interest Rates Reflect Time Preferences

The rate of interest in an economy is an important reflection of the time preferences of individuals. People are willing to forgo some amount of current consumption in order to invest in production processes which promise finished goods that are valued higher than the sum of the inputs to the production process. The spread between the amounts paid to the owners of the productive inputs and amounts obtained from the sale of the completed product is interest income to the businessman who advances money incomes to the resource owners in terms of wages and rents. The capitalist/ businessman then provides current buying power to workers and owners of other productive inputs in exchange for an amount we call interest. And looking from the opposite perspective, workers and other resource owners are willing to take a discounted amount in payment for their productive inputs in order to have current incomes rather than waiting for the completion of the product.

Of course in the market for loans, the interest rate also contains an entrepreneurial component which accounts for certain areas of uncertainty which are always present in borrowing and lending money. An inflation premium is included if the dollars to be repaid on the loan are expected to have less purchasing-power than the dollars that are lent. And a default-risk premium is included based upon the ability and/or willingness of the borrower to repay the loan as agreed. Thus the interest rate that is agreed upon in the loan market includes these entrepreneurial factors in addition to an amount sufficient to induce people to forgo current consumption in favor of consumption in the future.

The interest rate serves a coordinating function in the economy by providing useful information about the availability of credit and the profitability of investments to both lenders and borrowers, if, for example, people’s rates of time preference increase, this change is reflected as higher interest rates, which encourages more saving and discourages borrowing at the margin. This means that individuals in general are requiring more of an incentive to forgo current consumption than they did previously. There are two ways in which this coordinating function is hindered by governmental action in the economy.

New Money Gives a False Signal

Money is primarily a medium of exchange in the economy; and as such, its quantity does not have anything to do with the real quantity of employment and output in the economy. Of course, with more money in the economy, the prices of goods, services, and wages, will be higher; but the real quantities of the goods and services, and the real value of the wages will not necessarily change with an increase of money in the overall economy. But it is a mistake to think that a sudden increase in the supply of money would have no effect at all on economic activity. As Nobel Laureate Friedrich A. Hayek explained:


Everything depends on the point where the additional money is injected into circulation (or where the money is withdrawn from circulation), and the effects may be quite opposite according as the additional money comes first into the hands of traders and manufacturers or directly into the hands of salaried people employed by the state.

Because the new money enters the market in a manner which is less than exactly proportional to existing money holdings and consumption/savings ratios, a monetary expansion in the economy does not affect all sectors of the economy at the same time or to the same degree. If the new money enters the market through the banking system or through the credit markets, interest rates will decline below the level that coordinates with the savings of individuals in the economy. Businessmen, who use the interest rate in determining the profitability of various investments, will anxiously take advantage of the lower interest rate by increasing investments in projects that were perceived as unprofitable using higher rates of interest.

The great Austrian economist Ludwig von Mises describes the increase in business activity as follows:


The lowering of the rate of interest stimulates economic activity. Projects which would not have been thought “profitable” if the rate of interest had not been influenced by the manipulation of the banks, and which, therefore, would not have been undertaken, are nevertheless found “profitable” and can be initiated.

The word “profitable” was undoubtedly put in quotes by Mises because it is a mistake to think that government actions can actually increase overall profitability in the economy in such a manner. The folly of this situation is apparent when we realize that the lower interest rate was not the result of increased savings in the economy. The lower interest rate was a false signal. The consumption/ saving ratios of individuals and families in the economy have not necessarily changed, and so the total mount of total savings available for investment purposes has not necessarily increased, although it appears to businessmen that they have. Because the lower interest rate is a false indicator of more available capital, investments will be made in projects that are doomed to failure as the new money works its way through the economy.

Eventually, prices in general will rise in response to the new money. Firms that made investments in capital projects by relying on the bad information provided by the artificially low interest rate will find that they cannot complete their projects because of a lack of capital. As Murray Rothbard states:


The banks’ credit expansion had tampered with that indispensable “signal”-the interest rate—that tells businessmen how much savings are available and what length of projects will be profitable . . . . The situation is analogous to that of a contractor misled into believing that he has more building material than he really has and then awakening to find that he has used up all his material on a capacious foundation, with no material left to complete the house. Clearly, bank credit expansion cannot increase capital investment by one iota. Investment can still come only from savings.

Capital-intensive industries are hurt the most under such a scenario, because small changes in interest rates make a big difference in profitability calculations due to the extended time element involved.

It is important to note that it is neither the amount of money in the economy, nor the general price level in the economy, that causes the problem. Professor Richard Ebeling describes the real problem as follows:


Now in fact, the relevant decisions market participants must make pertain not to changes in the “price level” but, instead, relate to the various relative prices that enter into production and consumption choices. But monetary increases have their peculiar effects precisely because they do not affect all prices simultaneously and proportionally.

The fact that it takes time for the increase in the money supply to affect the various sectors of the economy causes the malinvestments which result in what is known as the business cycle.

Government Externalizes Uncertainty

Professor Roger Garrison has noted another way that government policy causes distortions in the economy by falsifying the interest rate. In a situation where excessive government spending creates budget deficits, uncertainty in the economy is increased due to the fact that it is impossible for market participants to know how the budget shortfall will be financed. The government can either issue more debt, create more money by monetizing the debt, or raise taxes in some manner. Each of these approaches will redistribute wealth in society in different ways, but there is no way to know in advance which of these methods will be chosen.

One would think that this kind of increase in uncertainty in the market would increase the risk premium built into loan rates. But these additional risks, in the form of either price inflation or increased taxation are borne by all members of society rather than by just the holders of government securities. Because both the government’s ability to monetize the debt and its ability to tax generate burdens to all market participants in general rather than government bond holders alone, the yields on government securities do not accurately reflect these additional risks. These risks are effectively passed on or externalized to those who are not a part of the borrowing/lending transactions in which the government deals. The FDIC, which guarantees deposit accounts at taxpayer expense, further exacerbates the situation by leading savers to believe their savings are risk-free.

For our purposes here, the key concept to realize is the important function of interest rates in this whole scenario. Interest rates serve as a regulator in the economy in the sense that the height of the rates helps businessmen determine the proper level of investment to undertake. Anything in the economy that tends to lower the interest rate artificially will promote investments in projects that are not really profitable based upon the amount of capital being provided by savers who are the ones that forgo consumption because they deem it in their best interest to do so. This wedge that is driven between the natural rate of interest and the market rate of interest as reflected in loan rates can be the result of increases in the supply of fiat money or increases in uncertainty in the market which is not accurately reflected in loan rates. The manipulation of the interest rate is significant in both cases, and an artificial boom and subsequent bust is inevitably the result.

Conclusion

Changes in the supply of money in the economy do have an effect on real economic activity. This effect works through the medium of interest rates in causing fluctuations in business activity. When fiat money is provided to the market in the form of credit expansion through the banking system, business firms erroneously view this as an increase in the supply of capital. Due to the decreased interest rate in the loan market brought about by the fictitious “increase” in capital, businesses increase their investments in long-range projects that appear profitable. In addition, other factors as well can cause a discrepancy between the natural rate of interest and the rate which is paid in the loan market. Government policies with regard to debt creation, monetization, bank deposit guarantees, and taxation, can effectively externalize the risk associated with running budget deficits, thus artificially lowering loan rates in the market. Either of these two influences on interest rates, or a combination of the two, can and do influence economic activity by inducing businesses to make investments that would otherwise not be made. Since real savings in the economy, however, do not increase due to these interventionist measures, the production structure is weakened and the business boom must ultimately give way to a bust.

Source www.thefreemanonline.org