Towards an Integration of Finance and the Austrian Theory of the
Business Cycle*
Jeff Oxman
Department of Finance
Opus College of Business
University of St. Thomas
[email protected]
651-962-4091
Keywords: Austrian business cycle; market distortion; business cycle
JEL Codes: B53, E32, G31
*Working paper. Please do not quote without permission.
1. Introduction
It is perhaps the most famous element of the school of thought known as Austrian
economics: the Austrian theory of the business cycle (ATBC). The Austrian school views
exogenous credit expansion (i.e. credit expansion not arising from the market process) as a type
of state intervention in the market economy1. Interventions by the state in the market process
have generally deleterious consequences because of both incentive problems and knowledge
problems.2The Austrian theory of the business cycle is especially important because among the
schools of economic thought, the Austrian theory identifies the cause of the “boom-bust” cycle
as intervention in the market for loanable funds. This hypothesis, if correct, suggests that an
unhampered (free) market for loanable funds would not cause economy-wide boom-bust cycles.
The Austrian school is alone in this view.
Unfortunately, the Austrian theory of the business cycle has not been updated in some
time, and this is evident in its current exposition. The purpose of this essay is to incorporate
some basic finance theory in order to modernize the ATBC. This is in order since the theory was
developed in the early 20th century and has not been significantly updated by incorporating new
insights from finance that bear on the theory. Important features of finance that I incorporate in
this essay include multiple interest rates and their term structure; capital budgeting; and recent
evidence on Federal Reserve policy implementation
That multiple interest rates exist is indisputable. The theories of the term structure,
however, tend not to fit the data very well. Further, they are based on Fisher, Keynes, and
Modigliani, whereas the Austrian view of interest favors Wicksell. A reconciliation of these
theories of the term structure is probably necessary, but this essay is not the place. As such, only
the empirical existence of multiple interest rates for the Austrian theory of the business cycle will
be discussed here.
The critical element of the Austrian theory of the business cycle is an unbalanced capital
structure in the economy. The capital structure is created by business investment. The process by
which firms analyze various potential investments and select the most promising ones is called
capital budgeting. Capital budgeting can be a very formal process, or more ad hoc, depending on
the size of the investment required for the new project and the sophistication of the borrower. For
example, the analysis for a new factory would be a very detailed, lengthy process. Deciding
whether or not to hire an extra person to help once the factory is up and running is likely to be
much easier. In any case, capital budgeting involves forecasting cash flows and choosing
appropriate discount rates to calculate the expected value of a given project. Monetary distortions
affect both of these factors.
1
Mises includes his work on ATBC in Part Six of Human Action ([1949], 2008): “The Hampered Market
Economy.” Rothbard’s section in Man, Economy, and State with Power and Market ([1962], 2009) is entitled
Binary Intervention: Inflation and Business Cycle. Clearly this is a special, but very important, type of intervention.
2
See Ikeda (1997).
The relevant market from which these distortions arise is the market for loanable funds.
The market for loanable funds is the market where savers and borrowers interact and in their
interactions set a market-clearing interest rate (the market rate of interest) and the quantity of
funds lent/borrowed. Because of uncertainty and the inability to move goods themselves through
time, the market rate departs from the natural rate of interest, the latter corresponding to strict
time preferences of borrowers and savers. Intervention by a money monopolist serves to distort
the market for loanable funds, and moves the price of future money, i.e. the interest rate, away
from the market clearing price that would be set by the unhampered interaction of borrowers and
savers. The most common intervention is the artificial decrease of the interest rate.
The money monopolist – usually a central bank – causes the monetary distortions. There
are three methods, to be discussed in detail later, but they all amount to increasing the amount of
funds available for lending in the loanable funds market, corresponding to a decrease in the
market-clearing interest rate. This decrease does not correspond to a change in the natural rate of
interest (i.e. people don’t want to save more than they did before) and so the chain of events set
in motion by this intervention do not correspond to a change in the desires of people. This is
what causes the subsequent boom to be ultimately unsustainable and become a bust.
Need a closing summary.
2. The Unhampered Loanable Funds Market
The Austrian view of interest appears to be based on Knut Wicksell’s (1936)
understanding of the natural rate of interest. In Wicksell’s view, the natural interest rate was the
one that would not cause the price level to fluctuate. He points out that the natural interest rate is
also the rate that would link the value of present and future real capital goods, in the absence of
money. The logical result of this is that when the market rate of interest is not equal to the natural
rate of interest changes in the price level will occur. This is the starting point for the ATBC.
One element of the natural rate of interest that is unclear is the time frame to which it
applies. Is it a daily rate, or perhaps a monthly rate? For clarity in his exposition, Wicksell
suggests we think about it as an annual rate, and this is certainly reasonable since most interest
rates are quoted on an annualized basis. But this does not imply that the life of the loan of capital
goods is one year, or should be thought of as such. It is probable that different loan lengths
would arise due to characteristics of the capital being lent, and thereby give rise to a term
structure of the natural rate of interest.
In the market for loanable funds, there is a clear term structure of interest rates for debt
securities. In general the term structure is upward sloping – as the time to maturity increases, the
interest rate also increases. Depending on inflation expectations, the term structure can be
inverted or humped, but such cases are rare. The upward slope is because uncertainty is
increasing in time. The rate uncertainty in the loanable funds market is related to maturity risk
(how will interest rates change in between now and maturity); default risk (what is the
probability of not receiving interest/principal); and liquidity risk (what is the probability of being
unable to sell the security). But does this apply to the natural rate of interest?
The above risks apply to the natural rate, in addition to other risks caused by the frictions
of dealing in non-fungible capital goods. In the evenly rotating economy, where there is no
uncertainty, it is reasonable to think that the term structure of the natural rate of interest is flat.
The introduction of various risks induces an upward slope in the term structure of the natural
rate. This implies that the longer the time from the start of the capital loan to the payback period,
the higher must be the expected return on the investment for the entrepreneur to find it
economically worthwhile.
If there is a term structure of the natural rate and a term structure of the market rate, it is
possible to have mismatches at any maturity. In a competitive market for both capital and
financing, the mismatches should be minimized as an arbitrage between the two rates will tend to
attract investment reducing expected returns on the investment. But because the term structure is
anchored by the short-term rates, which are sensitive to the fed funds rate, the effects of
monetary intervention are passed through to the entire term structure, not just the short rates.
This will be discussed further after a brief discussion of the market rate of interest.
The interaction of suppliers of savings and demanders of savings in the market for
loanable funds sets the market rate of interest. Demand and supply curves follow the typical
shape in this market, such that as rates decrease, fewer people are willing to lend money, but
more people want to borrow.
The rate of interest set in the loanable funds market is not observable. In fact, there is no
“loanable funds market” per se. What we observe are really existing rates of interest on various
securities, including time deposit accounts, bonds, equity securities, and so on. The rates of
interest offered on such securities compensate the holder not only for the time value of money,
but for the risks and other frictions involved in holding the securities. So the interest rate set in
the loanable funds market can be considered as a base rate for pure lending and borrowing, or the
starting point that guides the setting of all other rates of interest. This implies that when the
market interest rate is unequal to the natural rate of interest, the term structure will carry that
inequality through to all interest rates, although perhaps not proportionately.
The various interest rate markets have not received much focus from the Austrian school,
insofar as they have implications for the business cycle theory. The implications of interest rate
manipulation in these various markets will now be explored, since businesses raise funds in
multiple markets. The main division is between debt and equity.
Debt includes all forms of debt securities, from bank loans to Treasury bills and bonds to
corporate and municipal bonds. Yields (i.e. expected return or interest rates) on debt securities
vary due to differences in risks across debt types. Nevertheless, they all have a few basic factors
in common. First, all yields must be high enough to compensate the lender for their time value of
money. Normally this minimum is called the real risk-free interest rate. Yields must also
compensate lenders of expected inflation – that is, all nominal yields carry an inflation premium.
Combined, the real risk-free rate and inflation premium constitute the nominal return on shortrun securities (e.g. Treasury bills). Note that we do not observe the real risk-free rate, and so it
must be imputed from other securities. The most popular method currently is to estimate the real
risk-free rate as the difference between a nominal Treasury bond and a Treasury Inflation
Protected Security (TIPS) of the same maturity.
As risks increase, the yield also increases. For example, longer-dated debt securities
require a maturity risk premium, and corporate and municipal securities require a default risk
premium. These premiums are typically just handicaps added on to the base yields set in the
Treasury market. We note that, in debt markets, the fed funds rate constitutes the base rate for all
other lending. As shown in Figure 1, bond yields are closely correlated with the fed funds rate
except during the early-to-mid 1970s, when fed funds spiked but bond yields did not.
Even more closely related to the fed funds rate, and also more important for the Austrian
theory of the business cycle, is the bank prime credit interest rate. The relationship is mapped in
Figure 2. As one can see, there is an essentially fixed relationship between the fed funds rate and
the bank prime credit interest rate. This is because the fed funds rate is the rate charged for
overnight lending between banks and thus constitutes the minimum rate for interbank lending.
As banks’ economic profit is based on the spread between borrowing and lending, and their
dollar profit is based on the amount they can lend, it is natural that the prime rate be a fixed
difference from the fed funds rate. We will return to the banking system presently, as it is a key
factor in extending the disruptive consequences of interest rate manipulation through an
economy.
The other market, occupied only by corporations, is the stock market. More properly, we
refer to such securities as equity securities. The yield on equity securities is comprised of a base
rate, the nominal risk-free rate, plus a risk adjustment. The most famous equation in finance, the
Capital Asset Pricing Model (CAPM) states that the required return on equity securities is the
risk-free interest rate plus the market risk premium. The market risk premium is the excess return
over the risk-free rate offered by the stock market as a whole. In the CAPM, the market risk
premium is modified by the individual firm’s variance-weighted correlation (beta) with the stock
market. Other models have been offered, and today there are many, but they all include the riskfree rate plus some market risk premium plus other risk adjustments.
The total required return, or interest rate, on equity securities thus is governed by the
behavior of Treasury yields and the market risk premium3. As shown in Figure 3, neither of these
rates is particularly stable, but the Treasury yield is much more active than the market risk
3
The market risk premium is calculated as the discount rate that equates future free cash flow to equity to the
current market value of equity, given historical growth rates. See Damodaran (2010) for a thorough discussion of
these ideas.
premium. The market risk premium is typically between 2% and 6% per year and often is higher
when the other yields are higher. In the sample shown in Figure 3, this period coincided with a
period of high inflation. High inflation constitutes high risk for equities, thus investors require a
higher risk premium during such periods. As uncertainty due to inflation diminished during the
late 1980s and 1990s, the market risk premium decreased. Notice that after the dot.com bubble,
the market risk premium increased again. It went from a low of 2% in 1998 up to 4% by 2000. It
then spiked again to over 6% as the real estate bubble was causing havoc in equity markets.
The market risk premium does not display much relationship to the fed funds rate. They
do tend to have a common trend, in that they have similar slopes. Recently this relationship has
broken down as the fed funds rate is between 0 and 0.25% per annum while the market risk
premium is nearer 6%. It is reasonable to think that, while the Federal Reserve is attempting to
keep interest rates as low as possible equity markets are compensating for current uncertainty by
raising the risk premium. The net effect is to get a total required return that is more consistent
with the historical norm.
It must be noted that yields, for all securities, are derived from the future expected cash
flows and the current price paid for the securities. In essence, markets set prices that equate
demand and supply for certain securities, and the resulting price tells us the expected return, or
yield. This feature will be important going forward, as we come to understand that price
increases, which generate realized returns, also encourage returns-chasing behavior.
As explained by Rothbard ([1962] 2008), if the base rate from the loanable funds market
decreases because individuals have decided to save more of their income – thus ultimately
shifting the supply curve to the right – then there will be a change in capital structure of the
economy. Firms will find that projects that were once unprofitable, in an economic sense, have
become profitable. As firms embark on new projects, they must procure different factors of
production, including raw materials, intermediate goods, new plant and equipment, and likely
new labor. This shifting of the demand curve to the right for certain products, and to the left for
others, will create new opportunities for profit, and eliminate or curtail others. Thus a reordering
of the economy takes place. But this reordering is stable, for it reflects correctly the change in
consumer tastes.
In the context of the term structure, we may find that the reordering leads to an increase
in the long-term rate and a decrease in the short-term rate, or vice versa. As long as the market
rate is free to move, the reordering of the natural rate will become known through movements in
the market rate.
If the natural rate is persistently different from the market rate, the resulting inflation or
deflation will cause the reordering of the market. That this inflation occurs is an hypothesis of
Wicksell’s, but there is empirical evidence for the effect. Mascaro (2004) shows that when the
market rate is above the natural rate consumer price inflation increases, and vice versa. His
sample is for the 1960 – 2003 period, and he uses an estimate of the natural rate based on a
neoclassical Cobb-Douglas production function. Nevertheless, his results favor the Wicksellian
view of inflation.
The task now is to describe how the intervention works, and then to discuss why the
reordering is unstable. In most modern economies, a central bank has the power over the
issuance of currency and the setting of base interest rates. To fix ideas, the Federal Reserve Bank
of the U.S. will serve as a model. Note that the history and background of each bank differs, as
does the banking system itself, across countries. These details are not especially important for the
“thin” theoretical story told here.
3. Capital Budgeting
It is not as clear, for businesses, as the above discussion might imply. For if businesses
knew, or quickly ascertained, that the new money was not from increased savings, they would
likely not err in their judgment regarding which investments to make. Most businesses conduct
an analysis of net present value (NPV) of projects for capital budgeting purposes. A very
standard formula for NPV is:
1
where CF is the cash flow (positive or negative), t indexes the time period, T is the life of the
project, and r is the appropriate interest rate for discounting. The decision rule states that if a
project’s NPV is positive, the project will add value to the firm and should be pursued.4
For the average project for a firm, the r is the firm’s market value-based weighted
average cost of capital (WACC). The WACC of any firm is a weighted combination of the costs
of the various forms of financial capital used by a firm. The basic formula for the WACC of a
firm with straight debt and equity is:
1
where T is the firm’s marginal tax rate, w is the weight in of debt or equity (d or e) in the firm’s
capital structure, and r is the required return on debt or equity.
From the WACC equation, we can see two possible factors that can be affected by
changes in the fed funds target rate. As noted, the fed funds rate is the benchmark rate for all
lending, so that affects the firm’s cost of debt. Second, the cost of equity for the firm is
benchmarked as the risk-free rate of interest (interest on the risk-free asset) plus some adjustment
for risk. Thus the fed funds rate adjustment affects the WACC through its function as a
4
See Cwik (2008) for further discussion on how a lowering of interest rates affects the value of a firm’s current
working capital and fixed assets.
benchmark rate. The correlation among these various interest rates is positive, but may be
indirect. Thus, if the fed funds rate is lowered, the WACC of any given firm will decrease, but
this decrease will not be uniform across firms.
Now, firms do not react immediately to changes in the fed funds rate because they tend to
take a long view of the WACC. A firm’s historical WACC will not be much affected by
temporary reductions or increases in the fed funds rate. However, if the fed funds rate is kept low
for a long enough period, this data will enter the WACC calculation and projects that looked
previously to be value-destroying will come to appear to be value-increasing. If the fed funds
rate is artificially low, this signal will be illusory, and if the firm pursues such a project, it will
find the project was not worthwhile – that ultimately there were better uses for the financial
capital.
4. Intervention by the Money Monopolist
The primary method of central bank intervention is the setting of the so-called federal
funds (fed funds) rate. The fed funds rate is the rate charged on overnight interbank lending.
More importantly, it is the primary benchmark interest rate in the U.S.5However, the Federal
Reserve does not just declare the federal funds rate to be such-and-so; it uses three techniques to
manage bank reserves to try to keep the interbank lending rate close to the Federal Reserve’s
target rate.
The Fed has three tools for the implementation of its so-called monetary policy. The most
common, and most important for this discussion, is called “open market operations.” Open
market operations are transactions made by the Federal Reserve Bank of New York with certain
trading partners of U.S. dollars for qualifying securities – normally Treasury bonds. The second
tool is setting the interest rate for borrowing directly from the Federal Reserve (the discount
window). The final, and least used tool, is changing the required reserve ratio. Note that there is
recent evidence that the “announcement effect” is the main tool used to set the fed funds rate.6
To conduct open market operations, the Fed, through its New York branch, either buys or
sells debt securities from a select group of banks – the counterparties. The key here is when the
Fed buys debt securities from its counterparties the Fed credits the account of the seller’s
depository institution at the Fed. That credit did not previously exist. In other words, it is new
money. That new money creates an excess reserve for the counterparty which can then be lent
out to the counterparty’s customers. Purchasing securities shifts the demand for certain securities
(Treasury securities mostly) to the right, thus increasing the price of each security and lowering
5
See Reilly and Sarte (2010) for an empirical investigation on the relative impact of the federal funds rate on a large
variety of interest rates. They find that, excepting auto loans, most interest rates are highly correlated (R2> 0.6) with
common credit markets.
6
For more on the importance of the announcement effect, see Friedman and Kuttner (2010). It appears that, in
recent years, bank reserves have not changed in response to announced changes in the target fed funds rate but bank
lending rates still change.
the yield. These two factors combine to make more money available for lending at lower rates of
interest. This allows more borrowers to enter the market for loanable funds.
Note carefully that, at these lower rates of interest, fewer people want to lend. So if there
were simply a new interest ceiling, there would be a shortfall – more borrowing would be desired
than there would be lending available. But because of the new money created, that shortfall does
not occur. Herein lays the key to understanding the origin of future economic imbalances. What
has happened is that households have shifted their pattern of consumption to more present
consumption and less saving, while businesses see more money available for investment in
capital goods. Thus there is a mismatch in what households want and what businesses think
households want.
5. Fostering the Boom and Bust
The WACC calculation, as presented, is more relevant for a large public company.
However, the most important player in the transmission of the effects of cheaper lending is the
banking system, not public securities markets. Bank lending is the primary source of financing
for small to medium sized firms. Usually large public firms borrow from banks in addition to
other forms of financing, like bonds and equities.
Banks earn profit by the spread between bank borrowing and lending rates – this does not
depend on the absolute level of the rates. A bank can make a 3% annual return if the fed funds
rate is 2% or if the fed funds rate is 12%. But a bank earns no interest on excess reserves, except
for current extraordinary circumstances, so a bank always wants to lend its excess reserves. And,
the more a bank lends, the larger the dollar revenue. Under typical circumstances, then, the banks
lend as much as possible, given reserve requirements and capital restrictions. But banks do not
lend willy-nilly; they do want to maximize their risk-adjusted expected return on lending.
The importance of the banking system becomes clear when one remembers that
historically the Federal Reserve increases the amount of money in banks’ reserve accounts when
the Fed purchases securities from the banks. Thus money creation begins with the Fed’s
counterparties, and flows out into the economy through the banking system. Now two parts of
this story are in place. First, the Fed reduces the fed funds rate, which causes interest rates
generally to fall and makes more projects appear to be economically profitable. Second, to cause
the fed funds rate to drop, the Fed increases the amount of money in banks’ reserve accounts
which banks then lend to their clients.
A coherent story of economic imbalances must accommodate recent evidence that the
change in the fed funds rate is not necessarily accompanied by an increase in banks’ reserve
accounts. As noted earlier, it appears that the announcement effect is the primary driver of the
reduction in the fed funds rate towards the target rate.7 The traditional Austrian theory of the
trade cycle focuses on controlling the fed funds rate through monetary inflation. This was
correct, historically. As noted, however, in the past few years, this factor may be less important
in explaining the economic imbalances induced by the Fed’s intervention in the market for
loanable funds.
When the benchmark rates are reduced, more projects can be accepted. These are
necessarily worse, in terms of economic profitability, projects than those currently underway
since they were not accepted at a higher benchmark. The Austrian theory focuses on an increase
in the roundaboutness of production in response to a decrease in the cost of capital. This is a
natural extension of a capital-based theory of interest. It is, however, not complete. The other
factor that must be considered is the riskiness of the project.
A lower benchmark rate allows firms to embark upon projects with a longer incubation
period, or with cash flows that are more uncertain. As the Austrian theory focuses on the
incubation period with its attendant malinvestment in unneeded capital goods, this essay will
focus on the higher risk projects. The two effects, roundaboutness and riskiness, look quite
similar.
When benchmark interest rates are reduced, riskier projects are allowed. This increases
capital investment, which is financed by lending at first. One expects that the effect is smaller or
negligible at this stage for established firms, for two reasons. Older firms in older industries may
have fewer investment opportunities, even allowing for a lower benchmark rate. Second, and
more importantly, older firms have more experienced treasurers who are less likely to be led to
choose bad projects just because benchmark rates have fallen somewhat. There are better, i.e.
less risky, ways to take advantage of the lower rates (e.g. issue new, cheaper debt but maintain
business as usual otherwise) that will increase the value of the company.
Younger, smaller firms will borrow money, typically from commercial banks, to finance
projects. One cannot say, a priori, which projects will be chosen except that they are, as indicated
above, second best or worse projects. The last two business cycles in the U.S. were in real estate
and the technological sector prior to that. It is likely that would-be entrepreneurs see current
returns accruing to a particular industry or two, and extrapolate such demand into the future. But
remember that the projects being pursued would not be pursued had the benchmark rates not
been reduced. Thus the projects aim at providing something that consumers ultimately do not
want, though the project is higher up on the production chain. We know the latter to be the case
because consumers did not originally change their consumption/saving pattern to cause a
decrease in the loanable funds market rate of interest.
7
Note that the supply of money increases every year and often at varying rates of growth. This has its own
implications for economic imbalances because of the non-neutrality of money. While inflation of this type is an
important type of intervention, it is too large and complex of an issue to include in this essay. See Horwitz (2000)
for a discussion of inflation, and Subrick (2010) on the non-neutrality of money.
As these “first-movers” increase capital spending, they must acquire particular factors of
production. These factors may include raw materials for goods productions (say lumber for
houses), capital goods (bulldozers, backhoes, hammers), and labor. Since these projects are new
these factors must be bid away from current use. An increase in demand naturally will result in a
higher price and quantity supplied. But this is not accompanied by a decrease in demand for
factors from other sectors because households have not changed their saving/consumption
behavior.
What happens, rather, is that the factor prices are bid up for new projects and will begin
to draw factors away from other, currently productive, uses. That causes the supply for said
factors to go down, and thus increases the price of those factors even further. Rather than
equilibrating forces, prices are bid up across multiple industries for similar factors of production.
One can surmise the statistical effects that will show up: nominal wages will be increasing,
prices of goods and services will be increasing, and corporate performance (i.e. stock prices) will
be on the rise. So at this point, one thinks that the ‘economy’ should be looking quite good.
Bagus (2008) discussed in detail the effects of the intervention on asset prices generally.
He notes that increased asset prices provide more collateral for still more borrowing and this can
lead to increased malinvestment. One need only think of house “flipping” as an example from
the recent boom-and-bust. The important insight is that, from the initial intervention, a chain of
events proceeds that is sufficient to propagate the pattern of artificial price increases through the
entire economy. Furthermore it can, for a while, be self-sustaining. But eventually the turning
point arrives, and the boom is uncovered for the illusion it is.
Exactly when the next step will occur is unknown, but it will take a fairly long time –
several years likely. Entrepreneurs who undertook too risky projects will find the payoffs to be
too low, on balance, given the discount rate used. From a probability standpoint, entrepreneurs
will “Bayesian update” their prior beliefs regarding the benchmark rate that would have better
reflected the risk of the project. Of course, at the point the Bayesian updating occurs, it will
likely be too late to salvage the project and only exiting the project is feasible. Examples of exit
include bankruptcy (like the dot.com bubble bust), housing foreclosures, or simply leaving a
particular profession.
But what is it that reveals the projects to be such poor decisions? Recall that consumers,
in the first place, did not change their tastes of consumption versus saving. The production of
goods in anticipation of this change was false. The mistakes are discovered as an abundance of
supply of certain types of goods builds up. The excess supply causes prices to drop for goods
back to “normal” or market levels, which are much lower than the prices expected when the
project was analyzed in the first place. This leads to incomes from projects that are much lower
than expected. Finally, the effects ripples through the economy as capital goods become
worthless and recalculation takes place.
The period of recalculation is characterized by the low utilization of factors of
production. Measured capacity utilization will be low, and measured unemployment will be high.
Entrepreneurs will, as quickly as possible, find new uses for the purchased capital and the newly
unemployed. It is unknown how long the recalculation period would last, but is probably
coincident with how long the boom period lasted, as that is a measure of how out-of-balance the
economy has become.
If further intervention by the central bank occurs when the malinvestment is discovered
and prices drop then this will delay restoration of sustainable patterns of trade. Such intervention
will have the perverse effect of causing some businesses to try to sustain their malinvestment in
the hope of recovery. But this effect just sustains the value loss – the necessary demand for the
product still does not exist. If the prices were allowed to fall, then sales may be able to take
place. In any case, the business must discover the true value of the project so as to free up
whatever assets possible to be employed in uses that actually are valued. Essentially, further
intervention prevents the price system to point out the errors made, and thus correction cannot
take place.
6. Conclusion
In the unhampered market for money, savers and borrowers interact to establish a marketbased interest rate. That interest rate reflects the natural rate of interest which is based on
peoples’ time preference for consumption. The more people are willing to delay consumption
today in favor of greater future consumption, the higher will the supply of funds be at any given
interest rate. Thus, ceteris paribus, as a group of people becomes more patient, the equilibrium
market rate of interest will decline.
If the market rate of interest declines because of shifts in the fundamental tastes of people
for present versus future consumption, then the new investment that will take place because of
the lower interest rate will eventually be found to be economically profitable. This is so because
the interest rate signals correctly that people want to reduce current consumption in favor of
future goods. This signal leads businesses to accept projects that previously were rejected
because the forecasted economic profit was too low. These projects can both be riskier projects
and take longer to develop.
If the money monopolist intervenes in the market for loanable funds to cause the market
rate of interest to decrease, then the new investment will eventually be found to have been a
mistake. That is because there is a mismatch between what consumers actually want to purchase
and what entrepreneurs have been led to believe consumers want because of the false signals
from artificially low interest rate.
In the unhampered market, if people decide to save more and consume less, then the
immediate effect will be an apparent reduction in the demand for consumer goods right now.
This will lead to a reduction in factor utilization, including labor, in “late stage” industries.
However, that is balanced by an increase in factor utilization, including labor, in “early stage”
industries. Thus there is not a general slowdown, but rather a rebalancing among the stages of
production because of increased saving.8This increased saving leads to faster economic growth,
and more consumption and saving in the future. A focus on the future begets growth.
In the case of intervention, the people have not decided to save more. The new
investment thus competes with current investment for the factors of production and causes prices
of all factors to increase. This appears to be a boom, as investment, employment, nominal
revenue, and wages will increase in general. However this is not sustainable because the new
projects are set to deliver goods people actually do not want, and will not have the wealth to
purchase in the future since they haven’t actually set aside more savings. In fact, the intervention
leads people to consume more now, borrowing more and reducing the disposal wealth they will
have in the future. At some point, this mismatch is discovered, typically when expected demand
fails to materialize. Then, the boom becomes a bust.
There is recent evidence that the Federal Reserve does not actually increase the supply of
reserves in order to reduce the fed funds rate. Rather, there is an announcement effect such that
when the Federal Reserve sets a lower target rate, commercial banks react to this by setting the
bank rates lower. This announcement effect evidence has implications for the Austrian theory of
the business cycle because the Austrian theory assumes that the reserve supply must increase in
order to reduce the fed funds rate.9
In fact, the announcement effect should speed up the process of misallocating investable
funds. Since new money is not flowing through the system, the existing money must be
reallocated from existing uses. Thus prices of factors will react more quickly, and a boom will be
induced sooner than if money printing occurs. Similarly, the turning point will be reached more
quickly. For the interventionist to avoid the bust, then, it must continuously and more frequently
intervene in the loanable funds market to further reduce the benchmark interest rate. This
furthers the boom, but at the expense of an even bigger future bust.
People cheer when the boom is happening, and jeer when the bust occurs. This is
evidence that people are easily fooled by the money monopolist’s intervention in the market. If
people truly understood the result of intervention, the cheering and jeering would in fact be
reversed. In an unhampered market, the decrease in consumer spending would be a mark of
future growth, and this should be welcomed by all.
8
9
See Garrison (2001) for a detailed discussion of this rebalancing effect.
This, historically, is the case. The announcement effect appears to be a relatively new phenomenon.
References
Bagus, Philipp (2008). “Monetary Policy as Bad Medicine: The Volatile Relationship
Between Business Cycles and Asset prices.” Review of Austrian Economics. Vol. 21, 283
– 300.
Cwik, Paul (2008). “Austrian Business Cycle Theory: A Corporate Finance Point of
View.” Quarterly Journal of Austrian Economics. Vol. 11, 60 – 68.
Friedman, Benjamin and Kenneth Kuttner (2010). “Implementation of Monetary Policy:
How do Central Banks Set Interest Rates?” NBER working paper w16165.
Garrison, Roger (2001). Time and Money: The Macroeconomics of Capital Structure.
London: Routledge.
Horwitz, Steven (2000). Microfoundations and Macroeconomics. London: Routledge.
Ikeda, Sanford (1997). Dynamics of the Mixed Economy: Towards a Theory of
Interventionism. London: Routledge.
Mascaro Angelo (2004). “Using the Natural Rate Concept to Assess the Consistency of
Projections Ten Years Ahead for Real Interest Rates and Inflation.” CBO Technical
Paper series 2004 – 5, available here: http://www2.cbo.gov/ftpdocs/52xx/doc5279/20045.pdf.
Mises, Ludwig von. [1949] 2008. Human Action. Auburn: Ludwig Von Mises Institute.
Reilly, Devin and Pierre-Daniel G. Sarte. 2010. “Changes in Monetary Policy and the
Variation in Interest Rate Changes Across Credit Markets.” Economic Quarterly. Vol 96,
201 – 229.
Rothbard, Murray. [1962] 2009. Man, Economy and State with Power and Market.
Auburn: Ludwig Von Mises Institute.
Subrick, J. Robert (2010) “Money is non-neutral,” in Peter Boettke (ed.) Handbook on
Contemporary Austrian Economics, Cheltenham, UK: Elgar, pp. 111 – 123.
Wicksell, Knut. 1936. Interest and Prices. New York: Sentry Press.
T.Bond Rate
FF Rate
AAA
BAA
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
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Figure 1
18.00%
16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
FF Rate
Prime Credit
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
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1974
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Figure 2
20.00%
18.00%
16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
FF Rate
T.Bond Rate
Implied Premium (FCFE)
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
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18.00%
Figure 3
16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%