Week in Review
Those who wanted to get away from the United States’ limited government past and grow government had to do away with the gold standard. Those who favored a large and expansive federal government needed fiat money. They needed the power to print money at will. To fund deficits when they continually spend more than they have. Despite continuously raising taxes. When Nixon decoupled the dollar from gold in 1971 the fiat money people got their way. Now the Keynesians could tax, borrow, print and spend to their heart’s content. With the federal government in the driver’s seat of the U.S. economy. With their Keynesian economists advising them. Who said government spending was just as good as private spending. So go ahead and tax, borrow and print. Because all you need to create economic activity is to print money.
Of course they couldn’t have been more wrong. As the Seventies proved. Printing money just created inflation. Higher prices. And asset bubbles. With no corresponding economic activity. Instead there was stagflation. And a high misery index (the inflation rate added to the unemployment rate). Because there is more to economic activity than monetary policy. Tax rates and regulations matter a whole heck of a lot, too. As well as a stable currency. Not one being depreciated away with double-digit inflation. Rich people may get richer buying and selling real estate and stocks during periods of high inflation but working class people just see both their paycheck and savings lose purchasing power.
It was these Keynesian policies that caused the S&L Crisis. The dot-com bubble. And the subprime mortgage crisis. Giving is the Great Recession. The worst recession since the Great Depression. But have we learned anything from these failed policies of the past? Apparently not (see Blind Faith In The Fed Is Not Enough by Comstock Partners posted 4/12/2013 on Business Insider).
The move of the S&P 500 into new all-time highs is based on neither the economy, nor earnings, nor value, but almost completely on the blind faith that the Fed can single-handedly flood the market with enough funds to keep the illusion going. In this sense the similarity of the current stock market to the dot-com bubble of the late 1990s or the housing bubble ending in 2007 is glaring…
Real consumer spending has been growing at a mediocre 2% rate over the past year despite growth of only 0.9% in real disposable income over the same period. This was accomplished mainly by decreasing the savings rate to only 2.6% in February, compared to rates of 7%-to-11% in more prosperous times. With employment growth diminishing and the negative effects of the January tax increases and the sequester yet to kick in, consumer spending is likely to slow markedly in the period ahead. While March year-over-year comparisons may benefit from an earlier Easter, the reverse will probably be true in April. Keep in mind, too, our over-riding theme that consumers, still burdened with most of the debt built up in the housing boom, are in no shape to jump-start their spending…
In sum, the lack of support from the economy, earnings or valuation leaves the Fed as the only game in town. Although the old adage says “Don’t fight the Fed”, it did pay to fight the Fed in 2001 and 2002 and again from late 2007 to early 2009. In our view, the Fed can only try to offset the tightness coming from the fiscal side, but cannot get the economy growing on a sustainable basis.
The only real growth we had was from a tax cut. Surprise, surprise. Of course that cut in the tax rate of the Social Security payroll tax decreased the Social Security surplus. Moving the Social Security funding crisis up in time. That along with Medicare and whatever Obamacare will do will cause a financial crisis this country has yet to see. Which will cause great suffering. Particularly because people are saving less because they have less. Which is the only way they can compensate for the horrible economy President Obama and his Keynesian advisors are giving us. So they won’t have private savings to replace their Social Security benefits that the government will spend long before they retire.
And what does the government do? Why, spend more, of course. Because of the sweet nothings their Keynesian advisors are whispering into their ears. Saying the things big government types want to hear. Spend more. It’s good for the economy. If you wonder what got Greece into the mess they’re in this is it. Spending. And anti-business policies to pull more wealth out of the private sector so the government can spend it.
All the countries reeling in the Eurozone sovereign debt crisis are there for the same reason. None of them got into the mess they’re in because they had low taxes and low regulatory costs. Because countries with business-friendly environments create private sector jobs. And private sector jobs don’t cost the government anything. So they don’t have to tax, borrow, print and spend like they do when they listen to their Keynesian advisors. Because that is what causes chronic deficits to fund. And growing national debts. Things that don’t happen when you leave the economy in the private sector.
Tags: bubbles, consumer spending, disposable income, dot com bubble, federal government, fiat money, government spending, Great Recession, inflation, jobs, Keynesian, Keynesian economists, print money, private sector, private sector jobs, savings, savings rate, Social Security, subprime mortgage crisis, taxes
A High Savings Rate provides Abundant Capital for Banks to Loan to Businesses
Time. It’s what runs our lives. Well, that, and patience. Together they run our lives. For these two things determine the difference between savings. And consumption. Whether we have the patience to wait and save our money to buy something in the future. Like a house. Or if we are too impatient to wait. And choose to spend our money now. On a new car, clothes, jewelry, nice dinners, travel, etc. Choosing current consumption for pleasure now. Or choosing savings for pleasure later.
We call this time preference. And everyone has their own time preference. Even societies have their own time preferences. And it’s that time preference that determines the rate of consumption and the rate of savings. Our parents’ generation had a higher preference to save money. The current generation has a higher preference for current consumption. Which is why a lot of the current generation is now living with their parents. For their parents preference for saving money over consuming money allowed them to buy a house that they own free and clear today. While having savings to live on during these difficult economic times. Unlike their children. Whose consumption of cars, clothes, jewelry, nice dinners, travel, etc., left them with little savings to weather these difficult economic times. And with a house they no longer can afford to pay the mortgage.
A society’s time preference determines the natural rate of interest. A higher savings rate provides abundant capital for banks to loan to businesses. Which lowers the natural rate of interest. A high rate of consumption results with a lower savings rate. Providing less capital for banks to loan to businesses. Which raises the natural interest rate. High interest rates make it more difficult for businesses to borrow money to expand their business than it is with low interest rates. Thus higher interest rates reduce the rate of job creation. Or, restated another way, a low savings rate reduces the rate of job creation.
The Phillips Curve shows the Keynesian Relationship between the Unemployment Rate and the Inflation Rate
Before the era of central banks and fiat money economists understood this relationship between savings and employment very well. But after the advent of central banking and fiat money economists restated this relationship. In particular the Keynesian economists. Who dropped the savings part. And instead focused only on the relationship between interest rates and employment. Advising governments in the 20th century that they had the power to control the economy. If they adopt central banking and fiat money. For they could print their own money and determine the interest rate. Making savings a relic of a bygone era.
The theory was that if a high rate of savings lowered interest rates by creating more capital for banks to loan why not lower interest rates further by just printing money and giving it to the banks to loan? If low interests rates were good lower interest rates must be better. At least this was Keynesian theory. And expanding governments everywhere in the 20th century put this theory to the test. Printing money. A lot of it. Based on the belief that if they kept pumping more money into the economy they could stimulate unending economic growth. Because with a growing amount of money for banks to loan they could keep interest rates low. Encouraging businesses to keep borrowing money to expand their businesses. Hire more people to fill newly created jobs. And expand economic activity.
Economists thought they had found the Holy Grail to ending recessions as we knew them. Whenever unemployment rose all they had to do was print new money. For the economic activity businesses created with this new money would create new jobs to replace the jobs lost due to recession. The Keynesians built on their relationship between interest rates and employment. And developed a relationship between the expansion of the money supply and employment. Particularly, the relationship between the inflation rate (the rate at which they expanded the money supply) and the unemployment rate. What they found was an inverse relationship. When there was a high unemployment rate there was a low inflation rate. When there was a low unemployment rate there was a high inflation rate. They showed this with their Phillips Curve. That graphed the relationship between the inflation rate (shown rising on the y-axis) and the unemployment rate (shown increasing on the x-axis). The Phillips Curve was the answer to ending recessions. For when the unemployment rate went up all the government had to do was create some inflation (i.e., expand the money supply). And as they increased the inflation rate the unemployment rate would, of course, fall. Just like the Phillips Curve showed.
The Seventies Inflationary Damage was So Great that neither Technology nor Productivity Gains could Overcome It
But the Phillips Curve blew up in the Keynesians’ faces during the Seventies. As they tried to reduce the unemployment rate by increasing the inflation rate. When they did, though, the unemployment did not fall. But the inflation rate did rise. In a direct violation of the Phillips Curve. Which said that was impossible. To have a high inflation rate AND a high unemployment rate at the same time. How did this happen? Because the economic activity they created with their inflationary policies was artificial. Lowering the interest rate below the natural interest rate encouraged people to borrow money they had no intention of borrowing earlier. Because they did not see sufficient demand in the market place to expand their businesses to meet. However, business people are human. And they can make mistakes. Such as borrowing money to expand their businesses solely because the money was cheap to borrow.
When you inflate the money supply you depreciate the dollar. Because there are more dollars in circulation chasing the same amount of goods and services. And if the money is worth less what does that do to prices? It increases them. Because it takes more of the devalued dollars to buy what they once bought. So you have a general increase of prices that follows any monetary expansion. Which is what is waiting for those businesses borrowing that new money to expand their businesses. Typically the capital goods businesses. Those businesses higher up in the stages of production. A long way out from retail sales. Where the people are waiting to buy the new products made from their capital goods. Which will take a while to filter down to the consumer level. But by the time they do prices will be rising throughout the economy. Leaving consumers with less money to spend. So by the times those new products built from those capital goods reach the retail level there isn’t an increase in consumption to buy them. Because inflation has by this time raised prices. Especially gas prices. So not only are the consumers not buying these new goods they are cutting back from previous purchasing levels. Leaving all those businesses in the higher stages of production that expanded their businesses (because of the availability of cheap money) with some serious overcapacity. Forcing them to cut back production and lay off workers. Often times to a level below that existing before the inflationary monetary expansion intended to decrease the unemployment rate.
Governments have been practicing Keynesian economics throughout the 20th century. So why did it take until the Seventies for this to happen? Because in the Seventies they did something that made it very easy to expand the money supply. President Nixon decoupled the dollar from gold (the Nixon Shock). Which was the only restraint on the government from expanding the money supply. Which they did greater during the Seventies than they had at any previous time. Under the ‘gold standard’ the U.S. had to maintain the value of the dollar by pegging it to gold. They couldn’t depreciate it much. Without the ‘gold standard’ they could depreciate it all they wanted to. So they did. Prior to the Seventies they inflated the money supply by about 5%. After the Nixon Shock that jumped to about 15-20%. This was the difference. The inflationary damage was so bad that no amount of technological advancement or productivity gains could overcome it. Which exposed the true damage inflationary Keynesian economic policies cause. As well as discrediting the Phillips Curve.
Tags: businesses, capital, capital goods, central banks, consumption, depreciate the dollar, difficult economic times, dollar, economic activity, economic growth, employment, expand the money supply, fiat money, gold standard, high interest rates, inflation, inflation rate, inflationary policies, interest rate, job creation, Keynesian, Keynesian economics, Keynesian economists, low interest rates, monetary expansion, money, money supply, natural rate of interest, new money, Nixon Shock, Phillips Curve, prices, printing money, rate of consumption, rate of savings, recession, Retail sales, savings, savings rate, Seventies, stages of production, time preference, unemployment, unemployment rate
Ben Franklin’s Post Office struggles to Stay Relevant in a World where Technology offers a Better Alternative
Once upon a time people stayed in touch with each other by mailing letters to each other. Benjamin Franklin helped make this possible when he was America’s first Postmaster General of the United States. And it’s in large part due to his Post Office that the American Revolutionary War became a united stand against Great Britain. As news of what happened in Massachusetts spread throughout the colonies via Franklin’s Post Office.
In America Samuel Morse created a faster way to communicate. (While others created this technology independently elsewhere.) Through ‘dots’ and ‘dashes’ sent over a telegraph wire. Speeding up communications from days to seconds. It was fast. But you needed people who understood Morse code. Those dots and dashes that represented letters. At both ends of that telegraph wire. So the telegraph was a bit too complicated for the family home. Who still relied on the Post Office to stay in touch
Then along came a guy by the name of Alexander Graham Bell. Who gave us a telephone in the house. Which gave people the speed of the telegraph. But with the simplicity of having a conversation. Bringing many a teenage girl into the kitchen in the evenings to talk to her friends. Until she got her own telephone in her bedroom. Then came cell phones. Email. Smartphones. And Texting. Communication had become so instantaneous today that no one writes letters anymore. And Ben Franklin’s Post Office struggles to stay relevant in a world where technology offers a better alternative.
As Keynesian Monetary Policy played a Larger Role in Japan Personal Savings Fell
These technological advances happened because people saved money that allowed entrepreneurs, investors and businesses to borrow it. They borrowed money and invested it into their businesses. To bring their ideas to the market place. And the more they invested the more they advanced technology. Allowing them to create more incredible things. And to make them more efficiently. Thus giving us a variety of new things at low prices. Thanks to innovation. Risk-taking entrepreneurs. And people’s savings. Which give us an advanced economy. High productivity. And growing GDP.
Following World War II Japan rebuilt her industry and became an advanced economy. As the U.S. auto industry faltered during the Seventies they left the door open for Japan. Who entered. In a big way. They built cars so well that one day they would sell more of them than General Motors. Which is incredible considering the B-29 bomber. That laid waste to Japanese industry during World War II. So how did they recover so fast? A high savings rate. During the Seventies the Japanese people saved over 15% of their income with it peaking in the mid-Seventies close to 25%.
This high savings rate provided enormous amounts of investment capital. Which the Japanese used not only to rebuild their industry but to increase their productivity. Producing one of the world’s greatest export economies. The ‘Made in Japan’ label became increasingly common in the United States. And the world. Their economic clot grew in the Eighties. They began buying U.S. properties. Americans feared they would one day become a wholly owned subsidiary of some Japanese corporation. Then government intervened. With their Keynesian economics. This booming economic juggernaut became Japan Inc. But as Keynesian monetary policy played a larger role personal savings fell. During the Eighties they fell below 15%. And they would continue to fall. As did her economic activity. When monetary credit replaced personal savings for investment capital it only created large asset bubbles. Which popped in the Nineties. Giving the Japanese their Lost Decade. A painful deflationary decade as asset prices returned to market prices.
Because the Germans have been so Responsible in their Economic Policies only they can Save the Eurozone
As the world reels from the fallout of the Great Recession the US, UK and Japan share a lot in common. Depressed economies. Deficit spending. High debt. And a low savings rate. Two countries in the European Union suffer similar economic problems. With one notable exception. They have a higher savings rate. Those two countries are France and Germany. Two of the strongest countries in the Eurozone. And the two that are expected to bail out the Eurozone.
While the French and the Germans are saving their money the Japanese have lost their way when it comes to saving. Their savings rate plummeted following their Lost Decade. As Keynesian economics sat in the driver seat. Replacing personal savings with cheap state credit. Much like it has in the US and the UK. Nations with weak economies and low savings rates. While the French and the Germans are keeping the Euro alive. Especially the Germans. Who are much less Keynesian in their economics. And prefer a more Benjamin Franklin frugality when it comes to cheap state credit. As well as state spending. Who are trying to impose some austerity on the spendthrifts in the Eurozone. Which the spendthrifts resent. But they need money. And the most responsible country in the Eurozone has it. And there is a reason they have it. Because their economic policies have been proven to be the best policies.
And others agree. In fact there are some who want the German taxpayer to save the Euro by taking on the debt of the more irresponsible members in the Eurozone. Because they have been so responsible in their economic policies they’re the only ones who can. But if the Germans are the strongest economy shouldn’t others adopt their policies? Instead of Germany enabling further irresponsible government spending by transferring the debt of the spendthrifts to the German taxpayer? I think the German taxpayer would agree. As would Benjamin Franklin. Who said, “Industry, Perseverance, & Frugality, make Fortune yield.” Which worked in early America. In Japan before Japan Inc. And is currently working in Germany. It’s only when state spending becomes less frugal that states have sovereign debt crises. Or subprime mortgage crisis. Or Lost Decades.
Tags: Alexander Graham Bell, asset bubbles, Bell, Benjamin Franklin, capital, cheap state credit, credit, economic activity, Euro, Eurozone, France, Franklin, French, Germans, Germany, invest, investment, investment capital, Japan, Japan Inc., Japanese, Keynesian, Keynesian economics, lost decade, monetary policy, Morse, Morse code, personal savings, Post Office, productivity, Samuel Morse, savings, savings rate, telegraph, telephone
Healthy Sales can Support just about any Bad Decision a Business Owner Makes
“Industry, Perseverance, & Frugality, make Fortune yield.” Benjamin Franklin (1744). He also said, “A penny saved is a penny earned.” Franklin was a self-made man. He started with little. And through industry, perseverance and frugality he became rich and successful. He lived the American dream. Which was having the liberty to work hard and succeed. And to keep the proceeds of his labors. Which he saved. And all those pennies he saved up allowed him to invest in his business. Which grew and created more wealth.
Frugality. And saving. Two keys to success. Especially in business. For the business that starts out by renting a large office in a prestigious building with new furniture is typically the business that fails. Healthy sales can support just about any bad decision a business owner makes. While falling sales quickly show the folly of not being frugal. Most businesses fail because of poor sales revenue. The less frugal you’ve been the greater the bills you have to pay with those falling sales. Which speeds up the failing process. Insolvency. And bankruptcy. Teaching the important lesson that you should never take sales for granted. The importance of being frugal. And the value of saving your pennies.
Saving and frugality also hold true in our personal lives. Especially when we start buying things. Like big houses. And expensive cars. As a new household starting out with husband and wife gainfully employed the money is good. The money is plentiful. And the money can be intoxicating. Because it can buy nice things. And if we are not frugal and we do not save for a rainy day we are in for a rude awakening when that rainy day comes. For if that two income household suddenly becomes a one income household it will become very difficult to pay the bills. Giving them a quick lesson in the wisdom of being frugal. And of saving your pennies.
The Money People borrow to Invest is the Same Money that Others have Saved
Being frugal lets us save money. The less we spend the more we can put in the bank. What we’re doing is this. We’re sacrificing short-term consumption for long-term consumption. Instead of blowing our money on going to the movies, eating out and taking a lot of vacations, we’re putting that money into the bank. To use as a down payment on a house later. To save for a dream vacation later. To put in an in-the-ground pool later. What we’re doing is pushing our consumption out later in time. So when we do spend these savings later they won’t make it difficult to pay our bills. Even if the two incomes become only one.
Sound advice. Then again, Benjamin Franklin was a wise man. And a lot of people took his advice. For America grew into a wealthy nation. Where entrepreneurs saved their money to build their businesses. Large savings allowed them to borrow large sums of money. As bank loans often required a sizeable down payment. So being frugal and saving money allowed these entrepreneurs to borrow large sums of money from banks. Money that was in the bank available to loan thanks to other people being frugal. And saving their money.
To invest requires money. But few have that kind of money available. So they use what they have as a down payment and borrow the balance of what they need. The balance of what they need comes from other people’s savings. Via a bank loan. This is very important. The money people borrow to invest is the same money that others have saved. Which means that investments are savings. And that people can only invest as much as people save. So for businesses to expand and for the economy to grow we need people to save their money. To be frugal. The more they save instead of spending the greater amount of investment capital is available. And the greater the economy can grow.
The Paradox of Thrift states that Being Frugal and Saving Money Destroys the Economy
Once upon a time this was widely accepted economics. And countries grew wealthy that had high savings rates. Then along came a man named John Maynard Keynes. Who gave the world a whole new kind of economic thought. That said spending was everything. Consumption was key. Not savings. Renouncing centuries of capitalism. And the wise advice of Benjamin Franklin. In a consumption-centered economy people saving their money is bad. Because money people saved isn’t out there generating economic activity by buying stuff. Keynes said savings were nothing more than a leak of economic activity. Wasted money that leaks out of the economy and does nothing beneficial. Even when people and/or businesses are being frugal and saving money to avoid bankruptcy.
In the Keynesian world when people save they don’t spend. And when they don’t spend then businesses can’t sell. If businesses aren’t selling as much as they once were they will cut back. Lay people off. As more businesses suffer these reductions in their sales revenue overall GDP falls. Giving us recessions. This is the paradox of thrift. Which states that by doing the seemingly right thing (being frugal and saving money) you are actually destroying the economy. Of course this is nonsense. For it ignores the other half of saving. Investing. As a business does to increase productivity. To make more for less. So they can sell more for less. Allowing people to buy more for less. And it assumes that a higher savings rate can only come with a corresponding reduction in consumption. Which is not always the case. A person can get a raise. And if they are satisfied by their current level of consumption they may save their additional income rather than increasing their consumption further.
Many people get a raise every year. Which allows them to more easily pay their bills. Pay down their credit cards. Even to save for a large purchase later. Which is good responsible behavior. The kind that Benjamin Franklin would approve of. But not Keynesian economists. Or governments. Who embrace Keynesian economics with a passion. Because it gives them a leading role. When people aren’t spending enough money guess who should step in and pick up that spending slack? Government. So is it any wonder why governments embrace this new kind of economic thought? It justifies excessive government spending. Which is just the kind of thing people go into government for. Sadly, though, their government spending rarely (if ever) pulls a nation out of a recession. For government spending doesn’t replicate what has historically created strong economic growth. A high savings rate. That encourages investment higher up in the stages of production. Where that investment creates jobs. Not at the end of the stages of production. Where government spending creates only inflation. Deficits. And higher debt. All things that are a drag on economic activity.
Tags: bank, bank loan, Benjamin Franklin, capital, capitalism, consumption, down payment, economic activity, Economics, entrepreneurs, Franklin, frugal, frugality, invest, John Maynard Keynes, Keynes, Keynesian, loan, money, paradox of thrift, rainy day, recession, sales, sales revenue, saving, savings, savings rate, spending
Because of the Unpredictable Human Element in all Economic Exchanges the Austrian School is more Laissez-Faire
Name some of the great inventions economists gave us. The computer? The Internet? The cell phone? The car? The jumbo jet? Television? Air conditioning? The automatic dishwasher? No. Amazingly, economists did not invent any of these brilliant inventions. And economists didn’t predict any of these inventions. Not a one. Despite how brilliant they are. Well, brilliant by their standard. In their particular field. For economists really aren’t that smart. Their ‘expertise’ is in the realm of the social sciences. The faux sciences where people try to quantify the unquantifiable. Using mathematical equations to explain and predict human behavior. Which is what economists do. Especially Keynesian economists. Who think they are smarter than people. And markets.
But there is a school of economic thought that doesn’t believe we can quantify human activity. The Austrian school. Where Austrian economics began. In Vienna. Where the great Austrian economists gathered. Carl Menger. Ludwig von Mises. And Friedrich Hayek. To name a few. Who understood that economics is the sum total of millions of people making individual human decisions. Human being key. And why we can’t reduce economics down to a set of mathematical equations. Because you can’t quantify human behavior. Contrary to what the Keynesians believe. Which is why these two schools are at odds with each other. With people even donning the personas of Keynes and Hayek to engage in economic debate.
Keynesian economics is more mainstream than the Austrian school. Because it calls for the government to interfere with market forces. To manipulate them. To make markets produce different results from those they would have if left alone. Something governments love to do. Especially if it calls for taxing and spending. Which Keynesian economics highly encourage. To fix market ‘failures’. And recessions. By contrast, because of the unpredictable human element in all economic exchanges, the Austrian school is more laissez-faire. They believe more in the separation of the government from things economic. Economic exchanges are best left to the invisible hand. What Adam Smith called the sum total of the millions of human decisions made by millions of people. Who are maximizing their own economic well being. And when we do we maximize the economic well being of the economy as a whole. For the Austrian economist does not believe he or she is smarter than people. Or markets. Which is why an economist never gave us any brilliant invention. Nor did their equations predict any inventor inventing a great invention. And why economists have day jobs. For if they were as brilliant and prophetic as they claim to be they could see into the future and know which stocks to buy to get rich so they could give up their day jobs. When they’re able to do that we should start listening to them. But not before.
Low Interest Rates cause Malinvestment and Speculation which puts Banks in Danger of Financial Collapse
Keynesian economics really took off with central banking. And fractional reserve banking. Monetary tools to control the money supply. That in the Keynesian world was supposed to end business cycles and recessions as we knew them. The Austrian school argues that using these monetary tools only distorts the business cycle. And makes recessions worse. Here’s how it works. The central bank lowers interest rates by increasing the money supply (via open market transactions, lowering reserve requirements in fractional reserve banking or by printing money). Lower interest rates encourage people to borrow money to buy houses, cars, kitchen appliances, home theater systems, etc. This new economic activity encourages businesses to hire new workers to meet the new demand. Ergo, recession over. Simple math, right? Only there’s a bit of a problem. Some of our worst recessions have come during the era of Keynesian economics. Including the worst recession of all time. The Great Depression. Which proves the Austrian point that the use of monetary policy to end recessions only makes recessions worse. (Economists debate the causes of the Great Depression to this day. Understanding the causes is not the point here. The point is that it happened. When recessions were supposed to be a thing of the past when using Keynesian policies.)
The problem is that these are not real economic expansions. They’re artificial ones. Created by cheap credit. Which the central bank creates by forcing interest rates below actual market interest rates. Which causes a whole host of problems. In particular corrupting the banking system. Banks offer interest rates to encourage people to save their money for future use (like retirement) instead of spending it in the here and now. This is where savings (or investment capital) come from. Banks pay depositors interest on their deposits. And then loan out this money to others who need investment capital to start businesses. To expand businesses. To buy businesses. Whatever. They borrow money to invest so they can expand economic activity. And make more profits.
But investment capital from savings is different from investment capital from an expansion of the money supply. Because businesses will act as if the trend has shifted from consumption (spending now) to investment (spending later). So they borrow to expand operations. All because of the false signal of the artificially low interest rates. They borrow money. Over-invest. And make bad investments. Even speculate. What Austrians call malinvestments. But there was no shift from consumption to investment. Savings haven’t increased. In fact, with all those new loans on the books the banks see a shift in the other direction. Because they have loaned out more money while the savings rate of their depositors did not change. Which produced on their books a reduction in the net savings rate. Leaving them more dangerously leveraged than before the credit expansion. Also, those lower interest rates also decrease the interest rate on savings accounts. Discouraging people from saving their money. Which further reduces the savings rate of depositors. Finally, those lower interest rates reduce the income stream on their loans. Leaving them even more dangerously leveraged. Putting them at risk of financial collapse should many of their loans go bad.
Keynesian Economics is more about Power whereas the Austrian School is more about Economics
These artificially low interest rates fuel malinvestment and speculation. Cheap credit has everyone, flush with borrowed funds, bidding up prices (real estate, construction, machinery, raw material, etc.). This alters the natural order of things. The automatic pricing mechanism of the free market. And reallocates resources to these higher prices. Away from where the market would have otherwise directed them. Creating great shortages and high prices in some areas. And great surpluses of stuff no one wants to buy at any price in other areas. Sort of like those Soviet stores full of stuff no one wanted to buy while people stood in lines for hours to buy toilet paper and soap. (But not quite that bad.) Then comes the day when all those investments don’t produce any returns. Which leaves these businesses, investors and speculators with a lot of debt with no income stream to pay for it. They drove up prices. Created great asset bubbles. Overbuilt their capacity. Bought assets at such high prices that they’ll never realize a gain from them. They know what’s coming next. And in some darkened office someone pours a glass of scotch and murmurs, “My God, what have we done?”
The central bank may try to delay this day of reckoning. By keeping interest rates low. But that only allows asset bubbles to get bigger. Making the inevitable correction more painful. But eventually the central bank has to step in and raise interest rates. Because all of that ‘bidding up of prices’ finally makes its way down to the consumer level. And sparks off some nasty inflation. So rates go up. Credit becomes more expensive. Often leaving businesses and speculators to try and refinance bad debt at higher rates. Debt that has no income stream to pay for it. Either forcing business to cut costs elsewhere. Or file bankruptcy. Which ripples through the banking system. Causing a lot of those highly leveraged banks to fail with them. Thus making the resulting recession far more painful and more long-lasting than necessary. Thanks to Keynesian economics. At least, according to the Austrian school. And much of the last century of history.
The Austrian school believes the market should determine interest rates. Not central bankers. They’re not big fans of fractional reserve banking, either. Which only empowers central bankers to cause all of their mischief. Which is why Keynesians don’t like Austrians. Because Keynesians, and politicians, like that power. For they believe that they are smarter than the people making economic exchanges. Smarter than the market. And they just love having control over all of that money. Which comes in pretty handy when playing politics. Which is ultimately the goal of Keynesian economics. Whereas the Austrian school is more about economics.
Tags: asset bubbles, Austrian economics, Austrian school, Austrian school of economics, bad debt, banking, banking system, business cycle, businesses, central banking, cheap credit, consumption, credit, debt, depositors, deposits, economic activity, economic exchanges, Economics, economists, fractional reserve banking, free market, Great Depression, Hayek, human behavior, income stream, inflation, interest rates, investment, investment capital, Keynes, Keynesian, Keynesian economists, loan, malinvestment, market forces, market interest rates, mathematical equations, monetary tools, money supply, predict human behavior, prices, quantify, recessions, savings, savings accounts, savings rate, speculation, unquantifiable, workers