Austrian Business Cycle: Interest Rates or Money Supply?

Number of posts: 1202 Location: Boston, MA Registration date: 2008-04-02

I'm having a little trouble with one point on ABCT, and I was hoping somebody around here could help me work through it.

As ABCT is described, it almost always frames the boom of the business cycle as being caused by artificially low interest rates. Since interest rates are a measure of the availability of capital, it makes sense to me that low interest rates could fool entrepreneurs into thinking that there was more available capital than there really is. Ergo the unsustainable boom.

There is a common criticism of this theory wherein the critic suggests that entrepreneurs (particularly in the Austrian model) are not really that stupid. If an entrepreneur know that central banks are artificially lowering interest rates, then he will surely compensate for this.

Austrian economists have responded to this criticism by pointing out that what the central bank does is add static to the available monetary indicators, and that knowing there is noise in the signal doesn't make the signal any clearer. That makes some sense to me.

Here's what doesn't make sense: Why do people think the interest rate itself is so important in the first place? Obviously interest rates will be the determining factor for an entrepreneur in the financial sector, but elsewhere I find it hard to believe that it's interest rates that people are paying so much attention to.

Of all of the entrepreneurs I've known and worked with, I don't think any of them paid that much attention to interest rates, let alone wondered whether they were being artificially depressed. As entrepreneurs, none of them were experts in economics or financial markets. They were experts in a specific field, and they had (presumably) a good idea of whether there was market demand for the product or service they were developing.

It seems to me that that is what confuses entrepreneurs: the artificial demand which created by inflationary monetary policy. And while I find it hard to believe that many Austrian economists would disagree with that characterization, the ABCT is almost always framed as being an issue of interest rates.

Now, one could argue that these amount to the same thing, since interest rates are logically connected to the availability of capital, inflationary or otherwise. But it seems to me that it's the inflationary money supply which drives the low interest rate, not the other way around. Even if a nation outlawed usury (therefore diminishing the influence of interest rates) it could could still have an inflationary boom, and the corresponding bust.

I had a brief conversation about this with Bob Murphy and Robert Wenzel in the comment section of Murphy's blog. Wenzel seemed to agree with me to an extent, but Murphy--despite the concessions in a related paper--seems to think that interest rates really are the determining factor. He obviously knows more about economics and business cycles than I do, so what am I missing?

Last edited by Conrad on Fri May 15, 2009 5:16 am; edited 2 times in total

Stewart wrote:

I'm having a little trouble with one point on ABCT, and I was hoping somebody around here could help me work through it.

As ABCT is described, it almost always frames the boom of the business cycle as being caused by artificially low interest rates. Since interest rates are a measure of the availability of capital, it makes sense to me that low interest rates could fool entrepreneurs into thinking that there was more available capital than there really is. Ergo the unsustainable boom.

There is a common criticism of this theory wherein the critic suggests that entrepreneurs (particularly in the Austrian model) are not really that stupid. If an entrepreneur know that central banks are artificially lowering interest rates, then he will surely compensate for this.

Austrian economists have responded to this criticism by pointing out that what the central bank does is add static to the available monetary indicators, and that knowing there is noise in the signal doesn't make the signal any clearer. That makes some sense to me.

I think they also say that even when entrepreneurs know that there is a boom, there still is cheap credit awaiting them and they can seize profit opportunities if they think they can get out in time

Quote:

Here's what doesn't make sense: Why do people think the interest rate itself is so important in the first place? Obviously interest rates will be the determining factor for an entrepreneur in the financial sector, but elsewhere I find it hard to believe that it's interest rates that people are paying so much attention to.

Of all of the entrepreneurs I've known and worked with, I don't think any of them paid that much attention to interest rates, let alone wondered whether they were being artificially depressed. As entrepreneurs, none of them were experts in economics or financial markets. They were experts in a specific field, and they had (presumably) a good idea of whether there was market demand for the product or service they were developing.

one response may be that in the higher stages of production (e.g. the financial market) the interest rate is essential but as then the new money trickles down the economy it indeed becomes not so much the interest rate directly but the artificial demand (caused by the lower interest rate) by those businesses higher up in the production structure for the goods of those businesses an order lower. So the closer the businesses are to the concumption phase the less attention they pay to the interest rate and the more to increased demand.

Quote:

It seems to me that that is what confuses entrepreneurs: the artificial demand which created by inflationary monetary policy. And while I find it hard to believe that many Austrian economists would disagree with that characterization, the ABCT is almost always framed as being an issue of interest rates.

Now, one could argue that these amount to the same thing, since interest rates are logically connected to the availability of capital, inflationary or otherwise. But it seems to me that it's the inflationary money supply which drives the low interest rate, not the other way around.

yeah, although one could say that e.g. the Fed lowers the interest rate and the moment businesses start to use that the new money is created by the Fed, so in that sense the chronology is reversed, but they amount to the same thing.

Quote:

Even if a nation outlawed usury (therefore diminishing the influence of interest rates) it could could still have an inflationary boom, and the corresponding bust.

yeah

Quote:

I had a brief conversation about this with Bob Murphy and Robert Wenzel in the comment section of Murphy's blog. Wenzel seemed to agree with me to an extent, but Murphy--despite the concessions in a related paper--seems to think that interest rates really are the determining factor. He obviously knows more about economics and business cycles than I do, so what am I missing?

tis a shame that that discussion didn't continue

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the housing bubble is clearly related to the interest rate though

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Number of posts: 1202 Location: Boston, MA Registration date: 2008-04-02

Conrad wrote:

tis a shame that that discussion didn't continue

I might have been reading too much into it, but Murphy seemed a slightly irritated by my questions, and I'd rather not bug the man.

The more I think about this issue, though, the less sense it makes to me that Austrian economists focus on interest rates.

When the Fed lends money directly to banks, via its discount rate, then the interest rate is the chief concern. But the discount rate is, I believe, higher than the Federal funds rate, at which banks lend to each other. So that's not the principle mechanism by which the Fed sets monetary policy. Instead they achieve their target rate by buying and selling treasurys via their open market operations.

And isn't that what the real problem is? That the Fed buys and sells treasurys (and these days other assets as well) using money that they print out of nowhere? The unsustainable boom begins with this monetary inflation in order to set the interest rate. The low interest rate is an effect, not a cause.

My issue with standard ABCT is not about what the ultimate cause is, but rather about why entrepreneurs are so easily fooled into starting unproductive businesses. There have been many excellent explanations (several by Robert Murphy himself), but they all seem to be trying to explain why low interest rates do fool entrepreneurs, instead of explaining why other things--like the actual money in circulation--have the same effect.

I just don't find it believable that business owners (and potential business owners) are compelled into ventures by the interest rate alone. It suggests that these entrepreneurs are watching lending rates, and thinking that they will start their enterprise as soon as it drops below X%. As Robert Wenzel pointed out in his post:

Robert Wenzel wrote:

I don't think that entrepreneurs think in terms of interest rates as signals (or home buyers for that matter). A home buyer (and an entrepreneur) thinks, aha, my payments will be x, I can make this work. As economists, we know this is a price signal, to the average home buyer or entrepreneur, it works or it doesn't in terms of payments.

Guest

I've always found the ABCT to be a little confusing. I've listened to a zillion mesis.org audio files on the subject, so I get the basic gist of it... but I don't feel like I totally understand it.

Here's a question I was asking myself the other day:

Isn't an interest rate basically a price cap (on the price of money/credit)?

Price caps inevitable create a shortage (to the degree that they deviate from the market price), right?

So... does it make sense to say that lowing the interest rate below market level inevitably creates a shortage of money/credit?

Number of posts: 1202 Location: Boston, MA Registration date: 2008-04-02

RoR wrote:

So... does it make sense to say that lowing the interest rate below market level inevitably creates a shortage of money/credit?

No, but I can see why it might seem that way. If the government declared, by fiat, that all interest rates would be 1%, then people would rush to get these cheap loans until all available capital was gone. And then, like you said, there would be shortages.

The government doesn't declare interest rates by fiat, though. What they do is choose a rate, say 1%, and they start to buy Treasury bonds on the open market (typically from banks). Since they're purchasing these bonds using money that they're producing out of thin air, it has the effect of increasing the money supply. More specifically, it has the effect of increasing the banks' money supply. And when banks have more money to lend, they will "naturally" lend it at lower rates. The Fed continues to do this until their target rate has been achieved.

Guest

Stewart wrote:

RoR wrote:

So... does it make sense to say that lowing the interest rate below market level inevitably creates a shortage of money/credit?

No, but I can see why it might seem that way. If the government declared, by fiat, that all interest rates would be 1%, then people would rush to get these cheap loans until all available capital was gone. And then, like you said, there would be shortages.

The government doesn't declare interest rates by fiat, though. What they do is choose a rate, say 1%, and they start to buy Treasury bonds on the open market (typically from banks). Since they're purchasing these bonds using money that they're producing out of thin air, it has the effect of increasing the money supply. More specifically, it has the effect of increasing the banks' money supply. And when banks have more money to lend, they will "naturally" lend it at lower rates. The Fed continues to do this until their target rate has been achieved.

That's crazy. Thanks for the explanation.

Guest

Stewart wrote:

they start to buy Treasury bonds on the open market (typically from banks).

A Treasury bonds is basically like a loan to the government, right? So... if the government buys a Treasury bond, is it basically paying back the loan (through inflation)?

Sorry if that's a really stupid question... it's just that the workings of the Gov and the Fed are rather roundabout, convoluted, and confusing (even to an economic super-genius like myself).

Guest

ReIgNoFrAdNeSs wrote:

So... if the government buys a Treasury bond, is it basically paying back the loan (through inflation)?
.

Or are they just transferring ownership of the claim to the Fed (the Gov is now in debt directly to the Fed, rather than a branch bank)?

I'm so confused.

What's the difference between debt and inflation (if inflation involves borrowing from the Fed)?

Number of posts: 1202 Location: Boston, MA Registration date: 2008-04-02

ReIgNoFrAdNeSs wrote:

A Treasury bonds is basically like a loan to the government, right? So... if the government buys a Treasury bond, is it basically paying back the loan (through inflation)?

Basically.

Well, the government doesn't buy Treasury bonds. All sorts of individuals and institutions do, including foreign governments and central banks. The U.S. Federal Reserve, which is nominally independent from the U.S. government, buys its treasury bonds on the open market, from whoever is selling at the time.

In a roundabout way, though, this is how a pseudo-official branch of the U.S. government is able to pay off the state's debt by simply producing money out of thin air, and then giving it to people in exchange for bonds that the U.S. government was originally paid for.

ReIgNoFrAdNeSs wrote:

Or are they just transferring ownership of the claim to the Fed (the Gov is now in debt directly to the Fed, rather than a branch bank)?

Once the Fed owns the bonds, the U.S. Treasury still has to pay them back. On this point I'm a little uncertain of something myself. When the Fed gets paid for the Treasurys it holds, I believe that money eventually goes back to the U.S. government, because the U.S. Federal Reserve has a 100% tax on virtually all its income over a certain level. But that seems so transparently fraudulent that I'm hesitant to say that it's true.

ReIgNoFrAdNeSs wrote:

What's the difference between debt and inflation (if inflation involves borrowing from the Fed)?

If the Fed doesn't "monetize" the debt (that is, erase it by buying up Treasurys and debasing the currency), then government debt is just debt. If the central bank did not exist, then it would be basically the same as the debt that an individual has through a line of credit, except much larger.

Inflation is, strictly speaking, an increase in the supply of money. More often, however, people use it to mean an increase in the general price levels. The former will almost always cause the latter, but the latter is not necessarily due to the former. Neither of them (without the interference of central banks) can be caused simply through debt, though.

ReIgNoFrAdNeSs wrote:

Sorry if that's a really stupid question... it's just that the workings of the Gov and the Fed are rather roundabout, convoluted, and confusing (even to an economic super-genius like myself).

They're not stupid questions. The way central banking works is intentionally confusing to people who haven't spent any time looking into it. And I think it's not so much that the government explicitly wants us to not understand how this stuff works; it's just that they do better for themselves when we don't, so naturally politicians advocate for complicated financial systems that most people find utterly boring. It makes them easy to ignore.

Guest

Stewart wrote:

ReIgNoFrAdNeSs wrote:

A Treasury bonds is basically like a loan to the government, right? So... if the government buys a Treasury bond, is it basically paying back the loan (through inflation)?

Basically.

Ok, so... a treasury bond is basically when the government takes out a loan from private banks (or whoever buys the bond).

Here's where I'm confused:

a) Is it the Fed, or the government that decides to lower interest rates?

b) Who purchases the bonds in an effort to lower the interest rate through monetary inflation? The Fed, or the government?

c) Whoever purchases the treasury bonds (on the open market) becomes the government's creditor, right?

d) What is the distinction between the U.S. Treasury and the Fed? Is the Treasury just a government accounting agency whereas the Fed is an actual bank?

e) When the treasury takes out a loan (sells a bond), where is it supposed to get the money to pay it back? Taxation? The Fed?

This is a lot of questions, I know. It just seems like such a convoluted mess to me. I don't really get it.

Number of posts: 1202 Location: Boston, MA Registration date: 2008-04-02

ReIgNoFrAdNeSs wrote:

Ok, so... a treasury bond is basically when the government takes out a loan from private banks (or whoever buys the bond).

Yes. Instead of going to get a big loan from a single lender, they sell these bonds to anyone who wants them.

ReIgNoFrAdNeSs wrote:

a) Is it the Fed, or the government that decides to lower interest rates?

It's the Fed. And while it's nominally independent, there is no question that it responds to political pressure.

ReIgNoFrAdNeSs wrote:

b) Who purchases the bonds in an effort to lower the interest rate through monetary inflation? The Fed, or the government?

The Fed purchases them. And it uses "new" money to do it, thereby increasing the amount of capital that banks hold, and thus decreasing the interest rates they will lend at.

ReIgNoFrAdNeSs wrote:

c) Whoever purchases the treasury bonds (on the open market) becomes the government's creditor, right?

Right.

ReIgNoFrAdNeSs wrote:

d) What is the distinction between the U.S. Treasury and the Fed? Is the Treasury just a government accounting agency whereas the Fed is an actual bank?

More or less. The U.S. Treasury is an arm of the U.S. government. They collect our taxes, and issue bonds. The Federal Reserve is an actual bank, but it has a special charter from the U.S. government, giving it special abilities that normal banks don't hold, and giving it regulatory power over other banks. Most importantly the Fed has been given special dispensation from the government so that its bank notes are "legal tender". The head of the Fed, unlike other banks, is appointed by the President of the United States.

ReIgNoFrAdNeSs wrote:

e) When the treasury takes out a loan (sells a bond), where is it supposed to get the money to pay it back? Taxation? The Fed?

It's supposed to get that money from taxes. Most of the time it just floats the debt, like a person who keeps shifting his balance from one credit card to another. And while it's doing that, the Federal Reserve is slowly inflating the money supply, so the dollars that the Treasury repays its bonds with are always worth less than the dollars that it got from selling them in the first place.

Number of posts: 1202 Location: Boston, MA Registration date: 2008-04-02

Stewart wrote:

Once the Fed owns the bonds, the U.S. Treasury still has to pay them back. On this point I'm a little uncertain of something myself. When the Fed gets paid for the Treasurys it holds, I believe that money eventually goes back to the U.S. government, because the U.S. Federal Reserve has a 100% tax on virtually all its income over a certain level. But that seems so transparently fraudulent that I'm hesitant to say that it's true.

I looked into this a bit, just now, and I believe that it actually is as transparently fraudulent as I imagined.

Suppose that Bank of America buys a ten year, $10,000 U.S. Treasury note. Every six months the Treasury will have to pay BoA interest on this note, and after ten years they'll have to pay back BoA the full $10,000.

But suppose that after two years Bank of America sells this note to the Federal Reserve. Now, as long as the Fed doesn't sell it to anyone else, the U.S. Treasury is making interest payments on this note to the Fed.

But what happens to that money? The Fed's charter prevents it from keeping any money beyond what it needs to cover its annual operational expenses. Any profit beyond that is taxed at 100% and paid to... the U.S. Treasury.

Seriously? Yes. So let's follow this from start to finish:

The U.S. Treasury sells some bonds to private investors.
The Federal Reserve says, "Hey, we think interest rates should be lower, to stimulate the economy!"
Ben Bernanke fabricates a bunch of new money, and buys some of those bonds on the open market.
The U.S. Treasury makes interest and principal payments on those bonds to the Federal Reserve.
At the end of the year, the Fed writes the U.S. Treasury a big check for whatever money it didn't use.

This happens all the time. It just doesn't happen to an extent that's so grotesque that Americans lose their shit over it. Maybe we should, though.

Thanks for all the research Stewart. I would have assumed that either the Fed balance sheet grows when it accrues interest (it can go out and buy more bonds) or that it "retires" money if it desires to decrease growth in money. Now I want to do a little more research into this myself. To your general point though, the whole system is clearly a charade. One branch of the gov't (Fed) is said to be independent, but its actions are so dependent on what the treasury does that it could not truly be independent even if functionally it was (which clearly it is not, particularly at times like now).

On ABCT: I don't interpret ABCT so strictly and I would argue that those who do are probably falling into a trap that Austrians accuse all other economists of: forgetting that the assumptions of a model are assumptions. The real economy is full of feedback mechanisms so it impossible to say that causation occurs directly in only one direction.

In an important sense though I think your interpretation is more representative of the real world. The Fed can dictate whatever rates it wants, but the market must still clear. If the dictated rates are close to previous expectations then private parties might adjust their expectations and clear the market privately. If however, the dictated rates are significantly different from "natural rates" then the Fed must step in and clear the market through open market operations. Regardless of what you take to be the first cause, the open market operations are the mechanism that allow the market to clear at the dictated rates.

On your point about Entrepreneurs: I wouldn't interpret "Entrepreneur" too strictly either. Small business owners often aren't considering interest rates directly but the management of large businesses certainly are. Capital Investment, M&A activity, and capital structure are all dramatically influenced by the availability of cheap funds. If rates are low companies are going to invest more, expand more quickly, be more acquisitive of other companies, and tend to buy back stock driving up earnings per share and stock prices.

This type of activity does filter down to small businesses. Say all of the above are occurring and thereby driving up stock prices. In addition to driving an inflationary consumption boom as you discussed, this will also drive an investment boom as investors pile into risky investments. In addition to public equities, investors also herd into alternative assets like venture capital funds making excess capital available even those companies that aren't taking on debt.

Assume I am the founder of a start up company. I think I can be profitable by growing slowly and appealing to a specific niche. My competitor wants to appeal to the mass market and just took a $20 million round of venture capital. I fear that if my competitor expands rapidly, not only will I lose the chance to enter the mass market, but my competitor will also steal my niche audience. I might then be forced to choose between taking VC funds myself and expanding rapidly, even though I don't think it is a good idea, or shutting down.

As Conrad alluded to, there is a bubble psychology that forces even those that recognize the bubble to play along.

Number of posts: 1202 Location: Boston, MA Registration date: 2008-04-02

Static4367 wrote:

I would have assumed that either the Fed balance sheet grows when it accrues interest (it can go out and buy more bonds) or that it "retires" money if it desires to decrease growth in money.

It's somewhat confusing. And, of course, the Fed itself offers virtually no help on the matter. They don't even like to talk about the fact that they control the money supply in the first place. If you find anything more definitive, please let me know.

But here's what I've tentatively determined: When the Fed buys securities, it's increasing the money supply with new money. When it sells those securities, it's decreasing the money supply by (as you say) "retiring" that money.

But what happens while it holds onto those securities? The interest paid on a U.S. government bond has to be considered income for the Federal Reserve, just as the interest on a private bond would be. And since the Fed's profits are given to the U.S. Treasury Dept., it stands to reason that any interest the Treasury pays on Fed-held bonds is therefore effectively negated.

It's less clear to me what happens if the bonds are held until maturity. When the U.S. Treasury pays the face-value of the bond, what does the Fed do with that money? If the Fed was selling the bonds, then the money would be removed from the system. But they wouldn't be selling it on the open market, since it's matured, so they must be collecting on the loan. And if that collection is considered income--as I would imagine it must be--then the money necessarily goes back to the Treasury Department.

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Austrian Business Cycle: Interest Rates or Money Supply?

Austrian Business Cycle: Interest Rates or Money Supply?

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