The price system is a thing of beauty. F.A. Hayek was exactly right when he said that it would be considered among humanity’s greatest achievements had it actually been designed, created, and implemented. Instead, it just emerged without central planning or a wise order from a wise ruler.
The prices free markets generate aggregate and convey important information about what, how, where, when, and for whom to produce. As the economist Tim Harford put it in his book The Undercover Economist, competitive markets create a world of truth: he notes that in a competitive market, we produce the right stuff the right way for the right people and in the right proportions. The properties of competitive equilibrium have a certain beauty to them. We produce everything that is worth more than it costs to produce. We produce nothing that is worth less than it costs to produce. What gets produced is produced by the lowest-cost producers and consumed by the highest-value consumers. It’s an undesigned and unappreciated marvel.
That raises an uncomfortable question. If markets are so great, why do we have business cycles? What’s the deal with the roller coaster rides of boom and bust that create widespread reductions in output and employment, also known as recessions?
There are a lot of reasons.
In what follows, I want to explore one of the elements of the Austrian theory of the business cycle: a cluster of errors by people who, presumably, aren’t stupid and who, presumably, don’t waste resources intentionally. Here’s the punchline: monetary mischief means that prices are conveying inaccurate information about what, when, where, how, and for whom to produce. The signals that make markets work — prices, profits, and losses — are distorted relative to those that would tell the truth about underlying patterns of preferences and production possibilities. Hence, people make systematic errors. The prices, in other words, are lying.
Friedrich Hayek emphasizes the price we pay for the right to use other people’s money and stuff now rather than later: the interest rate. Let’s consider a couple of concrete scenarios. In the first case, the interest rate changes due to a change in saving and tells us the truth about people’s willingness to sacrifice present for future consumption. In the second case, the interest rate lies about what is really going on because the creation of new money is not the same thing as the creation of new resources. Here’s a parable: the parable of the asteroid miners and the chicken restaurants.
Suppose there is a change in people’s saving behavior. For this paper, I have been rereading James M. Buchanan’s Ethics and Economic Progress, and he devotes one chapter to the idea that, by our own standards and preferences, we would be better off if we all saved more — hence, Buchanan argues, the saving ethic has important “economic content.” Suppose that, on hearing this, people generally start saving more. This increases the supply of loanable funds and decreases the interest rate.
In his legendary lectures on Austrian business cycle theory, Roger Garrison distinguishes between the derived-demand effect and the interest rate effect. For retailers, restaurants, and other firms that serve consumers directly, the derived-demand effect dominates. If people suddenly stop buying sandwiches at Popeye’s and Chick-fil-A, this is going to have a larger effect on their production decisions than lower borrowing costs.
In the late stages of production, firms like Popeye’s and Chick-fil-A contract (relative to what they would have done, at any rate) because they aren’t selling as many sandwiches. Their (relative) contraction is a big part of what frees up the resources that make it easier for firms farther removed from immediate consumption to expand — companies like asteroid-mining firms with their eyes on asteroids said to be worth billions or trillions or even quintillions of dollars.
These firms expand because the interest rate effect dominates the derived-demand effect. They are far enough removed from the retail market for chicken sandwiches that what’s going on there isn’t going to affect them much. What will matter will be what the falling interest rates tell them about the wisdom of long-term investment. Lower interest rates make far-future payoffs more valuable.
At an interest rate of 5 percent, $1,000 one year from today is worth $952.38. At an interest rate of 1 percent, it is worth $990.10. The interest rate is transmitting extremely valuable information: people are now more willing to wait than they were before. Hence, it is a better idea to invest in projects that aren’t going to pay off for a very long time. Even if the payoff is a thousand years from now, we can in principle estimate the present value of a $700 quintillion asteroid. Suppose this is off by many orders of magnitude and the asteroid is worth “only” $7 quadrillion. If the interest rate is 1 percent and the payoff isn’t coming for a thousand years, that $7 quadrillion asteroid still has a present value of over $334 billion. At an interest rate of 2 percent, it’s about $17.5 million.
The interest rates are almost certainly too low because asteroid mining is a pretty risky venture. Lloyd’s of London will insure a lot of things, but the possibility of a 70.25-mile-wide asteroid hitting the Earth is a pretty spectacular risk. It probably wouldn’t be as dramatic as this simulation of a 500 km asteroid hitting the Earth, but it would almost certainly be an extinction event. The interest rates are low and the time scale is kind of absurd to make a point: small changes in interest rates can lead to big changes in asset values.
This all goes fine if the changes are happening because of an increase in saving. Some firms and sectors — those closest to consumers — contract. Other firms and sectors — those farthest from consumers — expand. The economy grows faster as we add capital goods.
Things go awry, however, when the change in the interest rate comes from the monetary authority messing around with things rather than a change in saving. A credit expansion, where the monetary authority creates new money, lowers interest rates and begins a cascade of errors because the lower interest rates are sending incorrect signals about what is most valuable where. The monetary authority creates more money; it does not, however, create more real resources to support expanded production.
The lower interest rate has two effects, one on consumers and the other on firms in the early stages of the structure of production like mining, where all the action aims at creating stuff and skills that are a few years away from being finished goods or services. People consume more because interest rates are lower and the reward for delaying gratification isn’t what it used to be. In response to higher sales, firms in the late late stages (like retailers and restaurants) sell more and make plans to expand.
In the earlier stages, the interest rate effect dominates. Firms in these stages, like the companies eyeing what they think are trillion- and quadrillion-dollar asteroids elsewhere in the solar system, see the present value of possible long-term investments rise. They try, therefore, to expand as well. In the short run, everything looks great. People are consuming more. People are investing more. Unemployment is falling, wages are rising. The economy is booming.
There’s just one problem: prices are lying. Specifically, the interest rate is lying, and as Hayek emphasizes, the lying prices sow the seeds of an eventual bust even though everything looks wonderful.
Everyone is trying to expand their operations because of the lower interest rate and higher spending on consumption goods; however, there simply isn’t enough real saving to support everyone’s plans at the same time. To be sure, there are more loanable funds, which gives every appearance of real saving; however, people aren’t actually cutting back on consumption and leaving real materials like lumber, bricks, and nails for others.
Every chicken restaurant orders more chicken at the same time, driving up prices and encouraging their suppliers to expand. They all plan to build new restaurants while, at the same time, asteroid-mining firms are borrowing money and trying to expand. This increases the prices of lumber, land, construction materials, labor, and everything else, but again, the real saving isn’t there to support it. People are making terrible choices and systematically malinvesting capital goods not because they are stupid but because the prices are not reliable. Importantly, this is not a theory of overinvestment, where people invest too much. It is a theory of malinvestment, where people invest in the wrong things.
They find this out when it turns out the prices they expected to remain stable start rising. This is just an unpleasant surprise for some people who may not enjoy as large a profit as they expected when they decided to expand their chicken restaurants and chicken farms and asteroid-mining concerns, but it is a catastrophe for others who were just on the margin of deciding to enter the market and who pulled the trigger once interest rates fell (in the early stages of production) or sales jumped up just a little bit (in the late stages of production).
This means there are half-built restaurants and half-built office towers that can’t be completed without more lumber, concrete, window glass, and copper wiring — but there’s not enough of these materials to go around. A lot of people have nowhere to turn but bankruptcy. The boom is over, and a bust — during which capital, land, and materials are liquidated and reallocated — is the inevitable consequence.