Interest Rates, Computational Boosts, and the Austrian Theory of the Business Cycle

Interest rates play a critical role in the economy. Were entrepreneurs limited to just asking to borrow the wealth and savings of friends and family, rather than loans from banks, certain projects and services could never be achieved. Further, interest rates play a nearly miraculous role that inadvertently gives society a sort of “computational boost.”

Let’s assume conditions are such that banks, on average, pay depositors nine percent interest on their deposits and charge borrowers 10 percent on their loans and profit the 1 percent difference. For example, they loan out $1,000,000, get back $1,100,000, return to savers 1,090,000, and profit $10,000. People who have no desire to start a business (or have inferior business ideas) would be motivated to lend their money to banks to earn 9 percent interest and, by doing so, they refrain from consumption-spending, thus increasing the amount of wealth-savings available to the future borrowers-entrepreneurs who have superior business ideas. These entrepreneurs can use the money and saved wealth it can be traded for to sustain a superior business idea and grow the economic pie by an amount greater than the 10 percent so they can pay back the loan with interest and make a profit.

Something amazing is going on here! Interest rates motivate the accumulation of wealth-savings and movement of money (and subsequent wealth it will be traded for). Minds (CPUs) that have inferior ideas or lack of desire to pursue a business as entrepreneurs can grow the economic pie slowly (0-9 percent rate). Entrepreneurial minds (CPUs) that have superior ideas and the desire to pursue profit through a business venture can grow the economy faster (>10 percent), thus giving a tremendous “computational boost” to society. The market interest rate is like a barometer that inadvertently or—to use the popular phrase from Adam Ferguson—as “the result of human action, but not the execution of any human design,” helps a mind decide whether it should do the saving or borrowing.

It is important to realize that, as the great economist Henry Hazlitt writes in his classic Economics in One Lesson: “‘Saving,’ in short, in the modern world, is only another form of spending. The usual difference is that the money is turned over to someone else to spend on means to increase production.” The more people save, the more money banks will have to lend out and the lower the interest rate will be as banks compete with each other by offering a lower interest rate to borrowers.

This also means that there is more real wealth available to sustain more business ideas. This is partially seen in the money that savers did not consume when they gave their money to banks. This saved money provides the opportunity for capital investment. If interest rates are at 10 percent, it does not make sense to borrow-consume to nourish an idea for a business that will have a return on investment of say nine percent because you’ll be losing money once the loan is paid back. If, however, interest rates go down to three percent because more people save, then it does make sense for additional entrepreneurs to borrow and nourish ideas that will yield nine percent to profit from the 6 percent difference once the three percent interest on the loan is paid back.

Now, it is very important to recognize the difference between a lower market interest rate because of increased voluntary savings versus artificially-lowered interest rates brought about by inflation. What happens if interest rates are lowered—not because more people refrained from consuming and thus increased the amount of saved-unconsumed wealth by lending their money to banks—because central banks artificially increased the money supply? Interests rates are now, for example, artificially lower than the market rate of 10 percent to the rate of three percent?

In this latter scenario, interest rates have been lowered like in the first scenario, but this is not because there has been an increase in actual saved-unconsumed wealth available for banks to loan out. We have an increase in the supply of money which will eventually be spent on—or “chase”—the same amount of goods. This will generally lead to higher prices as the additional money enters circulation.

The second thing to notice is that all the projects and business ventures which would not have been attempted by entrepreneurs at the market rate of interest now appear profitable. This encourages expansion of projects, buildings, factories, businesses, employees, etc. to be started (the economic boom). As the additional money and credit that was created is spent, this causes the prices of factors of production to increase also. The growth, however, is unsustainable and is revealed when the market demand for the consumer goods produced cannot be sold at prices that will cover costs and make a profit. The misallocation can also be revealed when the inflationary expansion of money and credit ceases. When this occurs, many businesses will no longer be profitable, go bankrupt, liquidate, or be required to retrench (the bust). 

Mises has a wonderful analogy that helps us understand the above. At any moment, given a certain market rate of interest (again, we assume 10 percent), there exists enough wealth in terms of “bricks” (saved wealth) needed to create 100 buildings-projects. If people have really saved more to bring down the interest rate from 10 percent to three percent, there are now more “bricks” (saved wealth) and 120 buildings-projects can be completed. If, however, the interest rate has gone down to three percent, not because there really are more “bricks” (saved wealth), but because more money has been inflated, the bases and some scaffolding for 120 buildings is attempted (the economic boom).

Eventually, there are now more businessmen with more newly-created money competing for the same amount of “bricks.” This causes an increase in the price of the factors of production, driving entrepreneurs toward those factors. Further, entrepreneurs eventually must face the unavoidable fact that there is not enough to complete all the projects, but this is only recognized after significant time, money, energy, and resources have been devoted. The final products cannot be sold at prices to complete their projects profitably. Therefore, a bust will eventually happen.

Partly-finished buildings that are uninhabitable are obviously massive losses of wealth that could have been used for the creation of useful finished products. Even though eventually perhaps 70 buildings are completed, the wealth-bricks that could have completed 100 projects were consumed-used to create several unfinished ones. This led to an inferior restructuring of society than would have occurred had governments and central banks not artificially lowered interest rates via inflation. The production of greater wealth saving, production, and capital investment. These actions are costly and take time. Creating money does not create such wealth. Mises summarizes:

Credit expansion cannot increase the supply of real goods. It merely brings about a rearrangement. It diverts capital investment away from the course prescribed by the state of economic wealth and market conditions. It causes production to pursue paths which it would not follow unless the economy were to acquire an increase in material goods. As a result, the upswing lacks a solid base. It is not real prosperity. It is illusory prosperity. It did not develop from an increase in economic wealth. Rather, it arose because the credit expansion created the illusion of such an increase. Sooner or later it must become apparent that this economic situation is built on sand.