In my last article, I pointed out some flaws in the Keynesian circular flow of income. In summary, Keynesians are incorrect to discourage savings and to encourage government spending, and their attitudes towards imports and exports can only be termed “mercantile.” The conclusions of the Keynesians logically follow from their representation of the economy as a circular flow and economic growth as increased spending on aggregate production.
I promised that in my next article I would explain why credit expansion doesn’t relieve us of the task of saving, but is instead behind our present economic malaise. As I alluded to A-level economics last time, I shall do so this time, too. Everyone, get your pens and paper at the ready.
THE PROPERLY FUNCTIONING ECONOMY
To begin with, I shall talk you through how a properly functioning economy would handle saving and borrowing, that is, the market for loanable funds.
1) Draw your standard supply and demand diagram
2) On the vertical axis goes ‘interest rate’
3) On the horizontal axis goes ‘quantity’
Where the two curves intersect is the market interest rate. The market equilibrates at IR-Q.
It is perhaps strange to think of interest rates as being a price, but that is just what they are: the price of money. If you want money now, then you pay the interest rate; if you want money in the future, you get the interest rate. Interest rates are the premium for saving and, in a properly functioning economy, the market price for loanable funds: the price at which the market is cleared.
Falling Interest Rates
If the supply of loanable funds increases (if people start to save more, for whatever reason), then, ceteris paribus, the price of loanable funds will decrease as the S curve shifts to the right to become S1, along the same D curve. The new equilibrium is IR1-Q1. In this case, more is supplied and more is demanded – no disequilibrium ensues.
If the demand for loanable funds decreases (if people stop taking out loans as often, for whatever reason), then, ceteris paribus, the price of loanable funds will decrease as the D curve shifts to the left along the S curve to D1. At new equilibrium, IR1-Q1, less is demanded and less is supplied – again, no disequilibrium ensues.
Rising Interest Rates
If the supply of loanable funds decreases (if people stop saving as much, for whatever reason), then, ceteris paribus, the price of loanable funds will increase as the S curve shifts to the left to become S1, along the same D curve. The result is a new equilibrium – IR1-Q1 – where less is supplied and less is demanded – no disequilibrium.
If the demand for loanable funds increases (if people start taking out loans more often, for whatever reason), then, ceteris paribus, the the price of loanable funds will increase as the D curve shifts to the right, along the same S curve, to become D1. The result is the new equilibrium- IR1-Q1 – where more is demanded and more is supplied – no disequilibrium.
So, these are the four scenarios which can affect the interest rate in a properly functioning economy, governed only by the laws of supply and demand. This economy has a healthy relationship with scarcity, so to speak. Never is there an oversupply or shortage and never is the price too high or too low. How, then, do things go wrong?
CREDIT EXPANSION: SHIFTING THE SUPPLY CURVE TO THE RIGHT…
Credit expansion is the answer. Printing more money, quantitative easing, monetary stimulus, call it what you will, credit expansion is very dangerous. It is dangerous because what it does is it introduces disequilibria to the hitherto properly functioning economy.
1) Draw your axes and label the horizontal axis ‘quantity’ and the vertical ‘interest rate’
2) Draw S and D intersecting at their market price and quantity (IR-Q)
3) Look at it for one last time and weep. You must now get out a new pen and become the central banker.
4) In your new pen, add a new S curve. Shift it along the D curve to the right. Don’t call the new S curve ‘S1’ – that would be incorrect – but instead call it ‘S+ΔMS’ (original supply plus money supply increase).
5) Draw in the new ‘equilibrium’, IR1-Q1.
6) You haven’t finished yet. Where this new interest rate (IR1) touches the old S curve, label this on the horizontal axis ‘Q2’.
Previously, in the properly functioning economy, the interest rate sent out certain price signals. If more loanable funds are supplied because people are saving more, then the interest rate falls to make demand meet the increased supply, i.e. so more people will take out loans. If the demand for loanable funds contracts because people aren’t borrowing as much, then the interest rate falls so as to ensure that saving falls in order that supply doesn’t outstrip demand.
What does diagram II show? At 4) I asked you to add S+ΔMS to the diagram and said that this is not the same as a normal S1. A shift to the right from S to S1 would illustrate an increased willingness on the part of suppliers to supply, that is, people are willing to save more money which can then be loaned out. In this case we have shifted supply to the right, but from S to S+ΔMS. This new S curve represents an artificial increase in the money supply through, as said before, “quantitative easing”, “a monetary stimulus”, or “printing more money.”
The question, then, is: how are the two shifts in S to the right different? The answer is that the former represents a freeing up of resources in the economy since it means that consumers have become savers and as such have refrained from spending the additional loanable funds they have supplied, while the latter represents a representation or appearance of that phenomenon. An artificial credit expansion is nothing more than the central bank pretending that lots of resources are now freed up and that a greater quantity of loanable funds have been supplied.
The new ‘S’ curve will have the effect of reducing the price of loanable funds, because, after all, more loans can be taken out, however dodgy these loans are. And yet, the old S curve remains. For, the artificial expansion of the money supply (by Q1 minus Q, to be precise), while pushing the interest rate down and increasing the demand for loanable funds, does not actually mean people are saving. In fact, with the old S curve and the new interest rate, less money (Q subtract Q2 less, to be precise) is saved than before.
WHAT TO EXPECT
Thus, the artificial shift to the right to S+ΔMS will both increase the demand for loanable funds, i.e. there will be more borrowing, and reduce the supply of loanable funds, since the old S curve represents real supply, i.e. people choosing not to consume, but to save. In short, credit expansion will lead to lower interest rates, less saving, and more borrowing.
Since borrowers borrow in order to pump this money into a good which they expect to ‘pay off’ in the future and thus allow them to pay back the loan with interest, credit expansion must be expected to lead to more investment as a corollary of increased borrowing. For example, an economy which engages in credit expansion might see a boom in the housing industry, since it’s standard practice to get a mortgage (a very big loan, indeed) to pay for a house. Such an economy might also see the price of goods like oil soar, since the surge in investment will bid up the price of goods instrumental in making other goods, i.e. goods which feature in the early stages of production (oil is a key ingredient for manifold goods whose production is relatively complex, such as plastic). Goods such as oil, as they are not often valued in and of themselves, are investments since they can be used to make other goods which will pay off in the future.
Lots of new investment projects will be taken on as a result of the lower interest rate and the artificial expansion of the money supply. Firms use the interest rate as a signal of whether to engage in projects which will pay off far in the future or relatively soon. To a firm, the lower the interest rate, the more it seems people are saving. Not only this, but since the interest rate is now lower, lots of new projects which will pay off in the distant future become viable, i.e. they seem like sensible projects to take on in light of the circumstances. Firms, convinced that projects X, Y, and Z are now in some sense in demand – since people are, they think, indicating a willingness to spend their money in the future rather than today – and induced by the increased affordability of credit to take out loans, start these projects.
This is the ‘boom’: firms will lengthen their structure of production both because they can afford to and because they think that is what consumers want them to do. For this reason, industries like the housing industry will take off.
Yet, this reduction in interest rates was not brought about by a increased willingness to save on the part of the consumers. In fact, since the premium offered by banks for saving has now fallen, it is now even more costly to save money and thus free up resources in the economy for the future – the future in which investors are now investing, more so than before. Hence, consumers consume more and save less and, ceteris paribus, reduce their ability to buy the end products of the investors’ investments and reduce the ability of the investors to actually finish these projects by consuming more and thus bidding up the prices of resources.
Eventually, nobody knows when, this farce stops. Eventually, firms start to realise that they cannot afford to complete their projects, that consumers don’t want them to finish their projects, and that they had better salvage what they can before they go bankrupt. Thus, firms start to dismantle their projects, lay off unnecessary workers, and reallocate their resources from relatively future-oriented production to relatively present-oriented production. This is the ‘bust’ or ‘recession’.
The recession is not to be feared. Several analogies have been used by Austrian school economists to help to explain this, their theory of the business cycle, i.e. booms and busts. One such analogy is that the recession is merely the hangover, while the boom was the drunken night out. The former may be unpleasant, but the latter is causes liver failure and damages brain cells.
Another analogy can be used to not only illustrate the difference between the boom period and the bust period, but also to argue against any fiscal or monetary stimuli to avert a recession. Imagine you are a builder and I give you a job and it pays pretty well. I then give you all of the tools and I give you some bricks and a plan of the house that I would like you to build. When you get started you are very excited about the project and you are constantly smiling and whistling to yourself while you’re working. Once you’ve been working on this house for about six months, you start to doubt my plan. As soon as you have these doubts, you call me and tell me that you aren’t sure you’ll have enough bricks to complete the house. What I do next, as your employer, marks me out as either an Austrian, or a Keynesian/Monetarist: if I tell you to dismantle the house as quickly and efficiently as possible and to salvage what you can while I draw up a plan for a smaller house, then I’m an Austrian; if I’m a Keynesian/Monetarist, then I’ll invite you into my office and ply you with booze.
What I have attempted to do is to start from the very beginning, from simple concepts like supply and demand, and end on the Austrian theory of the business cycle and all the while explain this rather complex theory in the language of A-level economics. It would seem to me that I have now done this. What do you think?