Why do Businesses Believe Artificial Interest Rates?

One of the leading tenets of Austrian economics is that artificial interest rates stimulate an artificial boom of production. By lowering interest rates, entrepreneurs make calculations that appear and would be profitable assuming interest rates are not manipulated. A lowering of interest rates indicates that more capital goods are available although in reality capital goods remain unchanged. This leads to businesses employing capital into ventures that only appear profitable due to the misleading interest rates. Capital is employed in processes that are profitable only as long as interest rates remain manipulated at their artificial level. This creates an unsustainable boom in production that will inevitably lead to a bust once real capital becomes exhausted or when interest rates are finally left to float freely.

One of the most common arguments against Austrian theory goes something like this:

If interest rates are artificially low and businesses know it, then why would they invest in unsustainable processes that they know to be only temporarily profitable? If the theory was true, then businesses that recognize interest rates as not an actual reflection of the true interest rate would abstain from unsustainable ventures and would be better off than other businesses that partake in the artificial boom.

So far it seems like a fairly rational argument and a legitimate concern. The aim of this article is to show why businesses can still choose to engage in inflationary booms even though they know it is unsustainable.

 

  1. Most people aren’t economists

The majority of people aren’t economists, and those that are economists aren’t Austrians economists. For businesses, the rate of interest is just another cost for factors of production. Most do not question whether an artificial drop in interest rates causes and unsustainable boom that consequently leads to a bust. A lowering of interest entices businesses to borrow more money, so long as the interest rate is lower than their rate of return. It’s a simple cost calculation. The sphere of calculation only pertains the business’s operations.

 

  1. There’s no true measure to compare artificial rates against

Interest rates are a market phenomenon, but if the market is being suppressed, how are we to know what the interest rate should be at? If interest rates are held artificially low, how can we compare this rate against a market rate? If the market is not allowed to function without interference, we cannot accurately tell where the actual interest rate will be. The artificial rate could by coincidence coincide with where the actual rate would be, but there’s not way of knowing.

 

  1. Other businesses will take advantage of the cheaper credit to expand

Suppose you are a business owner and correctly recognize interest rates as artificially low. This will not prevent other businesses from taking advantage of the cheaper credit. Suppose we have 6 businesses operating in a single industry. If 5 of the businesses decide to expand by borrowing additional funds from the cheaper credit and you abstain, the other 5 will grow at a faster rate than you. Sure, the 5 that invested will invest in some unsustainable projects that will never be completed and some of them will suffer losses or go belly up; but not all of them. It’s like a game of Russian roulette – only one company may bite the bullet or suffer great losses. When the bust comes, 1 company may go out of business, but now you are left competing with 4 other companies that grew faster and are now bigger and better positioned than you because they took advantage the cheaper credit and survived the lottery. They may have even stolen some of your customers by expanding production during the boom while you abstained.

 

  1. You may be right in the long run, but not make it through the short-run

Austrian economics can determine if capital is being invested in unsustainable ventures, but it cannot tell us when the bust will come. The market forces at play are too complex even for present statistical knowledge (which Austrians mostly reject).

Let’s look at an example:Graphs

Suppose you are a stock market speculator. If you believe prices will fall, you will short the market, meaning you will sell shares of stocks now that you don’t actually have, and deliver the shares previously sold at a later, agreed upon date by buying shares when the date of delivery arrives later and after the price has fallen. If the price moves as it does as the graph on the left, you may be delivering shares before the price has fallen, somewhere around the peak, and you lose money. Your prediction is the dotted black line, but you do not know how far prices will rise before the bust sets in. Your prediction was correct, but timing has robbed the opportunity.

If you believe prices will rise, you will instead go long, meaning you will buy a security to hold it. You may borrow funds (since interest rates are low) to maximize your profits. But if you go long on a stock and it decreases, the borrowers will ask for a margin call, extra money you need to pay the lender to cover the losses of your position. If the case on the right happens, you may predict an eventual rise as represented by the black dotted line, but if you get too many margin calls, you may run out of funds to support your long position, and you become insolvent. Again, your prediction was correct, but timing has robbed the opportunity.

 

  1. It can be profitable if you get out in time

A corollary to the previous example is timing. Some businesses may be aware that growth is artificial and they may take this into account with their capital decisions. If they know there is malinvestment and overconsumption due to an artificial boom, they may decide to ride the wave. Booms can last for years. The housing boom lasted for around 5 years before it fell apart. Companies can decide to invest in capital that comes to fruition and is expended within 5 years, and then get out. Or companies could lease the use of capital for short durations to capture artificial demand while it still exists, and withdrawing from the lease as soon as the bust appears. Timing is key, but mostly luck. Those that can buy low and sell high before the scheme collapses profit greatly.

 

  1. Hysteria of a bull

Tulip Mania

We like to think that as humans we are always rational beings, but this is not the case. My favorite example is Tulip Mania in 17th-century Holland. Tulips during this period experienced a bubble. Tulips bulbs were valued based on their aesthetic qualities, and people began to pay huge money to purchase them; imagine spending years or even decades of income to buy a single bulb. If you are a business and you see everyone willing to pay exorbitant prices that you can’t explain, many will be enticed to get in on the action. If someone is willing to pay this much, there must be a reason, and I will be left behind if I don’t follow the lead of my competitors. If it can happen in a commodity as simple as a tulip, it can happen for any commodity (you know, like houses).

 

In conclusion

So if interest rates are artificial and fuel an inflationary boom, why do businesses partake? The first reason is that it can be profitable. It’s not about believing, it’s about profit. Not everyone will be profitable, but some are willing to take the risk that they will gain and others will lose. Although we may recognize the boom as inflationary that inevitably leads to a bust, it can be profitable to ride the wave. All you need is timing. The second reason is peer pressure. Your competitors may see it fit to expand, or even the entire market. How willing are you to accept that you are the only one right and everyone else is wrong? The third reason is lack of knowledge. We do not know the discrepancy between the artificial and the actual interest rate. Even if we can determine the direction of an inflationary boom, we cannot determine when a reversal will occur nor can we rule out prices moving against us before they reverse and move for us.

 

 

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