How Business Owners Take Cues From Interest Rates

Authored by Frank Shostak via The Mises Institute,

According to the Austrian Business Cycle Theory (ABCT) the artificial lowering of interest rates by the central bank leads to a misallocation of resources because businesses undertake various capital projects that prior to the lowering of interest rates weren't considered as viable. This misallocation of resources is commonly described as an economic boom.

As a rule businessmen discover their error once the central bank - that was instrumental in the artificial lowering of interest rates - reverses its stance, which in turn brings to a halt capital expansion and an ensuing economic bust. From the ABCT one can infer that the artificial lowering of interest rates sets a trap for businessmen by luring them into unsustainable business activities that are only exposed once the central bank tightens its interest rate stance.

Critics of the ABCT maintain that there is no reason why businessmen should fall prey again and again to an artificial lowering of interest rates. Businessmen are likely to learn from experience, the critics argue, and not fall into the trap produced by an artificial lowering of interest rates. Correct expectations will undo or neutralize the whole process of the boom-bust cycle that is set in motion by the artificial lowering of interest rates. Hence, it is held, the ABCT is not a serious contender in the explanation of modern business cycle phenomena.

According to a prominent critic of the ABCT, Gordon Tullock,

One would think that business people might be misled in the first couple of runs of the Rothbard cycle and not anticipate that the low interest rate will later be raised. That they would continue to be unable to figure this out, however, seems unlikely. Normally, Rothbard and other Austrians argue that entrepreneurs are well informed and make correct judgments. At the very least, one would assume that a well-informed businessperson interested in important matters concerned with the business would read Mises and Rothbard and, hence, anticipate the government action.1

Even Mises himself had conceded that it is possible that some time in the future businessmen will stop responding to loose monetary policy thereby preventing the setting in motion of the boom-bust cycle. In his reply to Lachmann he wrote,

It may be that businessmen will in the future react to credit expansion in another manner than they did in the past. It may be that they will avoid using for an expansion of their operations the easy money available, because they will keep in mind the inevitable end of the boom. Some signs forebode such a change. But it is too early to make a positive statement.2

Do Expectations Matter?

Now, a businessman has to cater for consumers future requirements if he wants to succeed in his business.

So whenever he observes a lowering in interest rates he knows that this most likely will provide a boost to the demand for various goods and services in the months ahead. Hence, if he wants to make a profit he would have to make the necessary arrangements to meet the future demand.

For instance, if a builder refuses to act on the likely increase in the demand for houses because he believes that this is on account of the loose monetary policy of the central bank and cannot be sustainable, then he will be out of business very quickly. To be in the building business means that he must be in tune with the demand for housing.

Likewise, any other businessman in a given field will have to respond to the likely changes in demand in the area of his involvement if he wants to stay in business.

If a businessman has decided to be in a given business this means that the businessman is likely to cater for changes in the demand in this particular business irrespective of the underlying causes behind changes in demand. Failing to do so will put him out of business very quickly.

Hence, regardless of expectations once the central bank tightens its stance most businessmen will “get caught”. A tighter stance will undermine demand for goods and services and this will put pressure on various business activities that sprang up whilst the interest rate stance was loose. An economic bust emerges.

Furthermore, even if businessmen have correctly anticipated the interest rate stance of the central bank and the subsequent changes in the growth rate of money supply, because of the variable time lag from money changes to its effect on economic activity it will be impossible to establish the accurate timing of the boom-bust cycle.

Due to the time lag, prior changes in money supply could continue to dominate the economic scene for an extended period. (Given that the time lag is variable, it is not possible to ascertain when a given change in the money supply growth rate is going to start to dominate the economic scene and when the effect of past changes in money supply is going to vanish).

We can conclude that correct expectations cannot prevent boom-bust cycles once the central bank has eased its interest rate stance.

The only way to stop the menace of boom-bust cycles is for the central bank to stop the tampering with financial markets.

Comments

wetwipe buzzsaw99 Fri, 06/01/2018 - 15:33 Permalink

Reduce the interest rates to zero and the stupid man will think "wow, free money" and buy a house that he can't afford once rates normalise.... This is most people today. The smart man will think "wow, the economy must be really fucked" and begin to save more even though he is disincentivised to do so by the low interest rates.

 

As the rates stay low for a decade, the truly smart man will stick to his guns and the fact that interest rates remain low will tell him that he's on to something big. While everyone else is taking on more and more debt he remains calm and sticks to the original plan.

 

Eventually the collapse will come, and the wise man whether holding cash, PM's or bitcoin will be able to take advantage of the non-availability of credit in using the assets he has on hand to buy productive assets at a knock down price.

 

Be the smart man people!

 

We live in truly hellish times.... Thank god for my support group on FaceBook.

In reply to by buzzsaw99

JRobby wetwipe Fri, 06/01/2018 - 15:44 Permalink

It's no longer a business cycle driven by business conditions and demand cycles.

Oh no.

It's a credit cycle now. In fact, its a DEBT SUPERCYCLE that will crash with a screeching howl that will be heard throughout the immediate universe. Assholes in expensive suits will be hitting the pavement world wide. Literally hitting it at 32ft/sec.

Foolish fucking humans

 

In reply to by wetwipe

booboo JRobby Fri, 06/01/2018 - 18:52 Permalink

If the point of lowering interest rates is to boost lending and expand credit which in result will cause the economy to grow and Businessmen don't fall prey to it what is the fucking point of lowering interest rates? A lot of talking in circles. Besides the fact that businessmen are responding to demand, they are not the ones driving it. Are we really ruled by imbeciles that believe such tripe? Keynesians or Magic Monetary Theory believers need to be driven off a cliff. 

In reply to by JRobby

buzzsaw99 Fri, 06/01/2018 - 15:43 Permalink

some zh required reading for the mises institute:

By now it is a well-known fact that corporations have no real way of generating organic profit growth in this economy (the recent plunge in Q1 EPS was a stark reminder of just that), so they are relying on two things to boost share prices: multiple expansion (courtesy of central banks) and debt-funded buybacks (also courtesy of central banks who keep the cost of debt record low), the latter of which requires the firm to generate excess incremental cash. Incidentally, as SocGen showed last year, all the newly created debt in the 21th century has gone for just one thing: to fund stock buybacks...

https://www.zerohedge.com/news/2016-05-31/crazy-growth-corporate-debt-f…

Born2Bwired Fri, 06/01/2018 - 15:44 Permalink

businesses were smart enough to realize it was "free cheese" in a trap this time.

that is why they borrowed but something like 97% went to buyback stock so their options were golden. CapEx investment not at all.. 

basically they are smart enough to realize the World is f**ked by the Central Bankers while the bankers somehow think they are fooling everyone?? Ha.

Catullus Fri, 06/01/2018 - 16:31 Permalink

If you could refi you debt at low interest rates, you will. If you have more cash flow thereafter, buy back your debt when interest rates go higher and your bonds fall in the secondary market. 

 

But it financial market implied interest yields and natural interest rates are not the same thing