According to most commentators, artificially lowering interest rates by the central bank prompts businesses to increase investments in capital goods and the structure of production (e.g., tools, machinery, infrastructure). This is supposed to increase economic growth. In short, artificially lowering interest rates equals economic growth. But does it make any sense?
Individual Time Preferences and Interest Rates
According to thinkers such as Carl Menger and Ludwig von Mises, interest is the outcome of the fact that individuals assign a greater importance to present goods versus identical goods in the future. The higher valuation is not the result of capricious behavior, but because life in the future is not possible without sustaining it first in the present. According to Carl Menger:
To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of wellbeing in a later period.
Also, according to Mises,
He who wants to live to see the later day, must first of all care for the preservation of his life in the intermediate period. Survival and appeasement of vital needs are thus requirements for the satisfaction of any wants in the remoter future.
Hence, present goods are assigned higher importance than identical future goods. This is manifested by a premium on present goods over the same future goods. The premium is what interest is all about. Since individuals assign a higher preference to present goods versus future goods this means that interest must be positive.
Interest and the interest rate are just an indicator that mirrors individual time preferences. A lowering of the interest rates—absent intervention—signals to businesses that individuals have increased savings. Increased saving enables greater capital investment. An increase in capital goods enables the increase in the production of future goods and services, more efficiently and usually at lower prices. In a way, individuals have instructed businesses to increase the production of consumer goods in the future in relation to the current production of these goods.
On the other hand, the central bank’s lowering of interest rates through an artificial expansion of money and credit—in the absence of an increase in savings—diverts savings from other productive activities. It will result in the misallocation of savings and discoordination of the price and production structure. In this case, savings are diverted towards activities that have emerged on top of the central bank’s low interest rate policy. What we have here is the diversion of investment from wealth-generating activities to non-wealth-generating activities.
Does lowering the interest rate strengthen capital formation?
When the interest rate is not tampered with, it serves as an indicator to businesses regarding individuals’ wishes with respect to present consumption versus future consumption. Whenever the central bank tampers with the interest rate, it falsifies economic calculation, thereby causing businesses to disobey individuals’ instructions regarding the production of present consumer goods versus the production of future consumer goods. Rothbard wrote,
…once the consumers reestablish their desired consumption/investment proportions, it is thus revealed that business had invested too much in capital goods (hence the term “monetary overinvestment theory”), and had also underinvested in consumer goods. Business had been seduced by the government tampering and artificial lowering of the rate of interest, and acted as if more savings were available to invest than were really there.
The lowering of the interest rates by the central bank leads to an over-investment in capital goods and to an under-investment in consumer goods. The over-investment in capital goods results in economic activity, which is labeled as an economic boom. The liquidation of the over-investment is an economic bust. Hence, the boom-bust economic cycle.
Expanding Savings: Key to Growth
Without the expansion and the enhancement of the structure of production through capital investment, it is difficult or even impossible to consistently increase the supply of goods and services. The expansion and the enhancement of the infrastructure depends on increases in savings. Saving necessarily precedes capital investment. Hence, what matters for economic growth is not just tools, machinery, and labor, but also saving and capital investment which expands the structure of production.
Supply and Demand
Now, would an increase in consumer expenditure, due to artificially low interest rates, strengthen economic growth? The answer is no because greater production must precede greater consumption. In the market economy, producers do not produce everything for their own consumption. Part of their production is used to exchange for the goods produced by other producers. According to David Ricardo,
No man produces but with a view to consume or sell, and he never sells but with an intention to purchase some other commodity, which may be immediately useful to him, or which may contribute to future production. By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person.
This means that something is exchanged for something else. This also means that an increase in the production of goods and services sets in motion an increase in the demand for goods and services. An individual’s demand is constrained by his ability to produce and exchange goods and services. The more goods and services that an individual can produce, the more goods and services he can demand. All other things being equal, in the absence of an increase in the production of goods and services, and hence in the absence of the increase in savings, an increase in consumer outlays would be at the expense of other activities in the economy.
Conclusion
Changes in the interest rates should reflect the wishes of individuals and their social time preference, not the wishes of central bank bureaucrats. The artificial lowering of the interest rates generates the misallocation of savings and discoordination in the price and production structure. Ultimately, this weakens economic growth.
