Malinvestment and Interest

In his Theory of Money and Credit, Mises had based his analysis on the Wicksellian distinction between the natural rate of interest and the money rate.  But this distinction was untenable in light of Mises’s work on economic calculation and on the non-neutrality of money.  There is no such thing as a natural rate of interest, defined as the rate of interest that would prevail in a barter economy.  And even if there were such a “natural” rate of interest, it would still be irrelevant for the analysis of a monetary economy.  Money is not just a veil over a barter economy.  It affects all economic relations.  Prices, incomes, allocation, and social positions in an economy using money are completely different from what they would be in a society with no common medium of exchange.  And so the interest rate in a monetary economy is necessarily different from what it would have been in the same economy if the market participants had decided to forgo the benefits of money.  Even if one could hypothetically compare “natural” and money interest rates — which is not the case — it would not follow that intertemporal misallocations would ensue whenever the “natural” rate was higher than the money rate.

In Nationalökonomie, Mises gave a new exposition of his business cycle theory.  He came up with a new benchmark to identify pernicious reductions of the monetary interest rate.  The relevant benchmark was no longer the Wicksellian natural rate that would exist if the economy were a barter economy.  It was rather the monetary interest rate that would exist in the absence of credit expansion.

— Jörg Guido Hülsmann, Mises: The Last Knight of Liberalism (Auburn: Ludwig von Mises Institute, 2007), p. 780.

Even if we discard Mises’ new theory of interest (a pure time preference theory of interest in a monetary economy — like Fetter’s?) as equally as untenable, what this particular excerpt from Hülsmann’s book implies (to me) is that the crucial aspect of Austrian capital theory is not the derivation of the rate of interest but, in Sraffian terms, the inducement of severe intertemporal resource misallocation.  The underlining requirement for Austrian business cycle — and this is clear even in Hayek’s Prices and Production — is an increase in the stock of money representing savings and the distribution of this money to entrepreneurs.  This is why, in Human Action, Mises gives more weight to fiduciary expansion than the rate of interest.

Even in Prices and Production, the emphasis is put not on the rate of interest, but on the prices of capital goods of different stages of production.  What ultimately causes the structure of production to lengthen and widen are these price signals; the rate of interest is relevant only because Hayek (and Mises) recognized the loanable funds market as the main artery of intertemporal allocation and a relevant cost (the cost of borrowing theoretically reflecting the scarcity of capital goods).  Why did Hayek use a concept of the rate of interest foreign to the England of 1931?  I would say, because this was not what was really important in what he was trying to get across — he used it as a tool available to help illustrate his argument, similar to the use of the concept of equilibrium  (in Profits, Interest, and Investment he makes clear that his real goal is to explain how monetary changes can cause changes in the rate of profit, more so than in the rate of interest).

This does not mean that rate of interest is unimportant; just that Austrian capital theory does not hinge on the concept of a “natural rate of interest.”

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  1. “This does not mean that rate of interest is unimportant; just that Austrian capital theory does not hinge on the concept of a “natural rate of interest.””

    Austrian capital theory might not, but what about the ABCT?
    You should break the say news to Garrison.

    For Roger Garrison, the leading modern exponent of ABCT, uses the concept called a “market-clearing or equilibrium rate”:

    “The supply and demand for loanable funds … identify a market-clearing, or equilibrium, rate of interest …, at which saving (S) and investment (I) are brought into equality.” (Garrison, R. W. 2000. Time and Money: The Macroeconomics of Capital Structure, Routledge, London and New York. p. 39).

    On that same page in Time and Money: The Macroeconomics of Capital Structure (2000), Garrison makes it clear that this rate is essentially the Wicksellian rate causing intertemporal equilibrium.

    See Garrison, R. W. 2006. “Natural and Neutral Rates of Interest in Theory and Policy Formulation,” Quarterly Journal of Austrian Economics 9.4: 57–68, on p. 58f.:

    “So named by Swedish economist Knut Wicksell, the natural rate of interest is the rate that reflects the underlying real factors. …. the natural rate guides the economy along a sustainable growth path. That is, governed by the natural rate, unconsumed current output (real saving) is used for augmenting the economy’s productive capacity in ways that are consistent with people’s willingness to postpone consumption. In the hands of the Austrian economists, the natural rate became the rate that reflects the time preferences of market participants and allocates resources among the temporally defined stages of production. The output of one stage serves as input to the next in this logical and broadly descriptive representation of the economy’s production process. The temporal dimension of the economy’s capital structure is a key macroeconomic variable in Austrian theory. …. In summary terms, the natural rate is seen as an equilibrating rate. It is the rate that tells the truth about the availability of resources for meeting present and future consumer demands, allowing production plans to be kept in line with the preferred pattern of consumption. By implication, an unnatural, or artificial, rate of interest is a rate that reflects some extra-market influence and that creates a disconnection between intertemporal consumption preferences and intertemporal production plans” (Garrison 2006: 58–59).

    What are we to make of an Austrian theory whose leading theorist still embraces a non-existent natural rate which is a basis of his theory?

    • 1. That many Austrians (rightly or wrongly) embrace the concept of a natural rate of interest doesn’t say anything useful as to whether a natural rate is necessary or not for intertemporal misallocation to occur (as a result of monetary distortions).

      2. If we assume that the Wicksellian concept of a natural rate of interest is wrong, it doesn’t mean that the rate of interest does not reflect the underlying preferences of the different individuals who constitute a market. More broadly, it doesn’t mean that there aren’t processes of intertemporal allocation of resources (i.e. between savings and production).

      3. That we can conceivably think of a market clearing equilibrium rate and that we know that this rate is never actually achieved on the market doesn’t mean that resources cannot be intertemporally allocated. It implies that the process of intertemporal allocation is imperfect (like all market processes). But, this imperfection is not the same thing as the severe misallocations that occur with monetary (price) distortions.

    • I agree with Jonathan that we should be careful not to argue from authority, but Garrison is certainly aware of all these issues too. The fact that he talks about a natural rate tells me that it’s a modeling abstraction that helps with exposition but doesn’t do a lot of harm… which I think is something Jonathan is comfortable with too.

      Like he says – the processes governing a natural rate presumably still govern the varieties of rates that actually exist.

  2. “it doesn’t mean that the rate of interest does not reflect the underlying preferences of the different individuals who constitute a market. More broadly, it doesn’t mean that there aren’t processes of intertemporal allocation of resources (i.e. between savings and production).”

    (1) The interest rate is always a monetary phenomenon, not a real one.
    The trouble with all this is that pure time preference theory of interest does not take you far from Wicksell”s real rate, anyway.

    (2) obviously malinvestment occurs because uncertainty exists. In modern economies, however, there are such vast resources available especially by international trade that the intertemporal mis-allocation of resources in the way imagined by ABCT is highly implausible.

    • 1. What does this have to do with what you’re quoting? Economic calculation refers to the allocation of real resources by means (at least partially) of money prices. Nobody is denying that money is an integral part of the economy and that it influences economic calculation (in ways that would not exist without money — i.e. money is non-neutral). What you’re quoting goes well beyond just the “pure time preference” theory of interest.

      2. Yes, malinvestment occurs because of uncertainty — I agree. Entrepreneurs make mistakes. The second part of your point is a total non-sequitur, though. That there exists “vast resources” doesn’t mean that these no longer need to be intertemporally allocated, or that they aren’t being intertemporally allocated, and that there exists non-allocated resources that can make up for price distortions. In other words, a globalized economy doesn’t imply superabundance.

  3. “The relevant benchmark was no longer the Wicksellian natural rate that would exist if the economy were a barter economy. It was rather the monetary interest rate that would exist in the absence of credit expansion.”

    Trying to interpret. Does this mean that the monetary interest rate has to be set to some hypothetical interest rate that would exist in a non-fiduciary, 100% reserve banking system?

    • Not necessarily; Mises was not opposed to the issuance of fiduciary media. I admit the wording is ambiguous (“in the absence of credit expansion”), and it may be influenced by Hülsmann’s own theoretical preferences, but we can translate that as “in the absence of sustained (or distortionary) credit expansion.”

      • So early Mises says that the market rate of interest must be set to the natural rate of interest – that rate which would hold in a state of barter.

        Hulsmann says that the market rate of interest must be set to that rate of interest which would prevail in a 100% reserve system.

        Catalan says that the market rate of interest must be set to that rate which would prevail in the absence of sustained (or distortionary) credit expansion.

        • No, here Hülsmann writes “in the absence of credit expansion.” This, to me, implies an ambiguous way of saying “in the absence of credit expansion that leads to intertemporal misallocation.” Ultimately, the last two (on your list) ought to be interpreted in the same way: the rate of interest which would prevail on a free market. Just that Hülsmann is predisposed to believe that fractional reserve banking can exist only in a market with government interference and I’m the opposite. The essence, though, is the same.

  4. I’m not necessarily dis-agreeing with this post – I just don’t really understand what you are saying.

    If someone asked me “is the natural rate of interest important in Austrian theory” I would have said yes. The natural rate of interest is the rate that reflects the underlying rate of time preference and leads to a sustainable structure of production.

    If the central banks decides to increase the money supply by encouraging banks to lend extra money then the only way this can happen is by lowering the interest rate. My understanding is that that this lowered interest rate makes longer term investments more attractive while the additional fiduciary media means that money actually is available to fund these now more attractive investments. The deviation from the natural rate of interest and the increase in the money supply re just two sides of the same coin. The new money affects prices, but the rate of interest determines which prices are affected.

    One can imagine a situation where the money supply increases by other than additional lending (via ‘helicopter drops’ to use the modern phrase). Here the interest rate is only indirectly affected. One gets inflation but not mal-investment.

    • The natural rate of interest is the rate that reflects the underlying rate of time preference…

      Very broadly speaking, if we define the “natural rate of interest” that way I’d agree, but this is not how many Austrians define the “natural rate of interest.” Rather, they are referring to a more specific means of derivation, which is a ratio (or discount) between the preference for future consumption and present consumption.

      My point is that the more specific Misesian definition of interest (pure time preference theory) isn’t absolutely necessary for Austrian business cycle theory. All you need, as you state, is the concept of a rate of interest which would exist absent fiduciary over-expansion and this fiduciary over-expansion.

      • I would say that the “rate of interest which would exist absent fiduciary over-expansion” is a close approximation to my idea of the natural rate of interest which I take to be (something close to ) the “ratio (or discount) between the preference for future consumption and present consumption”.

  5. I’m surprised by Hülsmann’s words. If I remember correctly, in Human Action, at least, Mises doesn’t define at all the “natural rate of interest” as the rate of interest “that would prevail in a barter economy”. On the contrary, he specifies that this rate of interest necessarily exists in any kind of economy.

    Moreover, to oppose the “natural rate of interest” to the “money rate” is, in my opinion, misleading. Indeed, the “natural rate” can be, and most often is, expressed in (or applied to) monetary terms. The proper name for the “money rate” should be, as Rothbard put it, the “contractual rate of interest”. As a consequence, the levels of the two kinds of interest rates can perfectly be compared, at least conceptually.

    As I understand it, the “natural rate” and the “money/contractual rate” are at the same level, except when some credit expansion drives the latter downward. So, I think it’s not possible to oppose the “natural rate of interest” and the “credit expansion” as two rival explanations of he business cycle theory; I believe both are necessary parts of it.

    I add that, in my understanding, the “(natural) rate of interest” and “the (spreads of) prices of capital goods of different stages of production” are two different expressions for a same idea.

  6. I guess I don’t understand the problem.

    1.) Construct a basic n-good money-less production economy. Equilibrium describes the price ratios as a function of consumer preferences, etc.

    2.) Add money to the model. Money is said to be neutral if it replicates the distribution generated by 1.).

    3.) Add intermediaries between consumers and producers. Money is said to remain neutral if it still replicates the money exchange ratios in 2.). By implication, it is also neutral with respect to 1.).

    Now add time to the model (for simplicity make it two periods). Equilibrium in 1.) describes inter-temporal exchange ratios between goods. There will be as many equilibrium real interest rates as there are ratios (n-1). Add money. Neutral money implies a single money interest rate that generates the equilibrium in 1.). Now add intermediaries. Money is said to remain neutral if the new money rate of interest is the same as the money rate of interest in 2.), which may be called the “natural rate of interest”. By implication, this is also neutral with respect to real preferences, technology, etc.

  7. Good post Jonathan!

    Ok my English is not good, so I will make any clarifications about what I’m going to say if some ask me. And I apologize beforehand for any language-mistake I would make.

    Now, strictly speaking Hülsmann is perfectly right. Mises, when he had already developed his system, did not necessarily rely on “the natural rate of interest that would prevail in a barter economy”. When he is speaking of a monetary economy and interest rate affected by changes in supply of money, he is talking of the monetary rate which is not the same rate that would prevail in a barter economy.

    in Money, Method and Market Process he said: “The reasoning of modern marginal utility economics begins from the assumption of a state of pure barter… The economists depict a purely hypothetical entity, a market without indirect exchange, without a medium of exchange, without money. There is no doubt that this method is the only possible one… But we have to realize that it is a hypothetical concept which has no counterpart in reality. The actual market is necessarily a market of indirect exchange and money transactions.
    From this assumption of a market without money, the fallacious idea of neutral money is derived. ”

    And here is the best: “The direct exchange of consumer goods and closely related producer goods is, of course, possible; it exists today and did so in the past. However, the exchange of goods of a more remote order presupposes the use of money. The concept of the market as the essence of coordination of all elements of demand and supply, upon which modern theory does and must depend, is unthinkable without the use of money. Only with the use of money is it possible to compare the marginal utility of goods in all alternative employments. Only where money exists can we clearly analyze the difference in value between present and future goods. Only within a money economy can this value difference be comprehended in the abstract and separated from changes in the valuation of individual concrete economic goods. In a barter economy, the phenomenon of interest could never be isolated from the evaluation of future price movements of individual goods. To assume the existence of a highly developed market system without the intermediation of a generally accepted means of exchange would be a scientific fiction like Vaihinger’s “as i f theory.”

    So Mises was perfectly aware of that fact. Then you would say: “why in the world did Mises write this passage in his “Monetary Stabilization and Cyclical Policy”?:

    “In conformity with Wicksell’s terminology, we shall use “natural interest rate” to describe that interest rate which would be established by supply and demand if real goods were loaned in natura [directly, as in barter] without the intermediary of money.”

    The answer, I think, is found in a footnote in his Theory of Money and Credit:

    “The fact that I have followed the terminology and method of attack of Bohm Bawerk’s theory of interest throughout this chapter does not imply that I am an adherent of that theory or am able to regard it as a satisfactory solution of the problem. But the present work does not afford scope for the exposition of my own views on the problem of interest; that must be reserved for a special study, which I hope will appear in the not-too-distant future. In such circumstances I have had no alternative but to develop my argument on the basis of Bohm-Bawerk’s theory.”

    So, the same thing could be said about Wicksellian theory of “natural” interest. Mises in 1928 did NOT yet developed his own theory of interest, so he was “obligated” to write in wicksellian terms. We can not accuse Mises for not use a theory he had not developed yet, and because of that he had to base in others’s (with all “mistakes” it had).

    But let’s go to the grain. What had Mises to say about the “natural” rate and the trade cycle?

    In his 1940 book: Interventionism an Economic Analysis, when we can certainly say that he had already developed his thoughts on interest and other fields, he make some very clever points:

    “It has been asserted that the credit expansion is released by the rise in the rate of interest through the failure of the banks to raise their interest rates in accordance with the rise in the “natural” rate.3 This argument too misses the main point of the monetary theory of the cycle. Whether the credit expansion gets under way because the banks ease credit terms, or because they fail to stiffen the terms in accordance with changed market conditions, is of minor importance. Decisive only is the fact that there is credit expansion because there exist institutions which consider it their task to influence interest rates by the granting of additional credit.4

    And the footnote 4 is very important: “4. If a bank is unable to expand credit it cannot create an upswing even if it lowers its interest rate below the market rate. It would merely make a gift to its debtors. The conclusion to be drawn from the monetary theory of the cycle with regard to stabilizing measures is not the postulate that the banks should not lower the interest rate, but that they should not expand credit.
    This [Gottfried] Haberler (Prosperity and Depression, League of Nations, Geneva, 1939, p. 65ff.)” misunderstood and therefore his criticisms are untenable.”

    In Human Action pag 789 he repeats the same thing with a little different words.

    He clearly is defending himself from Haberler’s critique, but his words also clarify other things. And in the same 1940 book he also says:

    “There is no doubt that credit expansion leads to a reduction of the interest rate in the short run. At the beginning, the additional supply of credit forces the interest rate for money loans below the point which it would have in an unmanipulated market. But it is equally clear that even the greatest expansion of credit cannot change the difference in the valuation of future and present goods. The interest rate must ultimately return to the point at which it corresponds to this difference in the valuation of goods. The description of this process of adjustment is the task of that part of economics which is called the theory of the business cycle.”

    He clearly is not referring to a “rate of interest of a barter economy”, and even if it would be possible to low the money loan rate below the “natural” rate, that would NOT necessarily cause a business cycle. Mises put great emphasis on credit expansion, and not in the lower of interest by itself. The problem IS credit expansion, and is credit expansion what brings the effect on interest rate.

    So I think all this shows that the strictly Misesian theory (I am not including Hayek on this) is completely immune to Sraffa’s critique.

  8. I think I agree with Guillazo.

    To bring two small nuances, though: after having written about Wicksell’s terminology, in tTMC, Mises specified Up to this point Wicksell commands assent; but his further argument provokes contradiction.” Moreover, in an earlier part of tTMC, Mises already referred to the barter rate of interest, without any reference to Wicksell and without any caveat:“The issuers of the fiduciary media are able to induce an extension of the demand for them by reducing the interest demanded to a rate below the natural rate of interest, that is below that rate of interest that would be established by supply and demand if the real capital were lent in natura without the mediation of money, whereas on the other hand the demand for fiduciary media would be bound to cease entirely as soon as the rate asked by the bank was raised above the natural rate.”

    Anyway, as the quotations given by Guillazo make it clear, Mises no longer uses the barter rate of interest in the subsequent books. I add one quotation:“So far we have dealt with the problem of originary interest under certain assumptions: that the turnover of goods is effected by the employment of neutral money; that saving, capital accumulation, and the determination of interest rates are not hampered by institutional obstacles; and that the whole economic process goes on in the frame of an evenly rotating economy. We shall drop the first two of these assumptions in the following chapter (HA, XIX, 4)”.

    Beside, I note a small difference between Mises and Rothbard on the issue of the natural/bank rates relations.

    According to Mises (as I understand it), the bank rate is artificially decreased by the credit expansion and by this way is put below the natural rate; according Rothbard, the bank rate is put below the natural rate because the later increases (due to the inflation – the purchasing-power component — brought about by credit expansion) while the former is prevented to grow (because the new created money enters the system in the loan market):

    We are not concerned with a reduction in the natural rate of interest brought about by an increase in the issue of fiduciary media, but with a reduction below this rate in the money rate charged by the banks, inaugurated by the credit issuing suing banks and necessarily followed by the rest of the loan market.” (Mises, tTMC)

    “Recorded interest rates in the boom will generally rise, in fact, because of the purchasing-power component in the market interest rate. An increase in prices, as we have seen, generates a positive purchasing-power component in the natural interest rate, i.e., the rate of return earned by businessmen on the market. In the free market this would quickly be reflected in the loan rate, which, as we have seen above, is completely dependent on the natural rate. But a continual influx of circulating credit prevents the loan rate from catching up with the natural rate, and thereby generates the business-cycle process.” (Rothbard)

    I don’t know if my interpretation is correct.