Interest rates play an important role, as they coordinate production in time. You could say that the market interest rate is a price just as any other, and that it balances supply and demand all the same. Market interest rate balances the supply of savings and saved resources with the demand for loans and resources to be used for production. If the market participants raise the market interest rate, then it means that there isn’t as much resources available as they previously thought, so now they have to pay a higher price if they want to use them. On the other hand, lowered market interest rate tells us that there is more saved resources available for investments. What is important is that the market interest rate, just as any other market price, merely expresses the existing market supply and demand, not the other way around. This means that the market interest rate only follows the market supply of savings and the demand for loans.
When the central bank increases the money supply, it artificially lowers interest rates, but it does not immediately change the amount of savings on the market. There is a lot of new money to lend, but there are no new resources available to be bought for it. The demand for loans increases, because they are now cheaper, but the supply of saved resources remains the same as before! After all, people didn’t decide to consume less and save more. If they did, the raised supply of savings would lower the market interest rate instead of any such central bank intervention. Thus, the central bank policy tricks entrepreneurs into thinking that that there is more resources available for new investments than there really is! In so doing, the central bank disrupts the natural market coordination between consumption, saving, and production, leaving the market participants with false information. The entrepreneurs now think that there is enough saved resources to finish their present investments and reap the profits in the future. So there is a mismatch between the resources made available by saving and what producers think is available. Given this false information, the entrepreneurs are investing their money and resources in even longer-term ventures than before, ones that wouldn’t be profitable given higher interest rate. These businessmen thus start to hire more people, pay higher wages to acquire better workers, and invest in new capital goods. Everyone is spending more, and saving less.
You might think: What could be wrong with that? People have jobs, new companies are established, and the economy is doing great because people are spending more!
Here’s the problem: this situation is unsustainable and leads to erroneous investments — or malinvestments, as Ludwig von Mises called them. He illustrated this phenomenon by using a story about a master builder:
A builder started constructing a house once, thinking he had enough bricks. But in reality he had 20% less than he needed in order to finish the house. His design was not sustainable, but he was not aware of the fact. If he knew that he had fewer bricks, he would change his plans and build a smaller house, or would wait to save enough bricks. However, he realized that he did not have enough bricks only after he started to run out of them. The house cannot be completed and all the work of the builder, and his employees, was wasted, because now everything must have been demolished and redone. Of course, at the start of the construction the economy seemed to be doing great, because the builder and his workers had a job and we could all see the house being built; however, the eventual result was a waste of labour and other resources.
It’s important to note that the problem starts early: during the artificial boom, or at the time that the builder had been making plans that were based on false information about the available resources. In the absence of sufficient prior savings, many projects simply cannot be completed, are not sufficiently profitable, or there is no consumer demand for them. That is why during crises we can see plenty of unused newly built airports and other big projects, empty neighbourhoods of newly built houses that no one wants to buy, or bridges leading to nowhere. During the economic boom, resources are misused and malinvested, leading to their consumption and waste. This means that they are not used properly at the present and won’t be able to be used so in the future, thus leaving us with a lower future standard of living.
The boom cannot last forever and at some point it has to go bust. The interest rates have to go up eventually. When the time comes, the entrepreneurs will realise that the investments they made are unsustainable. They will start to cut costs, fire people and otherwise liquidate the investments.
Look at it this way. Artificially cheap credit is like a drug for a drug addict. The drug makes the addict feel great for a while, but the feeling doesn’t last. The economic downturn after an artificial boom is just like that: it’s a way to detoxicate after taking the poison of cheap loans. And of course it’s painful and unpleasant, but it’s eventually healthy. It’s a sign that the market is working to remove the poison of malinvestments, so that it can begin to function normally. Unfortunately, in recent times, when the crash comes, governments and central banks do not allow for this detox, and treat the problem by giving the drug addict another dose of the drug. So, they start to lower the rates again and to inject cheap credit into the banking system. This, of course, is not a healthy, nor sustainable process.
The Austrian Business Cycle Theory presented here was developed by Ludwig von Mises and then by F.A. Hayek, who won a Nobel Prize for his works.