To correctly understand business cycles and where economic crises come from, we need to understand two concepts: time preference and interest rates.
Time preference is the intensity of our desire to satisfy our wants now over satisfying our wants in the future.
High time preference means that we want to satisfy our wants immediately. For instance, we see something in the store, something that we were dreaming about and we want it now, without waiting a single minute.
Low time preference means that we are able to hold off on our consumption for now, in order to consume more in the future. For example: you want to go on vacation, but the only vacation you can afford right now is a small and short one. You decide to postpone your vacation so that you can have a better and longer one at a later date, after you have saved more. Another example: We want a decent life in retirement, so we decide to deny ourselves something now and invest the money, so that we may have more in the future.
Let’s talk about how interest rates should work in the market economy. People save and spend their money, so they deposit and withdraw money from banks continually. In full reserve banking, banks would only be responsible for keeping people’s money safe for a fee or lending only the part that the customer would agree to lend. In fractional reserve banking, banks can lend a part of a depositor’s money and keep only fraction of it in reserves, hoping that not everyone would want to withdraw their money at once. In this scenario, banks can also offer their depositors interest on their deposit. Thanks to that, banks are able to collect the money in order to give other customers loans at interest. The difference between the earnings of the depositors and interest paid by the borrowers is the bank’s profit.
Now look at the money like is any other good. What happens if a good is scarce? According to law of demand and supply, the price of the good increases, but where there is a lot of that product on the market, its price falls. So, if people have lower time preference, when the vaults are full, interest rates will fall. Think of it as a money on sale. When there is plenty of it, more people are able to get a loan from the banks. Falling interest rates is a very crucial bit of information for entrepreneurs. They see that people are saving their money now, so there is a lot of capital available and it is relatively cheap. They also know that the real resources for new projects are widely available, because people are not consuming them. What entrepreneurs usually decide to do in this case is to make longer term investments. As they increase their demands for the factors of production, the prices of capital goods start to increase. If interest rates were higher, those investments would not be profitable because the interest rate might exceed the return on investment. In the case of low interest rates, those investments are sensible and they provide a higher return than the interest rate. This way, entrepreneurs can prepare for greater future consumption since consumers have signalled this desire. After all, greater future consumption is the reason people save, and their lower time preference was reflected in the lower interest rate.
Time preference can also go in the other direction, and savers could say: “Well, we have saved a nice amount of money, now we can live more comfortably by spending our savings”. And the entrepreneurs can answer: “That’s fantastic — we are ready — we have prepared for this by investing in projects that are just now finishing”.
This mechanism contributes to balanced economic growth. Time preference and market interest rates are really important because they coordinate production in time. While people refrain from spending their funds immediately, those funds and the real resources are made available to producers and entrepreneurs. If people then increase their consumption, the arrangement of capital and production (also known as the capital structure) is capable of satisfying their desire to do so. Standards of living can grow because production is most effective when it is guided by this mechanism. If people’s time preferences switch from low to high, the money available for lending would become more scarce, and so interest rates would increase, encouraging depositors to save more and discouraging entrepreneurs from taking on long term investments. Therefore, interest rates should be dependent on people’s time preference, because only this way does it give important information about the availability of real resources in the economy. This way investments would be based on real savings and there would be no risk that there will not be enough resources to finish those investments.
In the absence of artificial interest rates set by central banks, there are no boom/bust cycles, although fractional reserve banking could lead to some problems even then, which will be discussed in another film. Of course there could still be some bad investments or slowdowns in some industries, but there would be no economy-wide or systemic malinvestments. Market interest rates give entrepreneurs all the information they need regarding the general availability of resources for production today. Artificially low or high interest rates give them the wrong information about the availability of saved resources.
In the next episode we’ll see why we have business cycles today and where these spectacular crises come from. If you don’t want to miss our next videos, subscribe on YouTube and like our page on Facebook. You can find the links in the video description below.