Does a stable price level mean an economy is at equilibrium?

[phattonez]

Not sure why it would necessarily lead to a crash. The economy will eventually adjust as you say, and the inflation will have no effect on relative prices in the long run (Fisher Effect).

Because companies take out loans based on predictions they make from current demand. Since the companies don't expect the demand to taper off, they will overinvest in capital goods (since introducing inflation like this requires "forced savings") and demand will have to fall off, meaning those investments will not pay off.

 

[drz-400]

Because companies take out loans based on predictions they make from current demand. Since the companies don't expect the demand to taper off, they will overinvest in capital goods (since introducing inflation like this requires "forced savings") and demand will have to fall off, meaning those investments will not pay off.

This sounds a lot like the keynsian cross w/ unplanned and planned investment + consumption.

Could you please expand upon the forced saving just so I am more clear about that point aswell?

 

[phattonez]

This sounds a lot like the keynsian cross w/ unplanned and planned investment + consumption.

Except it's not exactly because it doesn't rely upon propping up demand to fix things. The Austrian view depends on creative destruction to take care of failed investments.

Could you please expand upon the forced saving just so I am more clear about that point aswell?

In fractional reserve banking, you create multiple claims to the same dollar. When people realize this, they realize that their money was worth less than they thought it to be. It's as if then that they were forced to save.

Sorry if it's unclear still but I had to rush this message.

 

[oldreliable67]

Because companies take out loans based on predictions they make from current demand. Since the companies don't expect the demand to taper off, they will overinvest in capital goods (since introducing inflation like this requires "forced savings") and demand will have to fall off, meaning those investments will not pay off.

Close but not quite, plus you make a very large generalization there. The forecasting function in most larger companies is fairly sophisticated. Very few are naive extrapolations from current levels. Examine a sampling of the so-called 'forward-looking' statements from larger companies and you'll see what I mean. These statements require a delineation of risk factors, things that could go wrong, causing the forecast to not be realized.

Consider the current environment: investments are being made in productivity-enhancing equipment (double-digit gains in the last two quarters), but plant and equipment spending is still down. Certainly, these actions suggest, overall, a rather equivocal view toward near-term demand, as well as a high level of uncertainty with respect to coming taxes and regulations. The focus in the corporate world just now is to reduce overhead and try to keep productivity up while until the longer-term outlook becomes more sanquine. Consequently, your assertion that "companies don't expect the demand to taper off, they will overinvest in capital goods" seems quite heroic.

Moreover, loans are not "taken out' in a vacuum: expected future demand is not the only variable. When the decision is made to invest in plant and equipment, cost of capital is also a major consideration. That is, what proportion of the company's capital structure is to be made up of debt versus equity? Equity is expensive capital, relative to debt, but how much leverage is prudent given our outlook? Plus, how much cash do we want to hold, also given our outloook? Is our outlook sufficiently positive that we can re-invest accumulated profits (presently shown on our balance sheet as retained earnings and cash or equivalents), or are investment opportunities slim and our outlook uncertain, suggesting that perhaps stock buybacks or dividends would be a better use of capital?

 

[oldreliable67]

As an add-on to my above post re: generalizations and loans based on predictions, not the following from Deere & Co. forward-looking statement of last week,

...industry sales in Western Europe are now forecast to decline 15 to 20 percent due to general weakness in the livestock and dairy sectors. High levels of used equipment, especially harvesting machinery, also are weighing on Western European markets. Sales in Central Europe and the Commonwealth of Independent States are expected to remain under pressure due to challenging economic conditions.

Deere certainly expects "demand to taper off." That is, if you consider 15% to 20% a "tapering."

 

[phattonez]

Close but not quite, plus you make a very large generalization there. The forecasting function in most larger companies is fairly sophisticated. Very few are naive extrapolations from current levels. Examine a sampling of the so-called 'forward-looking' statements from larger companies and you'll see what I mean. These statements require a delineation of risk factors, things that could go wrong, causing the forecast to not be realized.

Consider the current environment: investments are being made in productivity-enhancing equipment (double-digit gains in the last two quarters), but plant and equipment spending is still down. Certainly, these actions suggest, overall, a rather equivocal view toward near-term demand, as well as a high level of uncertainty with respect to coming taxes and regulations. The focus in the corporate world just now is to reduce overhead and try to keep productivity up while until the longer-term outlook becomes more sanquine. Consequently, your assertion that "companies don't expect the demand to taper off, they will overinvest in capital goods" seems quite heroic.

Not exactly. No one can tell during the boom what is real wealth and what isn't. After all, you expect that the $10 you have in the bank represents $10 you can take out at any time. It's not so since banks are always overleveraged, so that $10 could be worth nothing. No one can tell, not even the banks, so you create a lot of uncertainty within the monetary system. Businesses still need to grow during the boom, and the successful ones will be growing while the smarter companies that decide not to will be left in the dust. If you don't keep growing you won't survive (this concept that I'm talking about has actually been shown with game theory).

Also remember the fact that most businessmen don't adhere to the views of the Austrian school so they think that the government can avoid a crash, so what reason do they have to not take out the loans?

Moreover, loans are not "taken out' in a vacuum: expected future demand is not the only variable. When the decision is made to invest in plant and equipment, cost of capital is also a major consideration. That is, what proportion of the company's capital structure is to be made up of debt versus equity? Equity is expensive capital, relative to debt, but how much leverage is prudent given our outlook? Plus, how much cash do we want to hold, also given our outloook? Is our outlook sufficiently positive that we can re-invest accumulated profits (presently shown on our balance sheet as retained earnings and cash or equivalents), or are investment opportunities slim and our outlook uncertain, suggesting that perhaps stock buybacks or dividends would be a better use of capital?

Cost of capital is a huge, tremedous factor. Hence why holding the market rate of interest below the natural rate will cause too much investment in capital.

 

[oldreliable67]

No one can tell during the boom what is real wealth and what isn't.

Sure you can. Whatever someone else is willing to pay for it. Or to put it in somewhat more economic parlance, the market-clearing price.

the market rate of interest below the natural rate

Define "natural" rate of interest?

 

[phattonez]

Sure you can. Whatever someone else is willing to pay for it. Or to put it in somewhat more economic parlance, the market-clearing price.

But that may be based on inflation that hasn't been realized yet.

Define "natural" rate of interest?

In very rough terms, what the interest rate would be without fractional-reserve banking and government interference.

 

[oldreliable67]

But that may be based on inflation that hasn't been realized yet.

It is based on whatever information is known or believed to be known at the time, plus the purchasers expectations of profitability, which is all encompassed in the purchasers internal rate of return, or hurdle rate, estimates. Inflation "that hasn't been realized yet" is so fuzzy as a concept as to be completely useless and nonsensical.

In very rough terms, what the interest rate would be without fractional-reserve banking and government interference.

Fuzzy, fuzzy, fuzzy. There is no direct relationship between the fractional reserve banking system and a "natural" rate of interest (assuming one can actually define the "natural" rate of interest in a meaningful way).

As for "government interference," by this do you refer to the actions of the central bank in executing monetary policy, or of the government in executing fiscal policy, or perhaps both? With either or both of these, you have a leg to stand on, otherwise...

 

[Lord Tammerlain]

Sure you can. Whatever someone else is willing to pay for it. Or to put it in somewhat more economic parlance, the market-clearing price.



Define "natural" rate of interest?

The natural rate of interest would be the interest rate people would demand for their capital to be used by someone else, without the direct interference of the central bank in either creating artifically low or high rates (typically low rates)

 

[phattonez]

It is based on whatever information is known or believed to be known at the time, plus the purchasers expectations of profitability, which is all encompassed in the purchasers internal rate of return, or hurdle rate, estimates. Inflation "that hasn't been realized yet" is so fuzzy as a concept as to be completely useless and nonsensical.

It's actually an important concept. Think back to 2007-2009 when the government increased the money supply greatly, yet we saw price levels remain relatively stable. Why was this? Prices should have fallen greatly in general once the economy started to go bad (because all of the value that we thought that we had in homes and other things was really just a charade). In 2006, the inflation had not yet been realized, in 2007 we were would have started to see a general fall in the price level. You can argue about whether or not that injection of money was good or not, but the point remains that prices would have fallen meaning that those capital investments would have failed. That's a tremendous reality, not a "fuzzy concept."

Fuzzy, fuzzy, fuzzy. There is no direct relationship between the fractional reserve banking system and a "natural" rate of interest (assuming one can actually define the "natural" rate of interest in a meaningful way).

Assume no central bank. Banks would only have so much to lend, and the interest rate would reflect savings and the amount that banks have already lent.

As for "government interference," by this do you refer to the actions of the central bank in executing monetary policy, or of the government in executing fiscal policy, or perhaps both? With either or both of these, you have a leg to stand on, otherwise...

Well mostly the central bank (though congress now has limited what interest rates can be on high interest loans). It can come from both, but I think historically the central bank is the bigger culprit.

 

[oldreliable67]

The natural rate of interest would be the interest rate people would demand for their capital to be used by someone else, without the direct interference of the central bank in either creating artifically low or high rates (typically low rates)

Sounds very much like whatever the market-clearing transaction prices might be at the moment.

I have a problem with the tendency of many to describe some economic phenomona as 'artificial.' Granted, it is mostly just me and it is perhaps a disctinction without a difference, or maybe it is even nit-picking, but...

Some rates are administered rates; fed funds probably being the best known example. Rates (or prices or quantities demanded or supplied) are never 'artificial' if transactions occur at those rates (or prices, etc.). 'Artificial' suggest something that is an imitation, not the real thing. In the 1980's, two year notes yielding 15% and thirty year bonds yielding 14% were quite real. Today, effective fed funds at 10 basis points is real: zillions trade daily. Yet in both instances, various observers characterize(d) them as 'artificial.'

Nit-picking, perhaps, but I just don't like the 'artificial' connotation.

 

[phattonez]

So instead of artificial, would you like me to say non-market based?