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So when you inflate the monetary supply in order to keep interest rates low, why does the bubble inevitably burst? Because:
Economic Recessions, Banking Reform, and the Future of Capitalism - Jesus Huerta de Soto - Mises Daily
But before that, and in honor of Hayek, we must remember the fundamental rudiments of capital theory, which up to the present time and — at least since the Keynesian revolution — have been almost entirely absent from the syllabus of most university courses on economic theory.
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In order to understand what will follow, we must visualize the real productive structure of the market as a temporal process composed of many very complex temporal stages in which most labor, capital goods and productive resources are not devoted to producing consumer goods maturing this year, but consumer goods and services that will mature, and eventually be demanded by consumers, two, three, four, or even many more years from now. For instance, a period of several years elapses between the time engineers begin to imagine and design a new car, and the time the iron ore has already been mined and converted into steel, the different parts of the car have been produced, everything has been assembled in the auto factory, and the new cars are distributed, marketed, and sold.
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This period comprises a very complex set of successive temporal productive stages. So, what happens if the subjective time preference of economic agents suddenly decreases and as a result the current consumption of this year decreases, for example, by 10 percent?
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The first effect is the new disparity in profits between the different productive stages: immediate sales in current consumer-goods industries will fall and profits will decrease and stagnate compared with the profits in other sectors further away in time from current consumption.
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The second effect of the new increase in savings is the decrease in the interest rate and the way it influences the market price of capital goods situated further away in time from consumption: as the interest rate is used to discount the present value of the expected future returns of each capital good, a decrease in the interest rate increases the market price of capital goods, and this increase in price is greater the longer the capital good takes to reach maturity as a consumer good. This significant increase in the market prices of capital goods compared with the relatively lower prices of the less demanded consumer goods (due to the increase in savings) is a second very powerful microeconomic effect that signals all around the market that entrepreneurs must redirect their efforts and invest less in consumer-goods industries and more in capital-goods industries further from consumption.
Finally, and third, we should mention what Hayek called the "Ricardo effect" (Hayek 1948, pp. 220–254; 1978, pp. 165–178), which refers to the impact on real wages of any increase in savings: whenever savings increase, sales and market prices of immediate consumer goods relatively stagnate or even decrease. If factor incomes remain the same, this means higher real wages, and the corresponding reaction of entrepreneurs, who will try in the margin to substitute the now relatively cheaper capital goods for labor.
What the Ricardo effect explains is that it is perfectly possible to earn profits even when sales (of consumer goods) go down — if costs decrease even more via the replacement of labor, which has become more expensive, with machines and computers, for instance. Who produces these machines, computers, and capital goods that are newly demanded? Precisely the workers who have been dismissed by the stagnating consumer-goods industries and who have relocated to the more distant capital-goods industries, where there is new demand for them to produce the newly demanded capital goods.
This third effect, the Ricardo effect, along with the other two mentioned above, promotes a longer productive process with more stages, which are further away from current consumption. And this new, more capital-intensive productive structure is fully sustainable, since it is fully backed by prior, genuine, real savings. Furthermore, it can also significantly increase, in the future, the final production of consumer goods and the real income of all economic agents. These three combined effects all work in the same direction; they are the most elementary teachings of capital theory; and they explain the secular tendency of the unhampered free market to correctly invest new savings and constantly promote capital accumulation and the corresponding sustainable increase in economic welfare and development.
So when you inflate the monetary supply in order to keep interest rates low, why does the bubble inevitably burst? Because:
- The price of the means of production must necessarily increase. In the earlier scenario, capital went from consumer goods industries to capital goods industries (think of workers mostly). Capital consumption in this scenario increases, but nothing has been done to increase the productive capacity of capital industries.
- The price of consumer goods must increase. Eventually the inflation trickles down and workers get a hold of that extra money when the price of capital goods increases. So workers have more money to spend. This means that the price of consumer goods is going to go up.
- Consumer goods markets will see greater profits than capital goods markets, because the costs for capital goods industries begin to rise. As de Soto says, "the profits of capital-goods industries . . . begin to stagnate when their costs rise more rapidly than their turnover."
- Falling real wages, and so lower demand for capital goods.
- An increase in the rate of interest eventually. Entrepreneurs, to finish their projects, will try to get financing, inducing a lot of competition in the loan market which will raise interest rates. Also higher risk premiums will be demanded.
- Capital goods industries will stop operating because of the losses that they are incurring. This will result in a liquidation of bad investments and a correction.
Economic Recessions, Banking Reform, and the Future of Capitalism - Jesus Huerta de Soto - Mises Daily