Understanding the Economic Impact of Artificial Interest Rate Drops
How Artificial Interest Rate Drops Impact the Economy
The Structure of the Economy
Capital goods consist of labor and materials, while consumer goods are produced using intermediate goods. It’s crucial to distinguish between net income (what we consume) and gross income (the total value of goods and services produced). A healthy economy requires sufficient savings to support ongoing investment in capital goods and factors of production.
The volume of savings is more critical than consumer spending. Wealthier societies tend to be more capital-saving. GDP, while called “gross,” represents the monetary value of final goods and services produced within a country over a specific period (typically a year). Consumption generally accounts for around 66% of GDP, while investment makes up the remaining 33%.
The Impact of Credit Expansion Without Increased Savings
Saving represents a period of deferred consumption. Capitalists can increase savings by reinvesting profits into their businesses (e.g., machinery, R&D). Workers and landowners can also contribute by reducing consumption and lending their savings in credit markets.
When credit expands without a corresponding increase in savings, several effects occur:
- Reduced Business Margins: Initially, profit margins in early stages of production may shrink or even disappear.
- Shift in Investment: Investment shifts away from consumer goods towards capital goods in later stages of production.
- Lengthening of the Production Structure: The production process becomes more complex and time-consuming, leading to increased productivity.
- Widening of Production Stages: More capital goods are employed in later stages, involving a greater number of companies and machines.
- Falling Interest Rates: As time preference changes, interest rates decline, leading to narrower profit margins and potentially higher wages.
This shift in investment is driven by the changing present values of future income streams. Lower interest rates make long-term investments more attractive, leading to increased demand for capital goods in later stages of production.
The Ricardo Effect
The Ricardo Effect describes the tendency of employers to substitute labor with machinery when wages rise and vice versa. In this scenario, nominal wages may increase slightly, but real wages (purchasing power) rise due to falling prices. This makes labor relatively more expensive compared to capital, particularly in stages closer to consumption, encouraging investment in more remote stages.
The Paradox of Savings
The paradox of savings argues that while individual saving is beneficial, if everyone saves, aggregate demand falls, potentially harming the economy. However, this is a misconception. Increased saving leads to a shift in capital towards later stages of production, ultimately resulting in lower prices and increased consumption possibilities for everyone.
Credit Expansion and the Boom-Bust Cycle
Expanding credit without increased savings can lead to an economic boom characterized by increased investment in all stages of production. However, this boom is unsustainable and ultimately leads to a crisis.
The Crisis
The crisis is triggered by several factors:
- Rising Wages and Input Costs: Competition for labor and resources in later stages of production drives up wages and input costs.
- Rising Consumer Goods Prices: Despite stable consumption, the production of consumer goods slows down, leading to higher prices.
- Artificial Profits: Profits in later stages may be artificially inflated due to insufficient depreciation and underestimation of default risks.
As these factors converge, businesses in later stages begin to experience lower-than-expected profits. This triggers a reversal of the boom, leading to disinvestment, liquidation of assets, and ultimately, a recession.
Recovery
Recovery requires a restructuring of the productive apparatus, including:
- Liquidation of Excess Capital: Excess capital goods in later stages must be sold off, often at significant losses.
- Redeployment of Factors of Production: Labor and other resources must be reallocated to more sustainable sectors of the economy.
- Increased Savings: Genuine savings are necessary to support sustainable investment and long-term economic growth.
Conclusion
Artificially lowering interest rates through credit expansion without increased savings creates an unsustainable boom that ultimately leads to an economic crisis. Sustainable economic growth requires genuine savings, a balanced production structure, and a well-functioning credit market.