Friday, January 7, 2011

Interest Rates and Risk

Interest Rates and Risk
by Alex Merced

In plenty of articles I've written or videos I've created I've discussed how interest raes can cause mal-investment and alter the structure of the economy. The increasing of the money supply and lower of interest rates as described by Mises, Hayek, and Rothbard although how money supply increases occur and how does the mal-investment manifest itself can be different from econom to economy. In this article I want to discuss how central banks control over he money supply and involvement in overnight lending transforms into mal-investment.

What is Mal-Investment?

A mal-investment occurs when actors in the economys behavior is altered by distortion of economic signals such as prices, interest rates, and the visible supply and demand of goods. These signals may be distorted by a variety of methods, sometimes by private actors through corruption or fraud although private actors are limited in resources so their is an actual abosolute limit to their fraud and corruption on top of legal ramifications if caught. More important these signals can be distorted by government regulations, laws, and taxes imposed by this institution which has potentiall limitless resources and little fear of legal ramifications which magnifies it's ability to distort economic signals beyond any private actors.

What is the Role of Risk?

If your familiar with my opinion of economics, you'll be aware of how big a role I think risk plays in a sound economy being one of he most important if not most important signals an economy produces. People always complain of corporate and individual greed which is really just a function of an economic actors perceived risk of entering cerain actions. Government more than an other actor distorts the risk signal through guaranteed loans, insurance schemes like FDIC and Unemployent, and tax and monetary subsidies which distort risk signals which magnify what many may perceive as greed.

So what about interest rates?

Interest rates which are often seen as the cost of capital, or the cost to have someone defer consumption so you can consume now can also be seen as the cost of taking financial risk. For example, if you labor for a wage and take risk with those wages and those wages are losts you may have to borrow money with interest in order to buy food or make rent. This same phenomenon occurs with banks in which rates such as the discount rate and fed funds represent the cost of making riskier investments, so if these rates are low then the banks will be willing to make risker loans as the cost to borrow capital if the risks don't pay off is low. Does this mean inerest rates should always be high so economic actors don't take excessive risks? Not at all.

Taking risks can be very rewarding, although having some cushion to limit the effects of a risk taking is also important which is an importat function of savings. Savings serves as a safe landing pad for individuals and for the financial system as a hole so they can take larger risks to grow the economy, so when the savings landing pad is plentiful the economy and banks are signaled to take larger risks via lower interest rates. When the individuals havn't saved for a rainy day, the economy signals for less risk taking via higher rates.

Central Banks via open market operations will purchase government securities (treasury bonds) and increase the money supply. This increase in the supply which enter via bank reserves appears like savings, although individuals don't truly have rainy day fund but the banks are flush with cash which distorts interest rates and the risk signal it gives out. On top of it, if the central bank can keep rates such as the fed funds rate and the discount rate low, banks will feel the risks of taking risk with these artificial reserves to be low yet the economy hasn't ceated the savings landing pad for such risk taking which ends in the boom and bust cycle.

This one way the austrian business cycle can manifest itself, money supply can increase in particular industry via government guarantees for loans for a particular industry increasing money readil lendable to tha industry creating price bubbles. Local towns may grant tax subsidies for people film a movie in their town creating an influx of cash to temporarily enter the town having a similar effect of the local economy. Although at the end of the day this whole process is a function of Interest Rates and Risk.


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