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.

Elaborating on the Austrian Time Preference Theory

Elaborating on the Austrian Time Preference Theory
by Alex Merced

I write this article after listening to Robert Murphys lecture Capital and Interest from Mises U 2010

While Listening to this having heard explanations of Time Preference theory plenty of times, I started having flash backs to an Austrian Scholars Conference lecture where Robert Murphey was actually giving a critic of the ATPT based on his dissertation, basically challenging the idea that a future good is always less valued than a present good. This made me start to think, I do understand ATPT, but I'm not sure if it fully explains why this preference exists fully other than a sort of hedonistic view of human nature to want to satisfy all it's wants now. Then again Patience is a virtue, and one can look at virtues as efforts to fight human nature.

First off let's recap the ATPT for those of you unfamilar...


Austrian Time Preference Theory

The Bottom Line: Present Goods are always more valuable then Future Goods

Example: Pre-Sale Tickets (future good) are cheaper than tickets at the door (present good)

This is an important theory for explaining the Austrians view on Capital and the Interest from Capital. For example I have a $100,000 and I have these two choices which would I make.

Buy $100,000 of Bonds and invest them in Bonds that yield 5%

or

Buy a $100,000 of fishing supplies expecting to catch enough fish to make $110,000 (10% yield)

So you see here the capital I have I'll put towards the fish equipment cause In the end I'll have a greater yield from my investments, this is how capital naturally gravitates towards it's most productive purpose. If my calculation was correct I can now buy another $100,000 of fishing equipment and next year catch enough fish to make $220,000. As you can see the more I go through this process the more capital I accumulate and the better my life gets even though no new science or technology has been developed, cause I've accumulated capital and can continue to re-invest that capital for interest.

This is what seperates developed countries from developing countries cause they may only be able to afford $20,000 of fishing equipment so a year later they'd only have $22,000 so it'll take some time and re-investment before the capital accumulation brings them to the developed level.

So where time preference theory comes into play is in the issue of why would someone pay me $110,000 for the fish if they can instead get the same fish by buying the Fishing Supplies for $100,000 and save themselves the $10,000. The reason is cause they have a time preference, they don't want to have to wait for a year of fishing to save $10,000 so they rather pay the extra $10,000 to have the fish now. So as we stated, the current good, these fish I've already fished is worth more than the future good, the fish they'd fish if they made the same capital investment.

Ok, so that should sum it up, so now for my addition...


Is it a "Time" Preference or a "Tangibility" Preference

I think the time preference exists not cause there is a time bias, but because there is a tangibility bias. A future good isn't as tangible as a current good so provokes less of a reaction. This Tangibility preference can not only be applied to intemporal scenarios but also other scenarios of differeing subjective values.

Example 1:

"The Stimulus Bill has saved the Jobs of Teachers and Public Sector Workers"

or

"If the Government had not gotten involved new jobs would've been created from capital reformation"

You ask the typical person which statement seems more plausible, they'd more than likely say the bizzarre keyensian statement I put up first. Why, it's more tangible to them cause they see the jobs that would've been lost, but they can't see the jobs that were prevented from being created. Now of course an Austrian is trained to understand opportunity cost so the increased tangibility from that understanding may have them choose the second statement.

Example 2

"Spend 10% of Income on Your Loved Ones"

or

"Have 10% of your income taxed which hypotheically benefit your loved once objectively just as much"

Which one you'd think a person would subjectvely value more, the first statement cause the results of this same expenditure is tangible, this would probably be true if the tax money got spent in the same way at the same time cause of it's tangibility. Although a left wing Keynesian might actually value the second statement cause they've been trained to value the benefit to society of impersonal expeditures like in the second statement so them it'd be more tangible.

So in conclusion, I feel time preference is a preference that exists but because of the tangibility of intemporal value. I would expect that a Austrian who is trained to think intertemporally would prefer future goods on occasion, cause it's more tangible. For example we prefer the future value of recession that the current good of stimulus spending. While it's a bit more complicated than simply jobs now versus jobs later a lot of Austrian theory actually emphasizes long term benefits over short term.


If you agree, we can still call this the ATPT, it'd just now stand for the Austrian Tangibility Preference Theory

US Economic History from 1913 to Today in 10 Minutes