My Take on the ABCT: Objections Considered

Referring to the ideas presented in My Take on the ABCT (Simple Version) and My Take on the ABCT (Complex Version), a Mises Forum member wrote...

Wrong. What you're describing is a credit cycle. It implies that all the government needs to do is to keep interest rates low. During a boom/bust cycle, the fundamental changes are not in interest rates, but in the productive structure of the economy.

An increase in the money supply does not cause a crisis. If the money supply increased equally across all sectors of the economy, there would not be any malinvestment, only price inflation.

What does cause a crisis is a decrease of the interest rate without an increase in the supply of savings. This decrease in the interest rate has to be funded by having new credit created. This funds special high cost projects. It funds the purchase of machinery, land, factories, houses, apartment buildings, vehicles, and other capital and durable consumer goods. In Austrian terms, durable consumer goods and capital goods are called "higher order goods." This increase in the purchase of higher order goods stimulates the production of said goods. Companies which produce these goods experience higher profits, attract more investors, hire more workers, and raise wages. In essence, they buy up resources which would be used by lower order industries. However, since people's time preferences have not changed or have changed very little, they will consume more than they did before, thereby reallocating their money to lower order industries. These lower order industries (e.g. retail) then experience higher profits and are able to attract more investors, pay higher wages, hire more workers, and bid away resources from higher order industries. This causes higher order industries to be less and less profitable, forcing them to lower wages and/or lay off workers while returning less profits to their investors. Lower profits means less consumption, which then means lower profits for lower order industries which produce consumption (lower order) goods. These lower order industries are then forced to continue the cycle by lowering wages, laying off workers, and returning less profits to their investors. Unemployment increases and consumption falls while the malinvestments made during the boom are liquidated and credit contracts.

My Reply..

Regarding lower interest rates inducing the purchase of more truly higher order goods, that is exactly what I meant when I wrote,

3. Interest Rate Decrease, which causes a general

4. (a) Longer Term Investment Increase, and, aided by 2(b), a (b) Sharp Demand for Particular Assets Increase, the first of which causes a general

"Longer Term Investment" implies a lengthening of the chain of production; that is, adding more links (more higher order goods).  I didn't want to write that out, because I thought it would be obvious, and I wanted to keep it from getting any more complicated than it already was.

 

However, since people's time preferences have not changed or have changed very little, they will consume more than they did before, thereby reallocating their money to lower order industries. These lower order industries (e.g. retail) then experience higher profits and are able to attract more investors, pay higher wages, hire more workers, and bid away resources from higher order industries. This causes higher order industries to be less and less profitable, forcing them to lower wages and/or lay off workers while returning less profits to their investors.

 

It seems to me that the increase in spending of wage earners would play itself out mostly in price inflation, not in a dramatic shift in the structure of production.  Industries that make goods of the first order (retail) get higher profits.  They use those higher profits to bid up prices of goods of the second order, giving the industries that produce them higher profits.  Those industries in turn use their higher profits to bid up prices of goods of the third order and so on.

Let's say the increased spending of wage-earners gives Wal-Mart higher profits, but not the company that makes the wheels for the toy cars that it sells.  Wal-Mart and the Toy Wheel Company both go onto the brick market.  Wal-Mart's enhanced purchasing power bids up the price of the bricks.  The Toy Wheel Company must pay more for the bricks than it otherwise would have, so it does indeed take a hit.  But Wal-Mart takes hits too.  First of all, it's not the only retailer that has more purchasing power.  So Rite-Aid and Target also bid for the bricks, and the price of bricks rises for retailers too.  Of course, considering only this much, they are still much better off than the higher order producers, because the latter don't have the higher profits of the former... YET.  I say yet, because Target is not only in the market for bricks with its enhanced purchasing power.  It's also in the market for toy cars, as are Toys R Us, Costco, Walgreens, and lots of other retailers who've experienced the same boom as Wal-Mart.  So the prices of toy cars get bid up.  The toy car companies, flush with profits, then bid up prices on toy wheels.  And the poor old Toy Wheel Company eventually gets its higher profits too.  Of course they get it later, which means the process does benefit the lower order producers more.  But it doesn't seem to be enough of a shift in fortunes to completely explain such a calamitous bust.

Do you think that people, after getting raises, tend to borrow more in absolute terms?  For example let's say a spendthrift who always borrows up to the hilt gets a raise.  Wouldn't he then borrow up to his new, higher hilt?  If so, then wouldn't this create an upward pressure on interest rates?  And if so, wouldn't an increased interest rate make production processes which were just barely viable under a previous lower interest rate no longer viable?

I know a sustainable economy is at bottom about there being enough savings to see through the production processes.  I just think that the way that fact expresses itself is through the interest rate.  If society's average time preference was actually higher, and therefore the wage earners, after getting a raise didn't borrow more, then the interest rate would stay low, justified by the increased savings, and the longer-term investment projects would see fruition.  But in the case of artificial credit expansion inducing the interest rate lower, the time preference is most likely not higher.  And this will express itself when the interest rates go back up to normal.

Furthermore, it's hard to imagine the housing bubble fitting the picture of producers investing heavily in higher order goods, only to have factors of production bid away from them later.  This would mean home owners invested too heavily in the capital good of "house-which-will-mature-into-a-house-in-the-future".  Were the factors of production of this process bid away from homeowners, thereby reducing their profits and making the production process non-viable?    But once the house is built, the only complementary factors of production necessary for turning the house into a future-house are time and maintenance expenses.  Obviously time can't be "bid away", so did housing prices collapse because the homeowners suddenly couldn't afford the basic upkeep of their homes anymore (minimal roofing requirements, etc)?  That seems extremely unlikely.