Interest Rates in Austrian Theory

What is the central claim of Austrian Business Cycle Theory? Prof. Tyler Cowen boils down the Austrians' boom-bust explanation: when the government manipulates the money supply, entrepreneurs get false ideas about the economy and make unsustainable decisions. When the central bank inflates the supply of money, the real interest rate falls because there is more money to be lent out. Since money is cheaper to borrow, entrepreneurs ramp up investment and take on riskier long-term projects—a boom often follows. But the man-handled market environment doesn't hold. False hopes lead to failures and an apparent boom, well, busts.

Tyler points to the housing bubble as a case study. Between 2001 and 2004, the Federal Reserve played fast and loose with credit. Booming borrowing to invest in housing inflated the housing bubble. But when house prices fell, these long-term investments proved to be unprofitable and brought on the bust.

How can we escape the cycle? Austrians propose that we steer clear of inflation—institute a gold standard or a monetary rule to avoid financial disaster. The rationale: a tighter money market means a more stable monetary supply that will enable entrepreneurs to keep expectations and investments in check. For many Austrians, kicking inflation takes on additional urgency based on their claim that once inflationary effects occur, the only corrective is to let investments fail and re-allocate remaining resources.

The Ideas in Action:

Turning to the Great Depression and our current financial crisis, Cowen explains that Austrians and Keynesians explain the downturns quite differently. For Keynesians and monetarists, both big busts could have been avoided if there was an increase in aggregate demand.
Austrians, on the other hand, blame the effects of loose monetary policy misleading entrepreneurs. Which theory does historical evidence support? One point in the Austrian corner: many credit bubbles, the Great Depression and recent recession included, correspond with periods of loose monetary policy.

But the Austrian angle has its shortcomings. First, put yourself into the mind of a bright entrepreneur for a moment; if you can reliably predict that loose money leads to riskier long term investments, wouldn't you exercise caution while taking on new projects in easy-money times? Second, we have to look at more than two historical case studies; in a broader field of view, we can find many economic downturns that have been caused by monetary contractions rather than expansions.

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[paulvahur]

If interest rate is not that important factor, why is there a government agency who sets the interest rate?

[scrappmutt]

I think the description is better than the video

[UnknownXV]

The problem with humanity is we are too impatient. We should have more discipline to simply wait and get what we want later when we really can afford it.

[FyterianTV]

LoL i love how a non-Austrian, and someone who I would guess hasn't actually read Human Action or Man, Economy, & State, is giving a video presentation on what the interest rate is in the Austrian theory :)))

[Castorios]

when people talk about 'a loss in confidence would cause interest to go up' what does that mean ?

[wiscatbijles]

In my view interest rates are secondary. They're just a secondary effect of buying in selling in a free market. In such a market interest rates only indicate risk.

[anacap]

Good point. I didn't consider the opportunity costs of said project.

[UmTheMuse]

Maybe I'm biased, but from my point of view, I think that both the monetarist and Austrian views can be reconciled fairly easily.
Interest rates govern the lenders' willingness to lend. The borrower is also influenced, but mostly indirectly. The borrower is looking at many more factors.
This matters because real estate, especially commercial real estate, is sticky in both prices and quantity of goods sold.

[noway]

Even when you finance a project entirely out of your own savings, the interest rate matters because you still have the option of borrowing and investing your cash somewhere else.

[commiekiller]

A loss of confidence means that the lender is questioning whether the borrower will be able to repay. If a lender believes that the borrower has a higher chance of defaulting he will increase interest rates to mitigate this risk.

With governments its basically the same thing but a little different. Gov will raise rates on bonds if demand is not sufficient enough to meet funding requirements. Demand goes down when creditors believe Gov will have a hard time paying back.

[Castorios]

so the interest rates are dictated by bond buyers (the market), not the FED ?

[JonathanSchattke]

The raw interest rate is less important for decision making than the real interest rate, especially for larger concerns.
Another factor is the savings to loan spread across the real interest rate; if a home loan costs 2% real interest and savings are at -2% real interest, it is a lot different than a spread of 5% cost and 1% return.

[Castorios]

I still don't know why I keep hearing that interest rates are controlled by the FED in some videos, and in other videos they say that interest rates are determined by the markets...

Please can someone tell me why I am confused ??

[josvazg]

Prices are very important signals in an economy.

And Interest Rates are the most important prices of all, cause they distort all the other goods and service prices.

[nbonasoro]

interest rates still matter in this situation because they help determine whether or not that funding is best used in the project or in investment or being placed in a cd etc

[josvazg]

But if you run revenue models of about the 5-10% benefit returns and interest rates are, for instance at 7%..

Why are are you going to waste all the work and effort to start/run a company to win a 6% when simply lending the money and waiting the same time will give you 1% MORE benefits?

[Dorky]

Interest rate is the cost of financing, and is very important in compensating the financier from higher inflation rate.

[anacap]

I think you're reversing cause with effect. Natural interest rates is simply a reflection of humanity's choice. Natural interest rates is simply a reflection on humanity's preference to consume over saving. The impatience is the result of the conditioning of continuously artificially low interest rates.

[Castorios]

thanks for the clarification, so if the FED does buy any major bond dump in the future, I guess it can keep rates low for a long time if it wishes.
But this would be bad no ?, if bonds are bought/traded with/for USD, wouldn't that cause huge spikes in the money supply ?

[anacap]

The only time interest rates don't matter is when a project is fully financed. Otherwise you have to borrow money. Other schools of thought tend to dissociate the meaning of interest rates because they take for granted what money is. Interest rates is the price of money. And money is a medium of exchange for goods and services. Therefore interest rates represent the value society places on consuming those goods and services now rather than later.