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We Shoulda Seen it Coming!

Mises Daily: Thursday, February 17, 2005 by

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These days, there is an increasing awareness of how artificially lowered interest misleads whole legions of entrepreneurs—a core point in the Austrian business cycle. But, still, the question always nags at people who think they grasp the basic idea: why do businessmen continue to fall for this scam?

The gist of their query is this: surely, Scott McNealy or Andy Grove could afford to hire a guy who's read a little Mises and Hayek and who could therefore "foresee" that his bosses are about to play a starring role in the Austrians' "raft of entrepreneurial errors"?    

But how can they foresee their impending mistake, however well-versed in Rothbard and Roepke they are?

Let's step back and suppose you run a small, specialist manufacturing company in upstate NY and you find you are beginning to get a higher volume of orders.

Happy days! As you never cease to read in the papers, business is looking up, at last.

So, you do the maths and it all seems to check out. You decide to expand to fill these orders and, for a while--perhaps a considerable while – the choice seems to be borne out by experience; all seems to be going well.

Then--possibly months, maybe years, later--you suddenly find that your customer's customer's customer (much further down the cone of production and perhaps half way across the globe) cannot afford to pay for any more of the goods to which you help give rise (not at the initial asking price, at least) because the ongoing credit inflation has caused one of his other co-factors of production (labour, raw materials, components, energy, real estate) to be bid up beyond his means, possibly by the eager participants in a completely different industry.

Either that, or the price this customer-thrice-removed can charge for his output is not as high as the one upon which he had reckoned because all the extra money which has been created is still chasing the same old, unexpanded supply off the original menu of consumer goods and thus there is too little left over to buy his wares, as well, at the necessary asking price.

Lowered interest rates in a free market, remember, would have implied a greater propensity to save and thus a lessened appetite for some, or all, of these original menu items.

This, in turn, would have ensured that the signal of lower interest rates would have been in harmony with: (a) a lesser demand for the complementary goods and services needed to see one's own product profitably all the way down through the chain to the retail outlet (so one's implicit estimates of these co-factors’ prices and availability would have been less likely to turn out as a disastrous underestimate) ; and (b) that the end consumers, having tired a little of the same old bread and potatoes, would actually want to buy your fancy cooking, once it has been brought out of the kitchen.

But, alas, the artificially lowered rates mean there has been no extra saving (in fact, there will probably be less!).

This, in turn, means that the existing consumer goods are likely to be in dearth, not surfeit, as the higher incomes (there’s a monetary inflation underway, remember) make their way into the wallets of the shoppers.

It also means that the need to produce these sought-after items in the same, or possibly even greater, profusion means that there will be a battle--a bidding war--for the men and matériel needed to make them. The producers of new goods are in no way guaranteed to win this war – certainly not without incurring a series of highly Pyrrhic victories, as far as the profit & loss account is concerned!

On both scores, then, as the ripples from this are not only felt, but concentrated, back up the chain, our innocent NY factory owner is going to find he’s become the subject of a nasty cost-price squeeze and he may even end up paying the ultimate corporate penalty--bankruptcy.

But, now, to return to the initial question; just how did our NY entrepreneur go wrong? What avoidable--what foreseeable--error did he make?

Must he become a monetary economist before ever he presses a sheet of steel or solders a circuit board?

Should he be looking, not just at the industry trade journal, but also at the weekly/monthly money supply stats from all the major central banks around the world and must he decide not ever to increase output because he always seems to see that money and credit are expanding faster than savings?

Clearly, though "error" may have been avoided, there wouldn't have been much material progress over the past however many years, if this were the case.

Moreover, to assume otherwise--that our man can derive the correct lesson from this data, well enough ahead of time to make a difference--is to fall for the "fatal conceit" of being able to calculate the specific micro-impact of such macro shifts, in the same way that the central planners do when they occasion them!

As Hayek said, a businessman can never, in any case, know just where he is located in the structure of production--matters are simply too complicated. However obvious the path along his famous schematic right-triangle seems to be, on paper--in reality, it has the topology of a complex manifold, not a Euclidean solid!

Incidentally, the fact is that this puzzlement about why we all get suckered, time after time, is a common one. Might we, therefore conclude that much of the Austrian literature is either a little too inaccessible or, worse, a little too glib, on this score to impart the message properly?

In my own experience, a business school type--a fellow who had obviously become enthused by the Austrian approach, but who hadn’t quite put it all together--asked me, in all earnestness: if we know that interest rates have been artificially suppressed below the natural rate of interest, by how much should we increase the discount factors we use in our standard return-on-investment calculations in order to compensate for this?

If only life were that straightforward.

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Sean Corrigan is an investment strategist. See his Mises.org Articles Archive, or send him mail (corrigan@sagecapital.com). Comment on this article on the blog.