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Credit Expansion and Submarginal Investments

January 3, 2008

Tags Capital and Interest TheoryInterventionismMonetary Theory


Markets are ruthlessly efficient, meaning in large part that people will not undertake investment projects with risk characteristics that are not aligned with savers' preferences. All profitable opportunities will be exploited in equilibrium, and no potentially profitable projects will be left undone.
 

One of the unfortunate consequences of credit expansion is that many projects which were formerly passed over by investors will be undertaken because of the incorrect signal sent into capital markets by artificially reduced interest rates. These problems will be compounded by the fact that savers will pull real resources out of the capital market, meaning that previously profitable investment projects will now be unprofitable malinvestments.

This has two components. First, to borrow from F.A. Hayek, we have to consider what a "market working right" looks like before we consider a "market working wrong." In a market for investable resources that is "working right," equilibrium would be established at an interest rate where investment (the quantity of investable resources demanded) is equal to saving (the quantity of investable resources supplied). If interest rates are allowed to fluctuate and provide reliable signals in capital markets, the market process will eliminate unprofitable production plans and reward profitable production plans. At an interest rate of 5%, for example, all projects yielding a return of 4% per year will not be undertaken because the cost of capital would exceed the return on investment. All investment projects with yields greater than 5% will be undertaken. This is illustrated in the following diagram, where the market for investable resources clears at the market rate denoted below.[1]

Figure1

At this point one might object that lower interest rates would be good because it would encourage more investment. This is true, but only if that lower interest rate is consistent with savers' intertemporal consumption preferences. When we look at the results of a monetary injection into the market for investable resources that lowers the interest rate to one that is artificially low, we see that the quantity of investable resources demanded increases (to I1) while the quantity of investable resources supplied decreases (to S1).

Suppose the Federal Reserve intervenes and lowers the interest rate by increasing the money supply. The interest rate falls, and in the market for investable resources, this looks to both savers and investors as if intertemporal consumption preferences have changed. This is not the case, however. If their intertemporal consumption preferences haven't changed — in other words, if the supply curve for investable resources has not changed — savers will move backward along their saving curve in response to the lower interest rate — after all, if interest rates are now lower, the opportunity cost of current consumption is also lower. People will consume more and invest less, leading to an increase in current consumption and fewer available investable resources.

At the same time, however, firms will attempt to invest more as they see that interest rates are lower. This will send the incorrect signal that consumers prefer higher future consumption and lower current consumption; firms, therefore, will attempt to lengthen the period of production and, therefore, they will invest in longer-term projects that will ultimately be revealed as malinvestments once the Federal Reserve takes its foot off the monetary accelerator.

There are two key implications. First, an artificially low interest rate destroys crucial information about the intertemporal consumption preferences of savers. There is no way to know what the interest rate should be, and this increases uncertainty in financial markets. As the interest rate is supposedly the price that capitalizes all of the expected costs and benefits of a particular project, it will become difficult to distinguish profitable from unprofitable projects. To the extent that this can be done, investors will have to invest heavily in screening devices aimed at eliciting the information that would have been revealed in the free-market interest rate.

Second, the new projects that are undertaken will have risk characteristics that are not consistent with the intertemporal consumption preferences of the saving and consuming public. Projects that were unprofitable at a free-market interest rate of 5% will be unprofitable at a distorted-market interest rate of 4%, provided that the interest rate consistent with intertemporal consumption preferences is 5%. The misallocation of resources is compounded by the fact that savers have reduced the supply of real resources available for investment.

In total, incorrect interest rates create a tug-of-war between consumers, who now prefer present to future consumption, and investors, who are receiving the incorrect signal that consumers prefer future to present consumption. In the long run, this results in malinvestment as people attempt to undertake production plans that are inconsistent with the market interest rate; moreover, it reduces the net investment produced by the economy because people will only be able to invest the real resources available.

The current problems in the housing market suggest that we are reaping the rewards of easy credit. Increases in the money supply eased consumers' ability to borrow money and increased lenders' willingness to take on otherwise-questionable risks. Investments that would not have been made had the market reflected the correct interest rate will be made in an environment of incorrect prices in capital markets; all of the attendant distortions in the structure of relative prices will ensue, and the necessary correction may take some time to reveal itself. By this time, it will likely be too late, and the only politically feasible recourse may be a "bailout" the likes of which is being promoted in Washington, DC in the wake of the subprime mortgage crisis.

Before closing, a word must be said about the moral debate implicit in the housing market crisis. Tyler Cowen has written on his weblog that people love a good morality tale even where none exists, and thus the housing market debate is sometimes portrayed as a conflict between the hapless subprime borrowers and the unscrupulous predatory lenders. As Cowen correctly points out, this is not a moral issue as much as it is an issue of monetary policy; Cowen is not himself a believer in Austrian Business Cycle Theory, but he is correct in noting that the current problems plaguing housing markets are related to policy rather than moral failings.

There has no doubt been malfeasance on all sides of housing market transactions. But to focus on the actions of some unscrupulous lenders or some borrowers who intentionally overstated their income is to skip the larger issue in favor of relatively minor considerations. The systematic problem arises from the fact that monetary policy sends incorrect signals into capital markets, reducing lenders' ability to distinguish between good and bad loans; it also sends incorrect signals to potential borrowers about what they can and cannot afford. The subprime housing crisis appears to be a case in which the proverbial chickens are coming home to roost.

Note

[1] This analysis follows closely that offered by Roger Garrison in his book Time and Money: The Macroeconomics of Capital Structure. Excellent PowerPoint slide shows explaining Professor Garrison's interpretation of Austrian Business Cycle Theory and other materials are available at his homepage.


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