What exactly are interest rates? How are they determined and what is their effect upon the economy? In short, interest rates are the price of money. The Austrian school of economics has a simple explanation that seeks to answer these questions.
The Austrian School Explanation
The Austrians explain that there are two basic types of economic ventures which co-exist at any one time. There is low-order production and higher-order production. Low-order production involves the manufacture of short-term ready supply items. Items that the public demand now. For instance, peanut butter, bread, milk and the like. These items are needed immediately and consumers are ready to purchase now. High-order production involves long-term projects that seek to produce goods for sale at a later time. Most building projects, farm equipment, labor-saving machinery and like tools would fall into this category.
Now, all production requires capital. Capital could be machinery or it could be laborers or cash. In the case of cash, most high-order production relies on loans and the interest rates for loans will tend to dictate when such ventures will be initiated. In a free market, interest rates fall when consumers choose to save rather than spend. This is so because in the aggregate the availability or supply of cash is increased and as an incentive to move that cash out in the form of loans to producers the interest rate drops.
The higher-order production start-ups are signalled by the lower interest rates. The assumption is, consumer spending is decreasing. The savings rate is increasing. Labor is being released from consumer goods production and servicing. There is a whole chain of events occurring which serves to release resources from low-order production.
Unfortunately, in a manged economy interest rates may be artificially set. An artificial lower interest rate sets a signal, and inducement for higher-order production. In this circumstance, the projects get started but the necessary resources to complete the projects are not released by the low-order production sector of the economy. What follows is a fantastic boom in which labor is in short supply. Both high-order and low-order production is occurring and the timing is not coordinated by the market. The longer it takes the high-order producer to recognize the problem the bigger the boom and the more costly it will be when the projects fail. This is why most economic Booms are followed by corresponding busts and the size of the boom is indicative of the size of the impending bust.
Occasionally, in a manged economy, an unnatural boom or bubble is created which when it bursts threatens to cause a bust or recession. Recession avoidance can lead to an artificial redirection of resources to another economic sector. This may send a signal that the boom was natural and that no bust will follow but in many cases it is simply a temporary delay in the upcoming correction. In some instances this delay allows an additional bubble to be inflated. In due time, the corrections will come.
Implications for Today
Currently, we face the results of the dot com bubble whose correction was diverted by the housing bubble which in turn was diverted by the bailout bubble. The bailout bubble is still inflating. Our economy is clearly ill, however, the corrections needed have been delayed. We should have had a serious correction following the dot com bubble. Instead we had a small correction followed by a real-estate bubble. The real-estate bubble should have caused an even greater recession but government bailouts have delayed the correction. Now we face a bailout bubble. This bubble will have a direct impact on the purchasing power of the dollar and lead to a dollar crises if it continues. In short, we are headed for a long drawn out depression because the economy is being artificially managed to avoid the pain of correction. Correction is needed simply because interest rates were artificially kept low for over a decade in an effort to fuel economic activity. Central planning is no substitute for the free market. These low-interest rates are now an obsticle for savings. Savings is desperately need so that the capital for higher-order production can be naturally created and the market timing restored.
The Importance of High-Order Production
High-order production leads to wealth generation and increased standards of living. This is so, because the high-order production is what enables new technology, labor-saving production tools etc. When we make stuff, or we reduce the cost of making stuff the goods flood the market. Prices drop and even if income levels remain stable the prices of goods reduce. We have all seen this principle at work in the electronics market. The silicon board has reduced the size and cost of a whole host of high-tech toys and tools. The silicon board was the result of high-order production. It clearly changed the lives of everyone and added to the wealth of the nation. When this productivity is artificially frustrated the cost to the economy as a whole can be devastating.