The interest rate serves to coordinate intertemporal production- that is, whether or not we produce consumer goods or investment goods. This rate is set, in the free market, by the coordination of the supply of loanable funds- i.e., savings- with demand for loans. When savings are scarce and the rate is correspondingly high, more consumer goods are produced relative to investment goods and the economy grows slowly. When savings are more abundant, loans are easier to come by and larger investments in capital goods are made, spurring faster growth in the economy's productive capacity. This cycle serves, in the Austrian model, to smooth out business cycles. When times are hard, people consume less and save more (as a hedge against uncertainty), pushing the interest rate down and spurring more investment, which in turn spurs economic growth, which then makes everyone feel better and start consuming more, paying off the investors and returning growth to a more sedate pace. When times are great, people save less, slowing growth and also raising the rate of interest. Responding to the higher interest rate, people shift from consumption to savings, spurring more investment and faster growth. Thus the interest rate serves to coordinate future preferences with present ones and all is right with the Austrian world, more or less.
Until the central bank enters the picture. By pushing interest rates artificially low, the central bank spurs investment and growth, but consumers don't want these investments or this growth. Malinvestments accumulate while consumption continues at its previous rate until these malinvestments collapse, dragging the economy down with it as fear and uncertainty spread. The best policy, the Austrians argue, is to let the malinvestments completely wash out of the system and allow the market for loanable funds to do its job, smoothing out these cycles.
So far, so good.
Dr. Garrison's monograph and PowerPoints demonstrate all this in a series of wonderful graphs. And it is these graphs that highlight my central problem with ABCT: where do all these investments come from?
But remember? A production possibilities frontier represents the limit of what an economy can produce. By definition, the economy cannot move beyond the frontier. Now, Dr. Garrison obviously knows this, and I read somewhere (I cannot remember where) that his PPFs are sustainable PPFs rather than absolute PPFs- in other words, they represent the production possibilities available if all the available resources whose employment is economical are in use. The implication is that the central bank inspired boom draws uneconomical resources into use, resources the market would leave untapped, saved for future use. This qualification, incidentally, answers Paul Krugman's claim that the Austrian model indicates that consumption would fall in a boom and rise in a bust- Austrian PPFs aren't the PPFs he's familiar with.
But what are these resources? One of the things I've gained from studying the Austrian school is a determination to examine the economy in terms of real things, not aggregates and dollar signs. So what are these newly employed resources? Assuming that pre-central bank the economy was at point M, with all economical resources in use, gives us one possible answer: labor with a low marginal productivity (specifically, productivity below the interest that could be earned by their employer if he simply saved their wages rather than hiring them) and natural resources that meet the same standard. (All of this is assuming that we are starting de novo rather than after a previous Austrian-style boom and bust, and that therefore there are no factories sitting idle and so forth).
Some aspects of our recent boom and bust match up with this pattern. Housing is built on land, which could otherwise sit empty without incurring any maintenance costs, by (relatively) low-skilled laborers. When the Fed pumped money into the economy, it flowed into housing, following channels carved by government policy, drawing previously undeveloped land into the economy and employing less productive workers. But every boom and bust doesn't fit this pattern. The dot-com boom, for instance, caught up a lot of highly productive workers and diverted a lot of existing capital (servers, etc.) to stupidity like Pets.com.
What's worse for the Austrian model is the question of all that labor. Austrians and free marketeers generally argue against the existence of long-term, nonstructural unemployment in the absence of government incentives to sit on your butt (welfare, minimum wage laws, unemployment benefits, et al.). So let's posit full employment in a totally free market and examine Dr. Garrison's model. How does the investment sector move to point I? Where do the workers come from? If everyone who wants a job has one (more specifically, if everyone who can be gainfully employed is), who are these investors hiring to carry out their malinvestments? Small children and retirees? In real life terms, where did all these construction workers come from for the housing boom? They certainly weren't repurposed web designers and computer engineers, and the time scale we are discussing is much too short to account for such a massive derangement of the labor market as to produce a massive surplus of electricians, roofers, carpenters, etc. Construction might not be rocket science, but it's more complex than fast food, and requires some investment in skills.
There is one source for these workers, though. See point K? Keynes (cue the booing from the Austrian crowd) argued that full employment is in fact a special case of equilibrium, and that equilibriums with suboptimal employment of resources were possible. Specifically, Keynes argued that the economy could settle at a point inside its PPF, with the result of involuntary unemployment. People who could be gainfully employed would not be, and the economy would not grow as fast as it could, reducing happiness all around and causing a lot of misery for the involuntarily unemployed.
Some might say, oh well. Those who cannot find work are unproductive, and should have made better choices and acquired more marketable skills. But unemployment causes real human misery that we cannot simply ignore. The Keynesian answer is that the government should push the economy to higher PPFs by reducing the interest rate, thus making less productive workers more employable. Modern Keynesians, like the aforementioned Dr. Krugman, recognize the incomparable coordination abilities of a free market and advocate doing this through monetary policy, in effect pumping money into the economy and letting the market determine its use- the exact thing the Austrians say causes busts- unless the economy is in the dreaded liquidity trap, which is essentially when interest rates cannot be pushed lower. Then, the Keynesians argue the government should spend the money directly.
But I don't think the Austrian argument that artificially cheap money spurs malinvestment and ultimately harms the economy can be ignored. Some- Bryan Caplan springs to mind- have questioned why these investments should be necessarily bad. I think the answer lies in marginal cost. A hypothetical investor rates his investment opportunities by expected return and picks the one that gives the best return. Once he has as much money as he can in that one (or as much as he is willing to risk), he moves to the next, and so on. Artificially lowered interest rates reduce the cost of making these investments, meaning that investments with a higher perceived level of risk become more appealing, as the cost of investing in them is lower. The investor starts moving down his preference scale, putting cheap money into (perceived) riskier and riskier investments. Now perception and reality aren't the same, but I think that given a large enough population of investors, the odds of these estimates of risk being right increases- in much simpler terms, if you throw more darts with less care (because you have a lot of darts), more darts will hit the wall. In an individual case, perhaps the first ten darts (representing the first ten investments that would have been made in the absence of artificially cheap money) would miss while the eleventh, given to the investor by the central bank, is a bull's-eye, but over the whole investor population, more careless throws (perceived riskier investments) miss more often.
And that is pretty much where I am at in my economic thought (such as it is) right now. I largely agree with the Austrian argument that artificially cheap money causes malinvestments and busts, but I also think the central Keynesian insight that suboptimal equilibriums are possible (even in an ideal system with no government policies promoting unemployment) is valid. So what's the answer? How do I square this circle, and what policies do I advocate? I don't really know. I am open to suggestions.
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