What would happen then, if interest rates did not represent the actual amount of savings available for borrowers? If this were the case, then in a situation where interest rates are low, borrowers will seek out more loans than the actual stock of real savings would otherwise sustain. This, in turn, would lead to a situation where firm and general investment is being fed incorrect information from the relevant price signals. What happens next is commonly referred to by Austrians as malinvestment.
Prolonged malinvestment in a given economy over time will lead to a bubble economy, where the production of goods, services, and expansion of projects and capital by firms accelerates. However, due to the unsustainable nature of this bubble, stemming from a lack of real savings and a disconnect between the relevant factors of the economy and the interest rates for the loans borrowers are taking out, the good times inevitably draw to a close, and a subsequent bust brings the economy crashing down back to more appropriate levels. Given enough events, this phenomenon becomes known as the business cycle.
The Austrian analysis of business cycles identifies a systemic cause for the disequilibrium that throws an economy out of sync, unlike Keynes’ seeming postulation that investors are inherently irrational. In this framework, investors can act completely rationally by following the relevant price signals (in this case, interest rates), and still commit malinvestment. The key issue for the Austrian economist is the faulty price signal. It would be prudent, therefore, to identify what exactly causes interest rates to decouple from the actual information of the economy.
In order for interest rates to be manipulated in the way previously described, there has to be a tampering of the money supply. As we know, money supply increases lead to decreases in the nominal interest rate, while decreases in the money supply lead to increases in the nominal interest rate. Therefore, to know the cause of the business cycle, we have to identify processes that artificially increase the money supply, since this would mean that there is more money in the economy (and savings) than there would otherwise be.
Luckily, it is not very hard to find out what causes these artificial money increases. All it takes is a thorough look at banking practices to identify pertinent issues. The system of fractional reserve banking is defined as a banking system where the loans set out on the market of a particular bank exceed the reserves of hard cash that the bank holds. Therefore, if all (or a relevant amount of) the customers of a fractionally reserving bank were to ask for a withdrawal of their deposits, they would be left in the dust, since there would not be enough reserves to cover the withdrawal demands.
If banks are loaning out more money than what they have in reserves, it is not hard to see the effect that this will have on the supply of money, and subsequently, the interest rate. The lent money will be partially placed back in a bank’s reserves, which will then use those reserves to loan out more money, etc. This phenomenon is known as the money multiplier effect. One of the unintended consequences, however, is that the supply of money increases and the interest rates begin to reflect more than just the amount of real savings consumers have set aside for investment.
Say’s law, as referred to back in part 1 of this series, becomes all the more important, since an incorrect understanding of how the economy works can lead to incorrect prescriptions. Keynes believed that spending drives the economy, and in order to deal with the bust section of the business cycle, it is necessary to increase spending, by any means necessary. One of the ways spending can be increased is through fiscal policy, or in layman terms, printing more money.
As we know from before, it is precisely the artificial increase in the money supply that causes the business cycle, and therefore the plague cannot be the cure. With this being the case, it becomes clear that it is not mere spending that drives the economy, but rather production as Say postulated so many years ago. Until more people can wake up to this stark reality, our politicians and economists will continue to fight fire with fire, and the world will grow increasingly hostile to the concept of markets, falsely equating state intervention and the failures that follow from it, with freedom.