Central Banks, Interest Rate and the Business Cycle
How to Eliminate the Business CycleBy: Jeff McLaren
Major Topic: Economics
Minor Topic: Politics
ABSTRACT:
Minor economic fluctuation will easily be turned into a recession by expansionary monetary policy in which the central bank's interest rate drops below the natural rate of interest. Such a policy will cause many business to make mistakes concerning their investments. These mistakes, which arise out of corrupted price signals, will lead to a correction. Or in other words a recession. Are recessions worth the trouble of unsustainable expansionary monetary policy? Or might the world be better if central banks stopped pursuing political objectives and concentrate on other tasks that do not involve setting the central interest rate? If so, then we ought to let the natural rates of interest of all the financial intermediaries be the determiner of interest rates.
“Inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output.” -- Milton Friedman, A Monetary History of the United States 1867-1960 (1963)
Most good business do a cost benefit analysis prior to undertaking a project. They estimate future demand based on today's best indicators. They estimate future factor input costs based on today's best forcasts. A prudent business should overestimate a little to prepare for unexpected errors in the estimation process.
One of the benefits of a central bank is to provide a uniformed interest rate across the entire country. In theory this is supposed to make it easier for businesses to calculate borrowing costs across the entire economy thereby making future estimates of demand and factor costs more accurate. This benefit is eroded with rapid and/or arbitrary changes in the central interest rate because it will become harder to determine future borrowing costs. A second and more insidious erosion of this benefit arises when the central bank's interest rate diverges from the natural rate for too long and/or by too much. When this happens a nation suffers systemic economy wide business errors that result in a recession.
The technical term for investment resulting from these business errors is malinvestment.
The Free market economy's “secret weapon” or great advantage, in terms of efficiency, over a command economy is its price signals. Price signals tell businesses where to invest productive resources. A high relative price for a good or service indicates that there is insufficient resources devoted to that good or service relative to other goods or services according to the consumers. A low relative price indicates that there is too much investment in the production of that good or service relative to other goods or services according to consumers as a class. Businesses will chase profits by adjusting their productive resources away from products or services that are in over supply and into products or services that are under-supplied. The end result is that consumers, as a class, get what they most want.
The freer the economy, the more accurate the price signals. The more accurate the price signals, the greater the needs and desires of the consumer, as a class, are satisfied.
Interference with price signals reduces the economy's ability to determine the needs and wants of consumers as a class. This net loss is mitigated buy the common fact that a special interest group (perhaps a charity, business, industry or government) benefits from the consumer class's loss. While some of these net losses from price signal interference may be minor or even necessary, there is one that is so atrocious and so prevalent that it bears closer examination to see if it is perhaps a bigger harm than benefit.
A central bank rate that is lower than the natural rate of interest creates an unsustainable economy wide effect on price signals. When the unsustainability becomes clear we have an economy wide recession. This is the question at hand: is the pain and detriment of a recession more than, less than or equal to the benefit of a centrally set interest rate to consumers as a class?
In order to see how the central bank can cause a recession we need to look at the necessities of the investment and production process. A good business will look at all the best data that are available to make an investment decision. Among the data they look at are input factor costs and credit costs. The interesting thing about credit costs is that the lower the credit cost, the more cost effective a long term investment becomes. However, there is added risk as the longer the term, the harder it is to predict input factor costs and credit costs in the mid-range and end-range of the investment project. Even a minor increase in factor costs and/or credit costs in the middle of a long term project can fatality damage an investment's profitability and consequently the firm's health. A central bank rate that is relatively constant helps, but it is more important that the central bank rate reflects consumers propensity to defer consumption. If consumers have reduced their spending then more money is saved and hence more money is loanable to businesses. The increase in loanable funds is reflected by a drop in the natural rate of interest. The central bank should follow suit. This makes business investment more attractive so businesses spend more. This business spending has the further effect of picking up the slack in demand caused by consumers' deferred spending. Factor prices will remain constant – a big plus for business planning.
If, on the other hand, the central bank lowers its Central bank rate below the natural rate (that is: if it sets an excessive expansionary monetary policy) then business' demand for factor inputs for capital goods competes with (instead of replaces) consumer demand. Due to the increase in demand generated by a lower central bank rate, factor prices will therefore increase.
Economic theory predict that an increase in demand will cause entrepreneurs to enter the market. This is very true but it can be a mistake if the demand is caused by a central bank rate being lower than the natural rate. If the natural rate of interest goes down it means that consumers, as a class, have decided to decrease present consumption by saving more. A decrease in present consumption necessitates increases in future consumption. Conversely if there is not any decrease in present consumption there will not be any increase in future consumption (without the savings benefit of new technology). Therefore if entrepreneurs enter a market due to price signals created by a central bank's artificial demand, they will find that in the future when the projects are completed, the expected future increase in the consumption of consumers will not exist. That is, consumers did not in fact increase savings in the recent past and therefore there is not any extra funds to spend later. Additionally, in the shorter term, input factor prices have increased making the projects more expensive to complete. This will lead to a marginal increase in the number of bankruptcies, layoffs, insolvencies and cost overruns. At some point the bad news will become such that consumer sentiment changes from optimistic to pessimistic. Then consumers will reduce current consumption. Since consumers can reduce spending instantly but because businesses are stuck in long temporal production and development processes, businesses are stuck hemorrhaging losses as they struggle to cut costs. Businesses then realize that investments that appeared sound were not and support industries that appeared red hot were in fact only blowing smoke.
The changing market conditions soon make clear that some business decisions to invest capital were in fact decisions to consume capital. Although there are some winners and losers in this process and their benefits and detriments may (or more likely may not) equal out, consumers as a class are all losers. We are all losers because consumer prices became higher than they would have been otherwise.
Therefore, I believe that, more often than not, a centrally set interest rate is of greater disadvantage to the class of individuals as individuals than it is an advantage.
What should be the replacement for the central bank rate? The Natural Rate of Interest.
Added on: 2009-04-16 22:45:27
By: Jeff McLaren
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