III. Where interest rates fit in

What’s true for distortions in the relative prices of consumer goods (such as automobiles and motorcycles) is true also for distortions in the prices of consumer goods relative to the prices of capital goods (such as bulldozers and skyscrapers). Indeed, Hayek argued that distortions in the prices of capital goods in relation to consumer goods are the chief source of booms and busts. The reason has to do with the central role of one particular set of prices: interest rates.

Interest rates reflect people’s “time preference”—that is, their preference for consuming today rather than delaying consumption until tomorrow. The lower is people’s time preference, the more willing they are to delay consumption. And the more willing people are to delay consumption, the more they save. More savings, in turn, mean lower interest rates. (Banks have more money on hand to lend.) The lower are interest rates, the more attractive are long-term investments.

For example, a transcontinental railroad that takes ten years to build is a more attractive investment for the potential builder if the interest rate is 3 percent than if it’s 10 percent. That’s because the amount of interest that must be repaid when the railroad finally starts to operate and generate revenue will be much lower if the railroad builder borrows funds at an interest rate of 3 percent than at a rate of 10 percent. So although this railroad might not be profitable to build at the higher interest rate, it will perhaps be profitable to build at the lower interest rate.

Low interest rates signal to entrepreneurs that people in general are very willing to forego consuming today so that resources can be used to produce, not MP3 players, hot tubs, and other consumer goods today, but instead steel rails, locomotives, bulldozers, and other capital goods.

But what if people really don’t want to delay their consumption for very long? What if interest rates “lie”—telling entrepreneurs that people are saving more than they really are saving? Hayek argued that such a lie plays an especially critical role in business cycles. When the money supply is increased, the new money typically enters the economy through banks—and to loan this new money, banks lower the rates of interest they charge borrowers. In Hayek’s view, the prices that are most dangerously distorted by expansions of the money supply are interest rates. The artificially low interest rates prompt entrepreneurs and businesses to borrow too much—that is, to borrow more than people are really saving. Artificially low interest rates lead producers to undertake more time-consuming—“longer”—production projects than they would undertake at higher rates of interest.

Unfortunately, interest rates are lower not because people are saving more but only because the creation of new money pushed these rates lower. In this case, plans to build long-run projects—such as, again, a railroad that takes ten years to complete—will eventually run into trouble. With people saving too little to allow all of the necessary steel rails, workers’ barracks, and other capital goods to be produced, the railroad builder in time finds that he cannot complete his project profitably. He must lay off his workers.

As time passes and the investments in excessively “long” business projects are finally entirely liquidated, laid-off workers find other jobs. This result, however, occurs only in the long run. Much economic trouble arises during the short run (which can be a long time when measured on a calendar). Once again, before all of the newly created money finally (“in the long-run”) is spread evenly throughout the economy, the pattern of relative prices is distorted by the stream of new money injected into the economy. During the time it takes for the newly created money to work its way from the markets where it is first spent into each of the economy’s many other markets, the distorted relative prices—including artificially low interest rates—mislead people into making economic decisions that are inconsistent with the true patterns of consumer demands and resource supplies.

It is regrettable that the process of unwinding unsustainable investments takes time. But lasting economic health requires that such unwinding occurs. Unfortunately, during the time required to unwind the unsustainable investments there is indeed a great deal of economic suffering. And, understandably, there are many appeals to political authorities to ease the suffering. As we’ll see in the next chapter, political authorities too often respond to these appeals with policies that only mask and worsen the problem.