How to Think about Monetary Intervention
The Boom-Bust Cycle
The economy’s constant flux is not random change but adjustments to the production apparatus in the pursuit of creating value. Value is a moving target because consumers want change over time and innovations and new opportunities. The constant adjustments mean the market is best understood as a process.
There are two fundamental tendencies in this. First, there are the adjustments made to existing production intended to keep efforts aligned with expected consumer value. Without these, production would become ever more misaligned with what consumers want. We would see falling living standards as a result.
Second, entrepreneurs try innovations that they imagine will create new value for consumers. When these are successful, they disrupt and replace already existing production. When production is revolutionized in this way, the economy grows and our standards of living rise.
The overall process is dependent on a functioning price system, which provides economic actors with the information they need to respond rationally to changes (we saw how this works in chapter 7). However, if prices are manipulated and give false information, entrepreneurs will make decisions on that faulty information. This means entrepreneurs are more likely to fail in their undertakings, but it also means entrepreneurs’ actions introduce errors into the production apparatus. The economy, as a result, becomes distorted.
The boom-bust cycle is a particular type of distortion in which manipulated price signals bring about malinvestments that produce an artificial, unsustainable boom followed by a bust as the errors in production become apparent.
The Rate of Return and Capital Investments
For any investment, it is important to think of the expected return as a rate rather than an amount. Why? Because it is the relative outcome that determines how good the investment is. A $1 million profit is not much if it comes from a billion-dollar investment. But $1 million is an enormous return if the original investment was $100,000. The profit in dollars is the same, but the latter is ten thousand times as much as the former.1
Thinking of profit in terms of rates of return makes it easier to compare different projects. It means an entrepreneur—and investors in the entrepreneur’s business—can compare alternatives that are different in every way. For example, a new airline would require a massive capital investment to acquire the planes, hire crews, and get access to airports, whereas a new lawn service requires a much smaller initial investment. But it could be that the larger investment is still expected to provide a much higher rate of return, which means that it makes more economic sense—even though it requires much more capital.
As we’ve discussed, market profits correlate with consumer value. An investment earns a higher return because of its greater value to consumers. This means we are all better off if the investments made get as high returns as possible.
A higher rate of return also means an entrepreneur can more easily borrow investment capital. Consequently, very capital-intensive projects (such as an airline) can still get the needed financing even though they are very expensive up front. And the entrepreneur can easily calculate whether the cost of capital is worth it. For example, if a project’s return will be 7 percent and a loan from the bank can be had at 5 percent interest, then the expected net gain is 2 percent. It means the entrepreneur can also compare this net 2 percent with, for example, what a much less capital-intensive investment (such as a lawn service) would earn—even if he would then not need external financing. If the lawn service is expected to provide a net return of 4 percent, the entrepreneur would not choose to start an airline. Its rate of return is only half of what he can make from his lawn service (2 instead of 4 percent).
But imagine if the interest rate were only 1 percent. Now the airline’s return is 50 percent higher2 than the lawn service’s, even though nothing else has changed. In this situation, we would expect entrepreneurs to start airlines rather than lawn services because that is where they will make more money—despite taking out loans for the investment. It takes more productive capital to start an airline, but this is not an issue at the lower interest rate.
If the difference between the rates of return is high enough, we might also see entrepreneurs sell or discontinue their lawn services to instead run airlines and other more capital-intensive businesses. This would be an appropriate economizing shift in investment because the airline industry provides more expected value to consumers (reflected in its higher rate of return). The existing capital would be invested where it can be used most productively in the service of consumers.
A higher rate of return is not only due to lower costs. It can also be the result of higher value creation. Lower costs and higher value creation can both increase the rate and vice versa. It is the expected bottom line relative to the investment needed that counts when making investment decisions.
However, even if the projects’ expected net rates of return are the same, their economic situations may not be. This is another example of how the market empowers actors by lowering the bar: an entrepreneur does not need to know why the rate of return is high to make an investment. But it makes a difference when we try to understand the economy. For example, when the interest rate is 5 percent, an 11 percent expected return on highly capital-intensive investments in air travel makes their net return 50 percent higher than the 4 percent return on lawn services.
But the economy is different. In the case of an 11 percent return and a 5 percent interest rate, the high rate of return is due to high expected value creation. The high interest rate suggests capital is scarce, which is why banks can charge a high interest rate. To attract investments—and therefore capital—airlines are expected to create more value. We saw this above: when airlines’ rate of return was only 7 percent, lawn services earned a higher net rate of return. When airlines’ rate of return rose to 11 percent, lawn services earned a lower net rate of return than airlines. Investors were then incentivized to pull their money from lawn services and other investments and put it in airlines to earn higher profits. This ac
Article from Mises Wire