Imagine with me a hypothetical factory. This factory specializes in the manufacturing of cars, and utilizes two main components to carry out its production processes: planners and workers. The planners decide the specifications of the cars that the factory is to build. The height, length, interior, and exterior and all decided by them in their planning room. They spend an entire week deciding the exact specifications of this plan, at which point they send it to the workers in the form of a blueprint to put the plan into action. As soon as this blueprint is sent, work begins on yet another blueprint.
At the beginning of the week, the blueprints for the car the workers are to build is sent down from the planner’s room. These blueprints tell the workers exactly how the planner’s wish the cars to be built. Once the workers have the blueprints, they spend the next day retooling and refitting the construction lines to accommodate that week’s new car model. The next day, after the adjustments are made, work can begin on the cars. At the end of the week, a new blueprint is sent down from the planners, and the process beings anew.
As long as this process continues as detailed above, no problems should arise. The planners tell the workers what kind of car should be produced, the workers retool the factory, and then cars begin to be produced. All seems well in our factory.
Let’s imagine that there is one planner who thinks that the other planners are all incompetent about anything car-related. He believes that their designs create inferior cars, and only he has the intellect to see the error of their ways. He then decides to change out the blueprints made by the other planners with blueprints of his own. He believes that the cars the other planners like are far too short. He wishes to see the cars produced be much longer. Consequently, his blueprints tell the workers to tool and adjust the factory machinery to create much longer cars.
When the workers receive these blueprints, they behave as if they were from the planners and refit their construction lines accordingly. The day after receiving the false blueprints, they start on production of the artificially long cars just like any other week. All the while, the planners are unaware that anything has happened. As far as they are concerned, their blueprints were put into action and the manufacturing process is continuing as planned.
They draw up another blueprint and send it to the workers the following week, but this blueprint is yet again swapped for the false blueprint by the single rouge planner. Again, his blueprint calls for the cars to be longer than the cars the planners had envisioned. As a result, when the retooling process begins, the workers continue to tool the factory as if the cars are to be manufactured relatively longer. Because this was the case with the last retooling, their retooling efforts here will not be directed towards changing the tools according to design, but making them more efficient, as the longer design is already in the factory production process from the last week.
Let us assume that this process continues for quite some time. The planners create plans which are swapped out by the rogue planner in exchange for his own plans for longer cars. As a result, the workers keep retooling the factories to accommodate for longer cars, looking to improve their efficiency and productivity in the process. However, all these efforts at retooling and creating new cars are all in conflict with the actual wishes of the planners.
Eventually, the rogue planner may decide that the other planners are actually correct. Perhaps these longer cars have not sold very well, or had engine troubles, or do not look atheistically pleasing. In any case, he ceases his fabrication of blueprints and allows for the actual blueprints from the planners get to the floor. When the workers receive the blueprints, they are shocked by the plans they receive. They have spent quite some time tooling their factories to be construct long cars. Week after week, they adjusted their equipment to be as efficient at this task as possible. Now all of the sudden, from their perspective, the plans call for the cars to be shorter.
This sends the workers in a panic. With all the time invested into creating longer cars, it will surely take longer than a single day to retool and refit the factories for the production of shorter cars. Instead of the usual one day it takes to retool the factory, it takes three days for production on the cars to begin. Because of this lag, the factory loses out on revenue that it otherwise would have had and the incomes of the workers and planners temporarily decrease. After some time, the factory will adjust back to its state before the intervention from the rouge planner and all will be back to normal.
This operation of this imaginary factory is dependent on the planners and workers collaborating together to produce cars. The operation of an economy, although exponentially more complex, works in a similar way. For the production of goods and resources, many different individuals, groups, and firms all work together in the unified purpose of production. Much like our factory, if these areas do not coordinate with each other, disaster will result.
The planners in our factory are equivalent to the consumption/savings preferences of individuals in society. Consumption allows for instant gratification. If I want an apple, I eat it; end of story. However, if I do nothing but consume, then my life has no potential for material improvement. If I wish to better myself and potentially eat even more apples, I must save and invest in capital. Instead of picking the apples off of the tree with my own two hands, I use several hours to build a contraption that easily knocks several off of the tree at once with one fell swoop. In this scenario, I use a bit of my time not consuming, but saving and investing so that I may consume more in the future.
Consumption and savings have identical functions in a modern society. If society as a whole decides to save more, this will allow more funds to be freed up from producing consumer’s goods and allocate them towards investment and capital goods. These investments will yield fruits in the future as they allow for consumer’s goods to produced at cheaper costs, and thus lower prices, allowing society as a whole to consumer more.
The blueprint in our factory functions similarly to the interest rate of an economy. The interest rate is the price premium that society places on consumption now versus consumption in the future. As such, it serves as an indicator for how much investment, higher consumption in the future, the businesses should embark upon. If people generally save most of their income, interest rates will be low because savings are so abundant. This signals to entrepreneurs and businessmen that they should invest more now because savings have been freed up as a result of people preferring more consumption later than consumption today.
If a lowering of interest rates results in more investment from businesses, then it also means that we would expect more businessmen to enter in lines of production that produce capital goods as opposed to consumer’s goods. Thus, whenever there is an increase (or decrease) in the consumption/savings ratio of people’s incomes, the entire structure of the economy changes. Production of consumer’s goods decreases and the production of capital goods increases. If savings decrease and consumption increases, then the opposite will occur. Production of consumer’s goods will increase and production of capital goods will decrease.
The workers in the factory serve the same function of businessmen and entrepreneurs in an economy. In our factory setting, there is only one good, but a real economy is composed of millions upon millions of different goods ands services. All of this production is directed by individuals, as well as their consumption and savings. As we showed above, if people consume more and save less, businessmen will move production into lines of consumer’s goods, and vise versa. As such, businessmen are directed by the wishes of society much like the workers are directed by the planners by the blueprints.
As long as nothing interferes in the production process in the factory, everything runs quite smoothly. Similarly, as long as nothing interferes in the market process, everything runs smoothly in an economy. The problem occurs in the factory once the rogue planner appears and starts changing the blueprints from what the planners had planned. If we have such an actor appear in an economy, the same breed of chaos can ensue. In the factory, it is the replacement of the blueprints that serves as the impetus for derailing the production process. In an economy, it is the artificial lowering of interest that causes the economy to start down a path leading to collapse.
The interest rate serves as the measure by which decisions are made for production of consumer’s goods versus capital goods. As such, it is vitally important that this gauge of society’s preferences be accurate. As long as there is no artificial tampering with the interest rate, this gauge will always tend to reflect the willingness of society to consume in the present versus the future. However, government has a habit of tampering with interest rates, usually through central banks. The reasons for doing this can be multifaceted. Government tends to run budget deficits, meaning it has to borrow money. If interest rates are lowered, this allows the government to minimize the amount of interest they have to pay on borrowed money.
Regardless of the rationale for artificially lowering interest rates below the market rate, the act of doing so puts the economy in an unsustainable position that it must correct itself from at some point in the future. If the interest rate is lowered, then this signals to entrepreneurs that they should invest more, leading to more investment and more businesses switching production into lines involving capital goods. However, in this case that signal is completely false. The consumption/savings preferences of society, or the planners in the factory, as a whole have not changed. The interest rate, or the blueprint from the planners, has been switched by the government and the businessmen are none the wiser! The production lines of the economy are now arranged so that they there is much less consumption goods being produced relative to the preferences of society as a whole.
As a result of the interest rate being lowered, the wishes of society are not fulfilled and the economy is an unsustainable position. The current state of elevated capital goods production is dependent completely on the artificially lowered interest rates. In our factory, the shift in production of cars is dependent on the false blueprints being sent as opposed to the actual blueprints. As soon as the true blueprints are sent from the planners, then the errors the workers made in tooling their factories will be revealed. Whenever the interest rate is allowed to come back up to its true market rate, then the errors made by entrepreneurs in moving their production lines over into capital goods production will be revealed.
As soon as the interest rate is artificially lowered, the bust and readjustment process in the future is inevitable. The misallocations made from the interferences in the interest rate must be rectified to move the production of the economy back into line with the preferences of society. Even though this readjustment is necessary, the damage can be mitigated if the interest rate is artificially lowered for only a short period of time. This minimizes the amount of misallocation that can take place. The longer that interest rates are kept low, the more entrepreneurs can move in capital goods production lines and more investment in those production lines can take place. As with the improvements made in the production lines in the factory, the misallocations only increase over time, building up a larger and more painful readjustment process.
When in this unsustainable state, the economy is comparable to a drug junkie. As soon as he gets high, the crash will inevitably come. However, if he keeps redosing himself, he can put off the crash further and further into the future. This will also make the crash that much worse and severe. To minimize the damage, the crash should happen as soon as possible.
This process of lowering the interest rate, leading to an unsustainable state in the economy, and to an eventual crash, is the essence of Austrian Business Cycle Theory. It is a bleak and unhappy picture to paint, as once we are in an artificial boom from the cheap money, the eventual crash hangs over us. Artificially low rates bring about an economic Sword of Damocles, which is destined to fall upon us at some point. We can push it into the future, but never avoid it altogether.
Throughout modern history, we have experienced this cycle over and over again ever few years. Must this be the case? Is there any way for us to avoid it? In our factory, the only way to prevent the readjustment process is to prevent the rogue planner from switching the blueprints. Similarly, the only way to prevent the economy from experiencing the crash is to prevent interest rates from being lowered below the market rate. As long as the economy remains free from interference with the interest rate, production will continue along smoothly, just as in the factory. Keep the rogue planner away from the blueprints and keep the government away from interest rates. However, once interest rates are lowered, the crash will come.
Business cycles are accepted by some to be a fact of life. An unfortunate side effect of living in a modern economy. You must take the good with the bad, as it were. This does not need to be the case. It is government and central bank interference with interest rates that causes this entire process to begin with. To vanquish the business cycle once and for all is no pipe dream, it is only a question of keeping the government away from our money and interest rates. It is only when we have made a return to sound monetary institutions that the economy can be permitted to grow uninterrupted by the constant up and downs of the government-imposed fate of the business cycle.
