Rate Cuts and the Austrian Trade Cycle
By Pete Lester, Sr.
January 21, 2008
When the Federal Reserve lowered interest rates last month to 4.25%, it was the third consecutive meeting of the Board of Governors that resulted in a cut in the discount rate. The last time the Federal Reserve dropped rates after three consecutive meetings was in 2001 (October, November and December of that year) following the terrorist attacks on the World Trade Center towers.
Despite the action back in 2001, the stock market still fell with the S&P 500 falling 2.53%.
Similarly, many view the action taken by the Federal Reserve in December as not enough. One naysayer has been very critical: Jim Cramer of MSNBC's “Mad Money.” If you listened to Mr. Kramer you would have thought that the Fed’s primary purpose is to satisfy the expectations of the traders and speculators on Wall Street. Mr. Cramer, who I do enjoy, blasted The Fed stating the ¼ of 1% cut was too little too late – and that the market had expected twice that.
Economists holding to the Austrian School of economics (in the footsteps of Ludwig Von Mises, Frederick Hayek and Hans Sennholz) would interpret this action as interference and potentially postponing a correction that the market, if left to natural market forces, needs.
A brief description of this trade cycle would include a relatively narrow view of interest rates. Austrian School Economists believe that interest rates should be a reflection of the supply of money (capital) available for investment, and the demand for that resource. As people save, the money available to be borrowed/invested grows and as a result interest rates fall.
As the cost of borrowing falls, both businesses and individuals will borrow funds. In the case of businesses, they borrow so that they can expand production, produce new products, expand into new markets; in the case of individuals or family units, maybe they purchase a new car, move out of their apartment and buy a home, or maybe they simply improve the home they currently own.
The Austrian School Economists would say that when the government interferes in this dynamic, the wrong signals are sent to the marketplace. Yes, interest rates fall, but there are no savings to support the fall in the interest rate. It is only with governmental interference that cheap money without savings can be extended to the market. Businesses expand production and invest in operations, but there is no real disposable savings to support the expansion. In this interpretation of events, governmental intervention in the markets causes mis-allocation of resources, and instead of a short recession, a period of economic expansion occurs.
However, the inevitable recession does come, and when it comes, because resources were mistakenly allocated, the recession is more severe and longer.
As I write this, it is the Martin Luther King Holiday and the American stock markets are closed. Internationally, the markets have been open, and all indications are that tomorrow morning, the markets will be volatile.
There is no doubt that pressures will increase upon the Federal Reserve to do something to stabilize the stock markets.
In my opinion, the Austrian Trade Cycle is a pretty accurate description of some situations, and this might just be one of them.
QUESTIONS for STUDENTS of ECONOMICS:
1) In your opinion, how can interest rates impact basic industries: Automobile, Home Building, Retail, etc.?
2) How can lower interest rates impact consumer spending?
3) What perils lay in the future if consumer spending increases without a rise in consumer incomes?
By Pete Lester, Sr.
January 21, 2008
When the Federal Reserve lowered interest rates last month to 4.25%, it was the third consecutive meeting of the Board of Governors that resulted in a cut in the discount rate. The last time the Federal Reserve dropped rates after three consecutive meetings was in 2001 (October, November and December of that year) following the terrorist attacks on the World Trade Center towers.
Despite the action back in 2001, the stock market still fell with the S&P 500 falling 2.53%.
Similarly, many view the action taken by the Federal Reserve in December as not enough. One naysayer has been very critical: Jim Cramer of MSNBC's “Mad Money.” If you listened to Mr. Kramer you would have thought that the Fed’s primary purpose is to satisfy the expectations of the traders and speculators on Wall Street. Mr. Cramer, who I do enjoy, blasted The Fed stating the ¼ of 1% cut was too little too late – and that the market had expected twice that.
Economists holding to the Austrian School of economics (in the footsteps of Ludwig Von Mises, Frederick Hayek and Hans Sennholz) would interpret this action as interference and potentially postponing a correction that the market, if left to natural market forces, needs.
A brief description of this trade cycle would include a relatively narrow view of interest rates. Austrian School Economists believe that interest rates should be a reflection of the supply of money (capital) available for investment, and the demand for that resource. As people save, the money available to be borrowed/invested grows and as a result interest rates fall.
As the cost of borrowing falls, both businesses and individuals will borrow funds. In the case of businesses, they borrow so that they can expand production, produce new products, expand into new markets; in the case of individuals or family units, maybe they purchase a new car, move out of their apartment and buy a home, or maybe they simply improve the home they currently own.
The Austrian School Economists would say that when the government interferes in this dynamic, the wrong signals are sent to the marketplace. Yes, interest rates fall, but there are no savings to support the fall in the interest rate. It is only with governmental interference that cheap money without savings can be extended to the market. Businesses expand production and invest in operations, but there is no real disposable savings to support the expansion. In this interpretation of events, governmental intervention in the markets causes mis-allocation of resources, and instead of a short recession, a period of economic expansion occurs.
However, the inevitable recession does come, and when it comes, because resources were mistakenly allocated, the recession is more severe and longer.
As I write this, it is the Martin Luther King Holiday and the American stock markets are closed. Internationally, the markets have been open, and all indications are that tomorrow morning, the markets will be volatile.
There is no doubt that pressures will increase upon the Federal Reserve to do something to stabilize the stock markets.
In my opinion, the Austrian Trade Cycle is a pretty accurate description of some situations, and this might just be one of them.
QUESTIONS for STUDENTS of ECONOMICS:
1) In your opinion, how can interest rates impact basic industries: Automobile, Home Building, Retail, etc.?
2) How can lower interest rates impact consumer spending?
3) What perils lay in the future if consumer spending increases without a rise in consumer incomes?
No comments:
Post a Comment