In a free market economy, savings are automatically matched with investment. Decisions about saving and investment in capital processes are often made by different actors. Investment decisions are made by entrepreneurs and businesses, whereas savings decisions are often made by people and households. 

The link between these independent actors is the interest rate. When interest rates rise, people will save more. When interest rates fall, more potential projects become economic, so businesses and entrepreneurs invest more. In a free market, interest rates rise and fall to clear the market and ensure that savings are matched by equivalent investments.

Banks often act as intermediaries between savers and producers. Savers deposit their spare wealth with the bank and receive interest. Producers borrow from the bank to purchase capital goods to increase the productive capacity of their business. Their increased productivity improves living standards for everyone.

This all goes wrong when governments give their central banks authority to set interest rates. A central banker does not know the future, so he does not know have enough information to set the interest rate. Following the dotcom crash in 2000, central banks pushed interest rates down, leading to the housing boom and following credit crunch.

Consequences

Artificially low interest rate interest rates cause dislocation in the economy. Households respond by reducing saving and increasing consumption (for most households, a car and a home are consumption goods and not investment goods).

Big spending on consumption goods makes people feel good, but it cannot last forever. When interest rates go up again, personal debt becomes a burden and interest payments take an ever greater share of disposable incomes. Households are forced to reduce spending on consumption goods to get their balance sheets back in shape.

When the demand for consumption goods declines, businesses have to cut back on the production of consumer goods. Ideally, the resources that are no longer needed to produce consumer goods should be switched to the production of investment goods. If this does not happen, the economy will decline as the resources that previously produced consumers will be underemployed.

Unfortunately, two things have happened that make this shift in resources impossible. Firstly, there is no additional savings available to fund any new investment expenditure. Although households have reduced their expenditure on consumption, their surplus income does not go into savings. Most of it goes toward payment of interest. Any surplus not used on interest is not available to fund additional investment, because it must go towards repayment of debt. Although there has been a decline in consumption, there are not additional savings to fund the purchase of new investment goods.

Producers

The second problem is that when interest rates were set artificially low by the central bank, producers took this as a signal to buy more capital goods. They have already purchased more capital goods than is required for a properly functioning economy. Just as households responded to low interest rates, by overspending on consumption goods, business responded by excessive spending on capital goods.

When demand for consumption goods declines and resources should be moving towards the production of capital goods, the demand for them also dries up, because businesses have already overspent on investment goods. Just when spare resources are freed up for the production of investment goods that would benefit the entire economy, businesses are trimming their investment plans to tidy up their balance sheets.

Fiddling with interest rates causes the relationship between consumption and production and saving and investment to get out of sync. The economy will go into recession, as demand for both consumption and capital goods declines at the same time.

This is the decline in aggregate demand that is dreaded by many modern economists. What they do not seem to understand is that this lack of demand is the consequence of the distortion caused by the actions of the central bank. Artificially low interest rates create excessive demand for consumption and capital goods that cannot be sustained. Something eventually has to give, and it hits both consumption and investment at the same time.

Modern economists advocate additional government spending to artificially stimulate demand, but this just perpetuates the dislocation of the economy.

Three Classes of Business

When the central bank sets interest rates artificially low, a credit fed boom will follow, as households reducing saving and make more purchases using credit. Assets rise in price as the cost of borrowing declines. When the credit-fuelled boom comes to an end, businesses can be classified into three categories.

1. Some businesses will have expanded to be far larger than they would be if interest rates had been determined in a free market economy.
2. New business will have emerged that would not exist were it not for low interest rates and the credit-led boom. Their aggressive growth often fuels the boom.
3. Some businesses that would be economic in normal times will have shrunk after being squeezed out by other businesses chasing the boom. Hopefully this is still the largest category.

This suboptimal situation cannot continue indefinitely. It reflects the dislocation of the economy caused by artificially low interest rates. To correct this situation, households will begin cutting back on their purchases, and saving hard to reduce their exposure to debt. Businesses in categories A and B that have been selling to people on credit will have to stop producing stuff that is no longer needed. As they cut back production, staff will be laid off, increasing unemployment and further reducing the demand for goods services.

Mainline economics says that best solution is for the government to increase expenditure to keep businesses in category A and B operating at their current levels. Businesses in category C will be unable to meet the demand for what they are producing.

For the economy to operate in an optimal way, free from distortions caused by government intervention, we really need businesses in category B to disappear and businesses in Category A to eliminate the production driven by the low interest rates. At the same time, we need businesses in category C to expand their production to the optimal level. Alternatively category A and B businesses could start producing the things produced by category C, if they could do it as efficiently.

The problem with the standard solution is that extra government expenditure just keeps businesses in category A and B doing what they were previously doing. That does not get the economy to the optimal situation. It may get businesses in category C producing more too, but not enough, because they would still be getting squeezed out.

The solution proposed by mainline economist just perpetuates the problem. It may prevent short term economic decline, but it results in long term sub-optimal performance.

No Easy Exit

The painful solution is for the government to do nothing and let the dislocation work its way out of the economy. Unfortunately, if the dislocation has been really severe, businesses in category A and B will have to make massive cuts in production. This will lead to high levels of unemployment that reduces demands for the output of business in category C. Category A businesses will shrink more than is necessary. Category C businesses, which should be the majority, will have to reduce production, when we really need them to increase production.

The painful solution is better in the longer term, as it allows the economy to move towards an optimal use of capital. This is the correct solution, but it may be very painful in the short. Very few people will choose short term pain for long term gain, so few governments will choose the Austrian solution.

I am not sure about which is the best policy. The short term pain of the correct solution may be so awful, and we are so grossly unprepared to deal with tough times, that we might be best not to go there yet. We might be better to live a while longer with suboptimal economic performance until we are ready to deal with real and costly change.

Of course, the best that governments can do is postpone any adjustment. We will have to face the day of reckoning eventually.

The real moral of the story is that getting into a situation where the only choice is between painful medicine and medicine that does not work well is foolish. Allowing central banks to distort an economy by manipulating interest rates is a journey down a “no exit” road.