Austrian Economics: Interest Rates Explained

Interest rates are a crucial aspect of economic theory and policy discussions, and the Austrian perspective offers a unique take on their determination. According to Austrian economics, interest rates are not just a tool for central banks to maintain economic stability but are inherently linked to individuals' time preferences and their willingness to delay consumption for future savings. This perspective highlights the potential distortions caused by central bank interventions, such as artificially low-interest rates, which can lead to excessive borrowing and investment, ultimately resulting in economic downturns. Austrian theory suggests that a free market approach, where interest rates are determined by individuals' time preferences, is key to long-term economic progress and the efficient allocation of resources. This framework, influenced by economists like Ludwig von Mises and Carl Menger, provides an alternative view to mainstream economic thinking and has implications for understanding the complex relationship between interest rates, production, and world trade.

Time preference theory

The time preference theory of interest, also known as the agio theory of interest or the Austrian theory of interest, explains that interest rates are determined by people's preference to spend money now rather than in the future. This theory was developed by economist Irving Fisher, who described interest as "the price of time" and "an index of a community's preference for a dollar of present [money] over a dollar of future income".

The time preference theory of interest argues that people prefer to spend today and save for later, so that interest rates will always be positive, meaning that a dollar today is more valuable than one in the future. This is because, according to the theory, the value of goods decreases as the length of time needed for their completion increases, even when their quantity, quality, and nature remain the same.

The time preference theory of interest is a key component of the Austrian school of economics and is used to understand the relationship between saving, investment, and interest rates. It is also referred to as the neoclassical theory of interest, which states that the rate of time preference is usually taken as a parameter in an individual's utility function, capturing the trade-off between consumption today and consumption in the future.

According to the neoclassical view, consumers who are choosing between spending and saving respond to the difference between their subjective sense of impatience to spend (their subjective rate of time preference) and the market interest rate, adjusting their spending and saving behaviours accordingly. Several factors can influence an individual's time preference, including age, income, race, risk, and temptation.

Interest rates and money supply

The Austrian School of economics offers an alternative view on interest rate determination compared to mainstream economics. While mainstream economists argue that interest rates are determined by liquidity, economic activity, and inflationary expectations, the Austrian School framework focuses on individuals' time preferences and their decisions regarding present consumption versus future consumption.

According to the Austrian School, when the central bank increases the money supply, it leads to a temporary decrease in interest rates. However, as the increased money supply strengthens economic activity, it sets in motion the "economic activity effect," which exerts upward pressure on interest rates. Additionally, an increase in the money supply can affect the prices of goods and services, leading to inflationary expectations that further push interest rates higher.

The Austrian School argues that the popular theory of interest rate determination by mainstream economists is descriptive rather than explanatory. They contend that interest rates are not solely determined by outside factors such as monetary liquidity, economic activity, and inflation expectations. Instead, they emphasize the role of individuals' conscious and purposeful actions in response to various factors.

In the Austrian School framework, the increase in money supply results in an exchange of nothing for something. When banks lend money unbacked by savings, it artificially raises the money supply. The recipients of this injected money can divert wealth from wealth generators, similar to counterfeiting. This increases their purchasing power, pushing asset prices higher and their yields lower.

However, the Austrian School argues that as long as the overall pool of wealth is growing, individuals' time preferences tend to decline, leading to a decline in market interest rates. Conversely, when the pool of wealth declines, time preferences increase, resulting in higher market interest rates. They suggest that central bank policies that distort interest rates can lead to a misallocation of resources and make it harder for businesses to understand consumers' true preferences.

Wealth generation and interest rates

The Austrian School of economics posits that interest rates are determined by individuals' time preferences, contrary to the mainstream view that interest rates are determined by monetary liquidity, economic activity, and inflationary expectations.

According to the Austrian School, an individual's time preference refers to their preference for consumption of goods in the present versus the future. In other words, individuals generally value present consumption more highly than future consumption. This preference for present consumption is often referred to as the "premium of present goods versus future goods".

When an individual's wealth expands, the cost of lending or investing decreases, as they can now allocate a portion of their wealth towards lending or investment while still maintaining their present consumption. This expansion of wealth will likely result in a lowering of the premium of present goods versus future goods, leading to a decline in interest rates. Conversely, factors that undermine real wealth expansion will increase this premium, resulting in an increase in interest rates.

For example, when money is injected into the economy by central banks or through unbacked lending by banks, this results in an exchange of nothing for something. The recipients of this money can divert wealth from wealth generators, becoming wealthier than before. As a result, they can increase their purchases of various assets, pushing prices higher and yields lower. While this exchange of nothing for something weakens the process of wealth generation, it can lead to a decline in market interest rates as long as the overall pool of wealth is growing.

In summary, the Austrian School views interest rates as being determined by individuals' time preferences, which are influenced by their wealth and consumption decisions. Increases in wealth tend to lower time preferences and interest rates, while decreases in wealth tend to raise time preferences and interest rates. This framework highlights the role of conscious and purposeful individual actions in driving economic phenomena, including interest rate determination.

Inflation and interest rates

Mainstream economists, including Milton Friedman, argue that three factors determine market interest rates: liquidity, economic activity, and inflationary expectations. According to this viewpoint, when a central bank increases the money supply, it causes the prices of financial assets like Treasurys to rise and their yields to decrease. This is known as the monetary liquidity effect, which is inversely related to interest rates.

An increase in the money supply, after a time lag, leads to a boost in economic activity, resulting in the economic activity effect. This effect exerts upward pressure on interest rates. Over a more extended period, the higher growth rate of the money supply starts to affect the prices of goods and services, leading to the emergence of inflationary expectations, which further push market interest rates upwards.

The Austrian School, however, offers a different perspective. They argue that interest rates are determined by individuals' decisions regarding present consumption versus future consumption, or what is known as time preference. According to this theory, when an individual's wealth expands, the cost of lending or investing decreases, and they become more willing to allocate a portion of their wealth towards lending or investment. This leads to a decline in the premium of present goods versus future goods, resulting in lower interest rates. Conversely, factors that hinder real wealth expansion will increase the premium of present goods, causing interest rates to rise.

The Austrian School's framework highlights that central bank policies can distort market interest rates, causing them to deviate from the rates dictated by individuals' time preferences. This, in turn, can lead to businesses making decisions that disobey individuals' instructions, resulting in a misallocation of resources.

In summary, while mainstream economics focuses on liquidity, economic activity, and inflation expectations, the Austrian School emphasizes the role of individual time preferences in determining interest rates.

Austrian Business Cycle Theory

The Austrian Business Cycle Theory (ABCT) is an economic theory that seeks to explain how business cycles occur. The theory originated with Austrian School economists Ludwig von Mises and Friedrich Hayek, the latter of whom shared the 1974 Nobel Prize in Economics, in part for his work on this theory.

According to the ABCT, business cycles are the consequence of excessive growth in bank credit due to artificially low interest rates set by a central bank or fractional reserve banks. The theory holds that low interest rates tend to stimulate borrowing, leading to increased capital spending funded by newly issued bank credit. This credit-sourced boom results in widespread malinvestment, which refers to a period of widespread and excessive business lending by banks, followed by a sharp contraction and distressed asset sales.

The Austrian School's explanation of the business cycle differs significantly from the mainstream understanding and is generally rejected by mainstream economists. Austrian theorists argue that the boom under these circumstances is a period of wasteful malinvestment. They believe that "real" savings would require higher interest rates to encourage depositors to save their money in term deposits for longer-term projects under a stable money supply. However, the artificial stimulus caused by bank lending creates a speculative investment bubble not justified by long-term market factors.

The "crisis" or "credit crunch" occurs when consumers reestablish their desired allocation of saving and consumption at prevailing interest rates. The "recession" or "depression" is the process by which the economy adjusts to the errors of the monetary boom and reestablishes efficient service of sustainable consumer desires.

Austrian School theorists argue that inherently damaging and ineffective central bank policies, such as unsustainable expansion of bank credit through fractional reserve banking, are the predominant cause of most business cycles. They believe that central banks tend to set artificial interest rates too low for too long, leading to excessive credit creation, speculative "bubbles", and low savings.

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