Garrison and the lowering of interest rates

(Part three of an examination of Garrison's business-cycle  theory as an over-investment theory: part two is here.)

It is true that lowering of the interest rate will raise the net present value of a long-term investment by more than it will reduce the net present value of a short-term investment. However, this does not mean that a lowering of the interest-rate will make it more likely that I will undertake a new long-term investment the new short-term investment. The fact is, what I will look at is the yield on my Investment versus my cost of borrowing to finance the investment. If the investment returns 5%, the interest rate was 6%, and it is been lowered to 4%, the investment now looks profitable to me, whether the investment is a one-year investment or 30 year investment. Thus, what we will see is more investment projects being undertaken, whatever the length of the project. (And of course, less saving.)

But doesn't the greater increase in the net present value of a long-term investment make them more attractive than short-term investments at the new lower interest rate? No, it does not. Why? Because I potentially can continually re-invest my one-year investment for 30 years and achieve the same stream of cash flows as I would on the 30-year investment, and the NPV of that stream, since it just is the same stream, will be the same as for the 30-year investment.

Of course, if I choose the one-year investment, I risk not being able to reinvest at 5%. On the other hand, if I choose the 30-year investment, I risk the interest rate going up and the investment becoming unprofitable. Theoretically, therefore, it is indeterminate whether I will choose shorter or longer term investment.

Thus what we can expect to see at the new, lower interest rate is a number of investments being undertaken, of whatever maturity length, that would not have been undertaken at the former, higher interest rate. Now, this is exactly what Keynes liked about low interest rates: it would prompt greater investment spending. But he was considering situations in which the money interest rate was above the natural interest rate, and therefore ought to be lowered. (And, thus, too little investment combined with too much saving.)

Hayek, of course, was looking at the opposite situation, where the money interest rate is lower than the natural interest rate. Garrison is certainly within this Hayekian tradition. My point here, however, is that I think his formulation of pushing "beyond the PPF" is superior to Hayek's, and that what actually occurs during the boom is that too many new investment projects are launched, of whatever length.

17 comments:

  1. First of all: this is a really great post !

    "Thus what we can expect to see at the new, lower interest rate is a number of investments being undertaken, of whatever maturity length, that would not have been undertaken at the former, higher interest rate."

    I agree with this but I'm suspecting that these new investments will be somehow more roundabout even when not longer in maturity.

    At a given level of time preference there will be marginal investments that are not adopted because the value of the final future output is just less than the value of the inputs used for other things when the wait time for the output from this investment is included.

    When time preference changes then in effect people valuation of that wait time falls and that processes will now be adopted.

    As a result compared to before the average amount of "wait time" embedded in all goods will have increased. This will be true irrespective of the time to maturity of these new project adopted. I think this can be said to "lengthen the structure of production"




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    1. My comment covers the case of a real fall in TP. I agree that a fall in interest rates not related to a change TP would have the effect that you say.

      Just to make sure I'm not missing anything here: The implication of what you are saying is that ABCT is based on a misconception about the effects of lowering interest rates, right ?

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    2. "The implication of what you are saying is that ABCT is based on a misconception about the effects of lowering interest rates, right ?"

      Not at all. My point is that I think Garrison's version is somewhat better than Hayek's -- but of course Garrison includes Hayek as well!

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    3. Garrison says in his "Capital-Based Macroeconomics" PPT presentation

      "The dynamics of boom and bust entail both overinvestment (as shown in the PPF diagram) and malinvestment (an unsustainable lengthening of the Hayekian triangle"

      Aren't you saying that the mal-investment part won't happen ? If so then I think you dis-agree with Garrison and take the same view as Friedman (that over-investment is the main effect of an increase in the money supply)


      Note: My quote is on slide 47 of http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&ved=0CDMQFjAA&url=http%3A%2F%2Fwww.auburn.edu%2F~garriro%2Fcbm.ppt&ei=kDY_Ua7DH8HLqgH_zYHQBw&usg=AFQjCNEIcN3VRZ6nbKA_mrMknI0Qmk0vuA&bvm=bv.43287494,d.aWM)

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    4. '"The dynamics of boom and bust entail both overinvestment (as shown in the PPF diagram) and malinvestment (an unsustainable lengthening of the Hayekian triangle"

      'Aren't you saying that the mal-investment part won't happen ? If so then I think you dis-agree with Garrison...'

      Well, rob, malinvestment needn't be only lengthening, but, in any case, this all is what I just said: I like the Garrison only part better than the Garrison & Hayek bits.

      "and take the same view as Friedman (that over-investment is the main effect of an increase in the money supply)"

      Where does F say this?

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  2. Garrison defines mal-investment (above) explicitly as "an unsustainable lengthening of the Hayekian triangle".

    And on Friedman: In Time and Money in the section called "Boom and Bust in the Monetarist Vision" Garrison presents a model using the same PPF charts that (I think) shows movement initially beyond the PPF driven by over-investment until relative prices re-adjust with no distortions to the structure of production taking place like he shows in the Hayekian version.

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    1. 'Garrison defines mal-investment (above) explicitly as "an unsustainable lengthening of the Hayekian triangle".'

      rob, I think this will proceed better if you stop lecturing me on what my co-author thinks! I KNOW he thinks... or at least when writing Time and Money, thought... that.

      I am saying I think that is of much lesser important than his over-investment angle.

      "Friedman": OK, I'll have to look. But my recollection is that Friedman thought there was no boom, only sporadic busts.

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    2. I wasn't meaning to lecture just to clarify - because Garrison's definition seemed at odds with your comment that "malinvestment needn't be only lengthening".

      I only skimmed the chapter on Monetarism in T&M so I too need to read in more fully to see where it fits in.

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  3. Rob my point here is that G's over-investment is itself a type of malinvestment, because there will be "holes" in the capital structure where complementary goods will be missing.

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  4. I agree that an unexpected increase in the money supply will disrupt the pattern of relative prices and potentially cause "holes" in the capital structure.

    As you demonstrate in your post though it will not cause a lengthening of the structure of production. This concept seems so key to ABCT that without it the theory is dead in the water.

    Its supporters could maybe say something like "when capitalists see falling interest rates they will assume that TP has changed and invest in longer term project anyway" - but that seems far-fetched.

    I think that boom/bust due to monetary expansion with-out an artificial lengthening is more-or-less the monetarist theory.

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    1. "As you demonstrate in your post though it will not cause a lengthening of the structure of production. This concept seems so key to ABCT that without it the theory is dead in the water."

      See my new post: Mises's theory hardly mentions the length of the structure of production, and does not depend on it at all.

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  5. "If the investment returns 5%, the interest rate was 6%, and it is been lowered to 4%, the investment now looks profitable to me, whether the investment is a one-year investment or 30 year investment. "

    Having thought about this some more - I now see that that the new investments that look profitable (and are adopted) after the fall in interest rates will indeed lengthen the structure of production for the reasons similar to the ones I gave in my first comment. The % of "return for waiting" embedded in the prices of these goods would be higher than the rate of interest before the change and lower afterwards. As a result of businesses starting to produce these goods the structure of production will lengthen.

    By "return for waiting" I mean the return to investors for waiting from when a cost is incurred to when a revenue is realized. It does not matter how long the wait time actually is - what matters is its ratio to the final price.



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    1. "By "return for waiting" I mean the return to investors for waiting from when a cost is incurred to when a revenue is realized. It does not matter how long the wait time actually is - what matters is its ratio to the final price."

      Say what?! If I can double my investment in one year, but triple it in 100 years, at whatever interest rate I'll prefer the 100 year tripling?!

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    2. I meant the annualized return to investors.

      My point is that it is the proportion of this "wait time" reflected in a goods equilibrium price rather than the actual length of the production process that produces it that determines its contribution to the length of the structure of production.

      In other words when you say "the investment now looks profitable to me, whether the investment is a one-year investment or 30 year investment" - I don't think the length of the investment is any guide to how much it lengthens the structure of production.



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    3. "I don't think the length of the investment is any guide to how much it lengthens the structure of production."

      Yes, rob, which is one of the reasons I don't think we could ever really tell if the "length" of production is shorter or longer.

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    4. "Yes, rob, which is one of the reasons I don't think we could ever really tell if the "length" of production is shorter or longer."

      I agree that talking about length of the structure of production is misleading and possibly plain meaningless.

      However when societies time preference decreases (and with it interest rates) then almost by definition the amount of wait-time embeded in the structure of production must increase, mustn't it ?

      I'm just struggling to get my head around how it could be measured given that "length..." is not a good measure.


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  6. yet more thoughts on this:

    Take an economy with 2 stages of production:
    year1=capital goods
    year2=consumer goods

    The more capital goods are produced in year1 the more consumer goods in year2.

    In this simple model "length of the structure of production" can just betaken as correlated to the ratio of investment in year 1 v year 2.

    Scenario 1: A real change in TP. Demand for consumer goods decreases and for capital goods increases. This lengthens the average structure of production by moving resources from production from year 2 to year 1. This will be true even if the new projects adopted are themselves quite short. For example perhaps a new widget that takes a day to produce will now be viable - but as its used in the capital goods stage it still adds to the average length of production.

    Scenario 2: Unexpected increase in the qty of money. This will probably lead to lower interest rates which will encourage more investment. However as the new money will likely also increase consumer demand (and not decrease it as in scenario 1) there is no reason I can see why overall the length of the structure of production will increase as there is no price-driven reason to move resources from year 2 to year 1.

    This seems contra to both Garrison and Hayek.


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