Saving Supply and the Natural Interest Rate

Examining the business cycle based upon the assumption that the supply of saving, the demand for investment, and the natural interest rate are unchanging is like putting on blinders. It is certainly possible that an excess supply of money will be matched by an increase in the real supply of credit and push the market interest rate below the natural interest rate. On the other hand, what happens if there is a decrease in the supply of saving?

Suppose the market interest rate was initially equal to the natural interest rate, and then the supply of saving decreases. At the initial market interest rate, the quantity of saving supplied is less than the quantity of investment demanded. That part of income not spent on consumer goods and services is greater than spending on capital goods.

The natural interest rate, where saving and investment are equal, is now higher. Assuming the market interest rate rises with the natural interest rate, the quantity of saving supplied increases and the quantity of investment demanded decreases. In the end, the amount saved and the amount invested are both smaller. The composition of demand has changed, with more demand for consumer goods and less demand for capital goods.

Of course, these inclusive aggregates--consumer goods and capital goods--mask important changes in the composition of demand within the aggregates. If consumer goods are homogeneous, then the increase the quantity of saving supplied is simply an offset or dampening of the initial decrease in the supply of saving. Equivalently, the decrease in the demand for consumer goods due to the higher market interest rate is just a partial offset or dampening of the increase in the demand for consumer goods due to the initial decrease in saving supply. However, since consumer goods and services are an aggregate, it is likely that there are shifts in the composition of the demand for consumer goods and services towards those with smaller interest elasticity of demand. For example, the demand for durable consumer goods like automobiles may decrease, while the demand for restaurant meals increases.

Similarly, if capital goods are all homogeneous, then the increase in the market interest rate simply decreases the demand for them. But capital goods are not homogeneous. And the particular purposes to which they are put are not independent of the interest rate. Those capital goods with higher interest elasticities of demand will see the greatest reductions in demand. In particular, capital goods that will generate consumption in the more distant future, perhaps because they are more durable, will especially lose value due to the higher interest rate.

Perhaps I have missed some of the subtleties of Austrian capital theory, but I hope this gives the proper flavor. The change in the composition of demand, both between aggregate like consumer and capital goods, as well as amount different consumer and capital goods, are important. Presumably, the demands for consumer goods and services with less interest elastic demands rise, as do the demands for capital goods specific for their production. The demands for consumer goods with demands that are highly interest-elastic fall, as do the demands for a variety of different capital goods depending on their interest elasticities of demand.

The relative prices of the goods and services with lower demands fall and the relative prices of the goods and services with higher demands rise. The change in relative prices and profitabilities results in changes in production and the allocation of existing resources, including labor. Employment expands in "consumer goods industries" and shrinks in capital goods industries. Or, more precisely, it rises in consumer goods industries where demand is less interest elastic and in closely related capital goods industries, while employment shrinks in capital goods industries where demand is more interest elastic. An entire integrated structure of production is developed based on this new pattern of demands through time.

It would seem that this reallocation of resources would be associated with both structural unemployment and capital losses for many capital goods that cannot be shifted to the direct production of consumer goods that do not have interest elastic demands. For example, a need for another stove in the restaurant may be an added demand for capital, but the robot welders on the auto assembly line will provide little help. Perhaps they can be shifted to the stove factory, but perhaps not.

High unemployment, firms failing, losses on capital goods, perhaps even capital goods abandoned, all appear to be consequences of a decrease in the supply of saving and the necessary increase in the natural interest rate. Can the economy recover? Yes, but it can only recover gradually. Labor needs to be reabsorbed in those sectors of the economy with growing demand--consumer goods with low interest elasticities of demand and related capital goods. New, more appropriate capital goods must be constructed. Eventually, unemployment will fall and output will recover--at last partially.

The reason for this discussion isn't to claim that the current recession, or any recession, has been the result of a decease in the supply of saving. My point was rather to suggest that there is little or no difference between this process and what advocates of the Austrian theory of the business cycle describe as a recession.

Perhaps more interesting, suppose rather than starting with a decrease in the supply of saving, what if this was a return to the composition of demand and allocation of resources from the recent past. Suppose the supply of saving rises, stays relatively high for a few years, and then returns back to its previous level. How different, really, would be the pattern of demands, production, and employment than the traditional "Austrian" cycle theory?

For example, suppose that the collapse of the dot com bubble left households poorer or fearful and they responded by saving more. The Fed, miraculously, adjusts the market interest rate to the new natural interest rate. A new pattern of demands and a new allocation of resources, including labor, develops. Capital goods specific to this pattern of demands are constructed. Then, after some time, households have rebuilt their wealth a bit or just no longer fear that this stock market crash will have the consequences of the one in 1929. The supply of saving falls. The pattern of demands and the allocation of resources must change again.

Focusing particularly on the "malinvestments" ("mal," only in the sense that they are inappropriate to the pattern of demands associated with low saving,) what are we to make of the entrepreneurs who purchased these capital goods and suffered the losses when saving fell again? Isn't this just an entrepreneurial error? And what was the nature of that error? Wasn't it the assumption that the temporarily low level of "the" market interest rate (and natural interest rate,) would be persistent and justified the production of capital goods that will only remain profitable if enhanced levels of saving persist?

Austrian cycle theory shows that an effort to use monetary policy to impact real interest rates, the composition of demand, the allocation of resources, and the functional distribution of income between labor and capital can at best only appear to work in the short run. In the long run, it is likely to have disastrous consequences. This insight has value. However, trying to explain actual business cycles using this theory, in a world where hardly anyone is using monetary policy for that purpose, is fraught with danger.

In particular, in a world where the demand to hold money, the supply of saving, and the demand for investment can all change, a pattern of thought that identifies increases in the quantity of money or decreases in market interest rates with an excess supply of money or a market interest rate pushed below the natural interest rate can be highly misleading.