Unit 3 Lecture Notes

**Excerpted from The Bitcoin Standard**

Whereas in a free market for capital the supply of loanable funds is determined by the market participants who decide to lend based on the interest rate, in an economy with a central bank and fractional reserve banking, the supply of loanable funds is directed by a committee of economists under the influence of politicians, bankers, TV pundits, and sometimes, most spectacularly, military generals.

Any passing familiarity with economics will make the dangers of price controls clear and discernable. Should a government decide to set the price of apples and prevent it from moving, the outcome will be either a shortage or a surplus; and large losses to society overall from overproduction or underproduction. In the capital markets, something similar happens, but the effects are far more devastating as they affect every sector of the economy, since capital is involved in the production of every economic good.

It is first important to understand the distinction between loanable funds and actual capital goods. In a free market economy with sound money, savers have to defer consumption in order to save. Money that is deposited in a bank as savings is money taken away from consumption by people who are delaying the gratification that consumption could give them, in order to gain more gratification in the future. The exact amount of savings becomes the exact amount of loanable funds available for producers to borrow. The availability of capital goods is inextricably linked to the reduction of consumption: Actual physical resources, labor, land and capital goods, will move from being employed in the provision of final consumption goods to the production of capital goods. The marginal worker is directed away from car sales and towards a job in the car factory; the proverbial corn seed will go into the ground instead of being eaten.

Scarcity is the fundamental starting point of all economics, and its most important implication is the notion that everything has an opportunity cost. In the capital market, the opportunity cost of capital is forgone consumption, and the opportunity cost of consumption is forgone capital investment. The interest rate is the price that regulates this relationship: as people demand more investments, the interest rate rises, incentivizing more savers to set aside more of their money for savings. As the interest rate drops, it incentivizes investors to engage in more investments, and to invest in more technologically advanced methods of production with a longer time horizon. A lower interest rate, then, allows for the engagement of methods of production that are longer and more productive: society moves from fishing with rods to fishing with oil-powered large boats.

As an economy advances and becomes increasingly sophisticated, the connection between physical capital and the loanable funds market does not change in reality, but it does get obfuscated in the minds of people. A modern economy with a central bank is built on ignoring this fundamental trade-off and assuming that banks can finance investment with new money without consumers having to forego consumption. The link between savings and loanable funds is severed, to the point where it is not even taught in the economics textbooks any more1, let alone the disastrous consequences of ignoring it.

As the central bank manages the money supply and interest rate, there will inevitably be a discrepancy between savings and loanable funds. Central banks are generally trying to spur economic growth and investment, and to increase consumption, so they tend to increase the money supply and lower interest rate, resulting in a larger quantity of loanable funds than savings. At these artificially low interest rates, businesses take on more debt to start projects than savers put aside to finance these investments. In other words, the value of consumption deferred is less than the value of the capital borrowed. Without enough consumption deferred, there will not be enough capital, land, and labor resources diverted away from consumption goods towards higher-order capital goods at the earliest stages of production. There is no free lunch, after all, and if consumers save less, there will have to be less capital available for investors. Creating new pieces of paper and digital entries to paper over the deficiency in savings does not magically increase society's physical capital stock, it only devalues the existing money supply and distorts prices.

This shortage of capital is not apparent immediately, since banks and the central bank can issue enough money for the borrowers - that is, after all, the main perk of using unsound money. In an economy with sound money, such manipulation of the price of capital would be impossible: as soon as the interest rate is set artificially low, the short age in savings at banks reflects into reduced capital available for borrowers, leading to a rise in the interest rate, which reduces demand for loans, and raises the supply of savings, until the two match.

Unsound money makes such manipulation possible, but only for a short while, of course, as reality cannot be deceived forever. The artificially low interest rates, and the excess printed money, deceive the producers into engaging in production process requiring more capital resources than is actually available. The excess money, backed by no actual deferred consumption, initially makes more producers borrow, operating under the delusion that the money will allow them to buy all the capital goods necessary for their production process. As more and more producers are bidding for fewer capital goods and resources than they expect there to be, the natural outcome is a rise in the price of the capital goods during the production process. This is the point at which the manipulation is exposed, leading to the simultaneous collapse of several capital investments which suddenly become unprofitable at the new capital good prices, these projects are what Mises termed malinvestments - investments that would not have been undertaken without the distortions in the capital market, and whose completion is not possible once the misallocations are exposed. The central bank's intervention in the capital market allows for more projects to be undertaken because of the distortion of prices that causes investors to miscalculate, but the central bank's intervention cannot increase the amount of actual capital available. So these extra projects are not completed and become an unnecessary waste of capital. The suspension of these projects at the same time causes a rise in unemployment across the economy. This economy-wide simultaneous failure of overextended businesses is what is referred to as a recession.

Only with an understanding of the capital structure and how interest rate manipulation destroys the incentive for capital accumulation can one understand the causes of recessions and the swings of the business cycle. The business cycle is the natural result of the manipulation of the interest rate distorting the market for capital by making investors imagine they can attain more capital than is available with the unsound money they have been given by the banks. Contrary to Keynesian animist mythology, business cycles are not mystic phenomena caused by flagging "animal spirits" whose cause is to be ignored as central bankers seek to try to engineer recovery. Economic logic clearly shows how recessions are the inevitable outcome of interest rate manipulation in the same way shortages are the inevitable outcome of price ceilings.

An analogy can be borrowed from Mises's work (and embellished) to illustrate the point: imagine the capital stock of a society as building bricks, and the central bank as a contractor responsible for constructing them into houses. Each house requires 10,000 bricks to construct, and the developer is looking for a contractor who will be able to build 100 houses, requiring a total of 1 million. But a Keynesian contractor, eager to win the contract, realizes his chances of winning the contract will be enhanced if he can submit a tender promising to build 120 of the same house while only requiring 800,000 bricks. This is the equivalent of the interest rate manipulation: it reduces the supply of capital, while increasing the demand for it. In reality, the 120 houses will require 1.2 million bricks, but there are only 800,000 available. The 800,000 bricks are sufficient to begin the construction of the 120 houses, but they are not sufficient to complete them. As the construction begins, the developer is very happy to see 20% more houses for 80% of the cost, thanks to the wonders of Keynesian engineering, which leads him to spend the 20% of the cost he saved on buying himself a new yacht. But the ruse cannot last, as it will eventually become apparent that the houses cannot be completed, and the construction must come to a halt. Not only has the contractor failed to deliver 120 houses, he will have failed to deliver any houses whatsoever, and instead, he's left the developer with 120 half-houses, effectively useless piles of bricks with no roofs. The contractor's ruse reduced the capital spent by the developer, and resulted in the construction of fewer houses than would have been possible with accurate price signals. The developer would have had 100 houses if he went with an honest contractor. By going with a Keynesian contractor who distorts the numbers, the developer continues to waste his capital for as long as the capital is being allocated on a plan with no basis in reality. If the contractor realizes the mistake early on, the capital wasted on starting 120 houses might be very little, and a new contractor is able to take the remaining bricks and use them to produce 90 houses. If the developer remains ignorant of the reality until the capital runs out, he will only have 120 unfinished homes that are worthless, as nobody will pay to live in a roofless house.

When the central bank manipulates the interest rate lower than the market clearing price by directing banks to create more money by lending, they are at once reducing the amount of savings available in society, and increasing the quantity demanded by borrowers, while also directing the borrowed capital towards projects which cannot be completed. Hence, the more unsound the form of money, and the easier it is for central banks to manipulate interest rates, the more severe the business cycles are. Monetary history testifies to how much more severe business cycles and recessions are when the money supply is manipulated than when it isn't.

** End of Excerpt**