Bad Signals

Bad Signals
by Mark Anderson, Columnist

June 27, 2002

Nobody does a better job at brainwashing rank and file conservatives than the neo-conservatives and neo-libertarians. Most people believe that interest rates are some huge market signal, that lower interest rates mean prosperity and, conversely, higher interest rates are bad.

That, however, is not true. Not only is it overly simplified, but also the interest rate is simply the overt price for credit expansion. Credit expansion involves other more obscure prices in itself. Particularly, credit expansion distorts market activity, leading to mal-investments; this becomes a very burdensome cost when the sun sets. How much longer will we bow down at the altar of interest rates?

The first recipients of the new credit are the first group of investors that become misled. As this new pseudo money created through credit expansion reaches its first recipients, these recipients receive a very misleading signal. Like a youth deliriously happy over receiving candy, these recipients believe that something truly remarkable happened as their "profits" seemingly soared. But lest we forget that new fiat money, created out of thin air, is nothing to be excited about.

The first recipients, who appear to have made a substantial gain as prices have not begun to rise, see this as a signal that the economy is moving upwards. This false assumption rests squarely on the misnomer that everybody else is now suddenly prosperous. This is where the old axiom that inflation redistributes wealth must be remembered. For this apparent gain by the first recipient, is another's loss. The last recipients suffer. I will cover the last group in a future article. The first recipients also suffer because of their decisions based on the idea that everybody else is better off. Truly, their calling has not yet come.

These first recipients, believing that the economy is moving upwards and demand for their service has increased, see fit to expand their enterprise, as their purchasing power has increased since prices have not yet shifted upwards.

There are two groups of goods. One of those groups is consumer goods. Consumer goods are the goods that satisfy our most urgent wants. These are also known as short order goods. These would include things like the clothes you wear, the food you eat, the computers you use, the televisions that you watch, and the cars you drive. The other group is capital goods. Capital goods are goods which are used to produce consumer goods. Some examples would be a printing press, or an auto manufacturing plant, etc. So capital goods or capital machinery do not satisfy our most urgent wants, but are used to satisfy, at some future time, our most urgent wants. These are called higher order goods.

The first recipients who misperceive this new credit as a positive signal end up expanding their enterprise by investing in capital machinery. The credit expansion completely distorts the decisions of its first recipients - as no expansion of business can truly be sustained. The credit expansion causes the first recipients to alter their time preferences by investing in higher order goods. This creates a disharmony between capital and consumer goods, it leaves investors with an excessive amount of capital machinery, and the very first of the investors end up with outdated machinery as well.

It is time that we stop paying homage to Alan Greenspan, the Fed and interest rates as though they constitute some sort of holy trinity. The mainstream interest rate doctrine is not some sort of scientific, holy writ. Higher interest rates are just what the doctor ordered. ***

Photo of the author courtesy of staff files