Interest Rates and Business Cycles

The cause of the business cycle has long been debated by professional economists. Recurring successions of boom and bust have also mystified the lay person. Many questions persist. Are recessions caused by underconsumption as the Keynesians would have us believe? If so, what causes masses of people to quit spending all at the same time? Or are recessions caused by too little money in the economy, as the monetarists teach? And how do we know how much money is too much or too little? Perhaps more importantly, are periodic recessions an inevitable consequence of a capitalist economy? Must we accept the horrors associated with recessions and depressions as a necessary part of living in a highly industrialized society?

Concerns about aggregate money supply levels and aggregate spending might make for interesting conversation, and a discussion of these matters might even reveal certain threads of truth, but they are inadequate in arriving at the cause of the boom and bust cycle that seems to pervade the economy in modern times. Economists in the Austrian school of thought have provided an explanation that bases economic fluctuations on microeconomic theory that is firmly grounded in principles of human action. These economists have pointed out that macroeconomic fluctuations, or what have come to be known as business cycles, are caused by extraneous manipulations of interestrates in the economy.[1] This manipulation of interest rates might entail conscious actions by governmental authorities or merely the result of governmental actions taken with other goals in mind...

Changes in the supply of money in the economy do have an effect on real economic activity. This effect works through the medium of interest rates in causing fluctuations in business activity. When fiat money is provided to the market in the form of credit expansion through the banking system, business firms erroneously view this as an increase in the supply of capital. Due to the decreased interest rate in the loan market brought about by the fictitious “increase” in capital, businesses increase their investments in long-range projects that appear profitable. In addition, other factors as well can cause a discrepancy between the natural rate of interest and the rate which is paid in the loan market. Government policies with regard to debt creation, monetization, bank deposit guarantees, and taxation, can effectively externalize the risk associated with running budget deficits, thus artificially lowering loan rates in the market.

Either of these two influences on interest rates, or a combination of the two, can and do influence economic activity by inducing businesses to make investments that would otherwise not be made. Since real savings in the economy, however, do not increase due to these interventionist measures, the production structure is weakened and the business boom must ultimately give way to a bust.

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