Rate Cuts and Profitability / Artikel mises.org

verfasst von - Elli -, 07.07.2003, 17:02

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<font color="#002864" size="1" face="Verdana">http://www.mises.org/fullstory.asp?control=1260</font>
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<font face="Verdana" size="2"><font color="#002864" size="5"><strong>Rate Cuts and Profitability</strong></font>
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<font size="4">by Richard C.B. Johnsson</font>




[Posted July<span class="200533612-07072003"><font color="#000080">&nbsp;</font><font color="#000000">7</font></span>,
2003]




[img][/img] We
have now seen yet another interest rate cut by the Federal Reserve, intended&nbsp;to
stimulate&nbsp;a recovery. However, you don't have to&nbsp;be a particularly
skeptical person to doubt that the rate cut will work this time—after all,
it is the 13^th&nbsp;cut in the last 2½ years.&nbsp;




The idea behind the cuts is more or less that by forcibly lowering the
interest rates, the costs of businesses and households will fall, consumption
and investment will commence, and profits will recover. But why hasn't it
worked the former 12 times? Is there something wrong with this idea? It is
tempting to say yes, since there are strong reasons to believe that this idea
involves a reversal of the causality. And as with all economic relationships,
such attempts are futile.&nbsp;




To illustrate that this idea hasn't worked out in the past, let us perform
a financial quiz:


<p align="left">QUIZ: What country is the text referring to?


<ul>
~
<div align="left">
14 months back in time:&nbsp;The central bank announced that
"prices will be stable," the decline in year-to-year domestic
wholesale prices"will become smaller" and that"the rate
of increase in consumer prices may virtually stop dwindling".
"In sum, [the] economy will probably continue to recover."
</div>
~
<div align="left">
<em>11 months back in time:</em>&nbsp;"Domestic wholesale prices
have now stopped declining but are likely to go down again. The
year-to-year increase in consumer prices will stay about zero as the
increase in cheap imports will exert downward pressures on consumer
prices, the so-called 'price destruction' phenomenon.""In sum,
while moderate economic recovery has been under way [the central bank]
lowered the official discount rate."&nbsp;
</div>
~
<div align="left">
8 months back in time:&nbsp;The"economic recovery has
paused […] despite expansionary forces that underlie the economy."
Furthermore,"prices are expected to continue a weak trend owing to
the weak economic recovery" and"the declining trend of
domestic wholesale prices is expected to persist while consumer prices
are also forecast to decrease somewhat year to year […].""n
these circumstances, […] considering the influence that an excessive
decline in prices may have on the economy," the central bank cut
rates again, this"expected to contribute to the sustainability of
economic recovery by stimulating demand […]."
</div>
~
<div align="left">
<em>5&nbsp;months back in time:&nbsp;</em>"[T]he pause in [the]
economic recovery continues' and 'prices are expected to remain
unchanged or decline marginally."
</div>
~ <em>Present time:</em>"I am often asked, both in and outside [the
country], whether continued recovery is assured, and how much possibility
there is of the recovery running out of steam, especially since the […]
economy stalled [last year] after barely starting a long-awaited recovery.
In fact, recovery this time has, up until now, been dependent mainly on
public investment and interest rate-sensitive housing investment; namely,
it has been supported by the effects of monetary and fiscal policies. Thus,
the important question now is whether the current momentum of recovery
will gather further strength and stimulate private demand such as business
fixed investment and personal consumption. In light of the following
factors, we at the Bank believe that compared to [last year], there is a
far smaller risk that the recovery will be disrupted."</li>
</ul>


Can you name the country? Does the scenario sound familiar? Where are these
words found? Is it from the latest the Federal Reserve speech about the U.S.
economy? The ECB about the European? The Bundesbank about the German economy
or the Riksbank about the Swedish?&nbsp;




No, the"present time" of the quiz happens to be April 1996, when
the Governor of Bank of Japan (BoJ) in a speech addressed the recent economic
development in Japan of that time, and the earlier quotes are from the BoJ[i]&nbsp;Quarterly
Economic Outlook for 1995.&nbsp;




BoJ had just lowered the interest rate to a record low level and in the
speech he was assuring the public that everything was going according to the
plans, despite the fact that he openly admits that the rate cuts hadn't been
effective. After all, had the rate cuts been effective, the speech wouldn't
have been about the risk of"running out of steam" or the small
"risk that the recovery will be disrupted," would it?




The main tool BoJ used to try to force the economy to recover was cutting
interest rates. Now, cutting interest rates clearly hasn't worked out in the
past in Japan. After all, the BoJ rates are at 0.1%, i.e. almost zero, without
profits recovering. And now the Federal Reserve rate is at 1.0% and the ECB
rate is at 2%.&nbsp;These are&nbsp;almost desperate attempts to make things
work out according to the central bank planning.&nbsp;




But what exactly is wrong with the idea behind the rate cuts? In what way
could it be said to involve a reversal of causality?




In his 1912 <em>The Theory of Money and Credit</em>,&nbsp;Austrian
economist Ludwig von Mises (1881-1973) elaborated on an idea about interest
rates that was originally developed by Swedish economist Knut Wicksell
(1851-1926). According to this idea, by setting the rate of interest at a
level diverging from the 'natural rate of interest', this could in the end
have real effects<a title href="http://www.mises.org/fullstory.asp?control=1260#_edn1" name="_ednref1"></a>.
For example, according to Wicksell, by setting the rate of interest below the
natural rate, this could cause prices to rise in a non-neutral way, thereby
providing a short-run interpretation to the quantity theory of money. With his
book, Mises laid the foundation to what later has been referred to as the
Austrian Business Cycle Theory.&nbsp;




The most common"Austrian" explanation to what the natural rate
actually should be is that it is connected to time preference. It is the rate
that would be established in a free market where individuals make judgments
over how much to consume today as opposed to investing today in order to be
able to consume tomorrow.&nbsp;




By forcibly keeping the interest rates below the natural rate, investment
activities commence that would otherwise not have been started, i.e.
malinvestment occurs, at the expense of current consumption. As champions of
the free economy,"Austrians" consistently oppose all kinds of
government intervention, including government money creation and interest rate
manipulations.<a title href="http://www.mises.org/fullstory.asp?control=1260#_edn2" name="_ednref2">[ii]</a>




Let's see how Mises's ideas could provide support for the claim that
cutting interest rates to force profits to recover&nbsp;involves a reversal of
the causality.&nbsp;To do this we might have a look into the ideas that were
around when Mises first formed his ideas. For example, Adam Smith
(1723-1790) noted that"[t]he interest&nbsp;[rate] of money is always a
derivative revenue […] paid from the profit that is made by the use of money
[…]." He thus claimed that the rate of interest was determined by the
rate of profit. With this in mind he even tried to track the rate of profit
back in time by studying the official rates, for he was certain that"[n]o
law can reduce the common rate of interest below the lowest ordinary market
rate." In the same manner, David Ricardo (1772-1823) was considering
what was"the cause of the permanent variations in the rate of profit,
and the consequent permanent alterations in the rate of interest,"
clearly indication his view on the causal relation.<a title href="http://www.mises.org/fullstory.asp?control=1260#_edn3" name="_ednref3">[iii]</a>




However, Smith was only partly right in asserting that no law [i]per se&nbsp;could
keep the rate of interest below the rate of profit. In the shorter term, this
is indeed possible, as later Wicksell showed and&nbsp;as we just have
discussed. Wicksell later asked himself if it would 'at all be possible for
the banks to keep the rate of interest either higher or lower than its normal
level, prescribed by the simultaneous state of the average profit on capital?'<a title href="http://www.mises.org/fullstory.asp?control=1260#_edn4" name="_ednref4">[iv]</a>&nbsp;While
he provided a negative answer to this question, the interesting thing in this
context is that here we suddenly see that he referred to the natural rate as
equal to the average rate of profit<a title href="http://www.mises.org/fullstory.asp?control=1260#_edn5" name="_ednref5">[v]</a>.
After all, it seems&nbsp;as though&nbsp;Wicksell actually shared the same idea
as Smith and Ricardo.




But is this really any different from Mises's view? All of the economists
mentioned here could be said to agree that the interest rate is determined by
the natural rate of interest. But while the pre-Mises economists argued that
the natural rate was equal to the rate of profit, Mises himself claimed that
it was determined by the rate of the time preference. Who was right? Or were
all of them wrong? Well, for instance, the average rate of profit is more or
less observable, while the rate of the time preferences isn't. But that is
hardly a sufficient theoretical argument in favor of the former. However,
there might be a straightforward solution available.&nbsp;




That solution would be to say that the rate of profit is the natural
determinant of the rate of interest, while the time preference is a major
determinant of the rate of profit. In this way, the time preference is a major
determinant of the rate of interest, however only in an indirect way, via the
rate of profit.<a title href="http://www.mises.org/fullstory.asp?control=1260#_edn6" name="_ednref6">[vi]</a>&nbsp;And
consequently, we could say that all the great economists mentioned here are in
agreement over the causal relationship between time preference, profit and
interest.&nbsp;




Fed and other central banks are not succeeding in their attempts to force
the respective economies to recover simply because they are acting on ideas
that have reversed the causal relation between the rate of interest and the
rate of profit. The rate of profit is the natural determinant of the rate
of interest, not the other way around.&nbsp;On this there seems to be full
agreement among economists like&nbsp;Adam Smith, David Ricardo, Knut Wicksell
and Ludwig von Mises—a pretty impressive line-up with some pretty impressive
arguments.&nbsp;




In order for profitability to recover, it is essential that we let profits
and the economy recover on their own. All attempts to the contrary will be
futile<a title href="http://www.mises.org/fullstory.asp?control=1260#_edn7" name="_ednref7">[vii]</a>.
If the economy is left on its own, profits will recover because the springs of
profitability are inherent. And remember, from an economy-wide perspective,
"a low rate of profit actually works to encourage more capital investment
than less"<a title href="http://www.mises.org/fullstory.asp?control=1260#_edn8" name="_ednref8">[viii]</a>.


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Richard C.B. Johnsson works at&nbsp;The
Ratio Institute&nbsp;in Stockholm, Sweden. He earned a Ph.D. in economics
in March 2003 at the University of Uppsala, Sweden, after successfully
defending a thesis that included the construction and application of a
Computable General Equilibrium (CGE) model. See also his article&nbsp;Deflation
- Some Classical Lessons from Japan&nbsp;and his&nbsp;The
Liquidity-Trap Myth. Contact author at&nbsp;richard.johnsson@ratio.se
or visit&nbsp;his personal website.<br clear="all">



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<div id="edn1">


<a title href="http://www.mises.org/fullstory.asp?control=1260#_ednref1" name="_edn1"></a>&nbsp;He
propounded this idea in his [i]Interest and Prices&nbsp;from 1898,
calling it the ‘cumulative process’. Incidentally, he found much of
his ideas in the works of Austrian economist Eugen von Böhm-Bawerk’s
(1851-1914) Capital and Interest.


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<div id="edn2">


<a title href="http://www.mises.org/fullstory.asp?control=1260#_ednref2" name="_edn2">[ii]</a>&nbsp;Interestingly,&nbsp;Mises
wrote that “t is not possible to determine Wicksell’s natural rate
of interest.”&nbsp;See&nbsp;[i]On the manipulation of money and credit.
1978. P. 157.


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<div id="edn3">


<a title href="http://www.mises.org/fullstory.asp?control=1260#_ednref3" name="_edn3">[iii]</a>&nbsp;See
Smith’s The&nbsp;Wealth of Nations, Bk.I, Ch.VI, Bk.I,
Ch.IX and Bk.II, Ch.IV, Pt.II and Ricardo’s <em>Principles of Political
Economy and Taxation. </em>1911.&nbsp;Ch.VI.


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<div id="edn4">


<a title href="http://www.mises.org/fullstory.asp?control=1260#_ednref4" name="_edn4">[iv]</a>&nbsp;See
his essay The Influence of the Rate of Interest on Prices, Economic
Journal XVII (1907), pp. 213-220.


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<div id="edn5">


<a title href="http://www.mises.org/fullstory.asp?control=1260#_ednref5" name="_edn5">[v]</a>&nbsp;Although
he for some reason called it the normal rate.


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<div id="edn6">


<a title href="http://www.mises.org/fullstory.asp?control=1260#_ednref6" name="_edn6">[vi]</a>&nbsp;This
is a feature of economist George Reisman’s Net Consumption and Net
Investment Theory. See his 1996 book Capitalism:
A Treatise on Economics, Ch. 16.


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<div id="edn7">


<a title href="http://www.mises.org/fullstory.asp?control=1260#_ednref7" name="_edn7">[vii]</a>&nbsp;The
current rate cuts are thus not likely to raise overall profits in any
lasting way. However, if profits actually were to rise in the near future,
it would be despite the rate cuts. Sure, the statistical relation&nbsp;would
look pretty from the rate cutter’s perspective. But the plausible causal
relation still is that the rate of profit determines the rate of
interest, not the other way around. We would then have to find another
cause for the rising profits; a cause strong enough to counter the rate
cuts. But that’s another story.


</div>
<div id="edn8">


<a title href="http://www.mises.org/fullstory.asp?control=1260#_ednref8" name="_edn8">[viii]</a><font size="2">&nbsp;For
more on these last points, see George Reisman’s book Capitalism:
A Treatise on Economics, Ch.16, pp. 778.


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