Savings and Investment (4) - Three Classes

When the central bank sets interest rates artificially low, a credit fed boom will follow, as households reducing saving and make more purchases using credit. Assets rise in price as the cost of borrowing declines. When the credit-fuelled boom comes to an end, businesses can be classified into three categories.

A) Some businesses will have expanded to be far larger than they would be if interest rates had been determined in a free market economy.

B) New business will have emerged that would not exist were it not for low interest rates and the credit-led boom. Their aggressive growth often fuels the boom.

C) Some businesses that would be economic in normal times will have shrunk after being squeezed out by other businesses chasing the boom. Hopefully this is still the largest category.

This suboptimal situation cannot continue indefinitely. It reflects the dislocation of the economy caused by artificially low interest rates. To correct this situation, households will begin cutting back on their purchases, and saving hard to reduce their exposure to debt. Businesses in categories A and B that have been selling to people on credit will have to stop producing stuff that is no longer needed. As they cut back production, staff will be laid off, increasing unemployment and further reducing the demand for goods services.

Mainline economics says that best solution is for the government to increase expenditure to keep businesses in category A and B operating at their current levels. Businesses in category C will be unable to meet the demand for what they are producing.

For the economy to operate in an optimal way, free from distortions caused by government intervention, we really need businesses in category B to disappear and businesses in Category A to eliminate the production driven by the low interest rates. At the same time, we need businesses in category C to expand their production to the optimal level. Alternatively category A and B businesses could start producing the things produced by category C, if they could do it as efficiently.

The problem with the standard solution is that government expenditure leads to businesses just keeps businesses in category A and B doing what they were previously doing. That does not get the economy to the optimal situation. It may get businesses in category C producing more, but not enough, because they would still be getting squeezed out.

The solution proposed by mainline economist just perpetuates the problem. It may prevent short term economic decline, but it results in long term sub-optimal performance.