Savings and Investment (3) - Producers

The second problem is that when interest rates were set artificially low by the central bank, producers took this as a signal to buy more capital goods. They have already purchased more capital goods than is required for a properly functioning economy. Just as households responded to low interest rates, by overspending on consumption goods, business responded by excessive spending on capital goods.

When demand for consumption goods declines and resources should be moving towards the production of capital goods, the demand for them also dries up, because businesses have already overspent on investment goods. Just when spare resources are freed up for the production of investment goods that would benefit the entire economy, businesses are trimming their investment plans to tidy up their balance sheets.

Fiddling with interest rates causes the relationship between consumption and production and saving investment get out of sync. The economy will go into recession, as demand for both consumption and capital goods declines at the same time.

This is the decline in aggregate demand that is dreaded by many modern economists. What they do not seem to understand is that the lack of demand is the consequence of the distortion caused by the actions of the central bank. Artificially low interest rates create excessive demand for consumption and capital goods that cannot be sustained. Something eventually has to give, and it hits both consumption and investment at the same time.

Modern economists advocate additional government spending to artificially stimulate demand, but this just perpetuates the dislocation of the economy.

Savings and Investment (2) - Consumers

Artificially low interest rate interest rates cause dislocation in the economy. Households respond by reducing saving and increasing consumption (for most households, a car and a home are consumption goods and not investment goods).

Big spending on consumption goods makes people feel good, but it cannot last forever. When interest rates go up again, personal debt becomes a burden and interest payments take an ever greater share of disposable incomes. Households are forced to reduce spending on consumption goods to get their balance sheets back in shape.

When the demand for consumption goods declines, businesses have to cut back on the production of consumer goods. Ideally, the resources that are no longer needed to produce consumer goods should be switched to the production of investment goods. If this does not happen, the economy will decline as the resources that previously produced consumers will be underemployed.

Unfortunately, two things have happened that make this shift in resources impossible. Firstly, there is no additional savings available to fund any new investment expenditure. Although households have reduced their expenditure on consumption, their surplus income does not go into savings. Most of it goes toward payment of interest. Any surplus not used on interest is not available to fund additional investment, because it must go towards repayment of debt. Although there has been a decline in consumption, there are not additional savings to fund the purchase of new investment goods.

Savings and Investment (1)

An interesting aspect of a free market economy is the way that savings are matched with investment. Decisions about saving and investment in capital processes are often made by different actors. Investment decisions are made by entrepreneurs and households. Savings decisions are made often made by people and households.

The link between these independent actors is the interest rate. When interest rates rise, people will save more. When interest rates fall, more potential projects become economic, so businesses and entrepreneurs invest more. In a free market, interest rates rise and fall to clear the market and ensure that savings are matched by equivalent investments.

Banks often act as intermediaries between savers and producers. Savers deposit their spare wealth with the bank and receive interest. Producers borrow from the bank to purchase capital goods to increase the productive capacity of their business. Their increased productivity improves living standards for everyone.

This all goes wrong when governments give their central banks authority to set interest rates. A central banker does not know the future, so he do not have enough information to set the interest rate. Following the dotcom crash in 2000, central banks pushed interest rates down, leading to the housing boom and following credit crunch.

Falling Prices (6) - Investment Strategy

If inflation stopped completely and prices began to decline slowly, investment strategies would also have to change dramatically. Buying an asset and just waiting for the capital gain would no longer be a feasible strategy. That would be a good thing for the economy, as investors would shift to assets that are actually productive.

Investment decisions would require real wisdom and prudence. Ownership of a house would not be viable unless it could be let out for a rental that covered all expenses and any decline in price. Most investors would have to switch to investments that produce something real and valuable.

Inflation has disrupted investment patterns in a very negative way. One of the reasons is that real incomes in the western world have not grown as much as we would like is that most savings (and massive imported savings) have been ploughed into residential dwellings. The problem is that residential dwellings do a produce a return that benefits the economy in turns of jobs and output.

If inflation disappeared, investment would flow into assets that are productive and produce goods and services that people are willing to purchase. Declining asset prices would push investors into more productive investments, which would be good for the economy. More productive investment would benefit society be increasing employment and wealth.