Banking and the Business Cycle

Banking and the Business Cycle

International Economic RelationsMetropolitan University PragueMartin Kolmhofer2012/2013

Are Business Cycles avoidable?

• Why is there a sudden general cluster of business errors?

• Individual entrepreneurial mistakes are normal

• Where do the peaks come from? Are they linked to a common cause?

Time Preferences• People usually value the present higher than

the future• Reasons: Shortness and uncertainty of life - it

takes imagination to visualize the future (people systematically underestimate future needs)

• Example: Soldiers before the battle

Time Preferences

• High Time Preference:

• Low Time Preference:

Time Preferences

• Capital (Def: factors of production that were created by people and enhance our

ability to produce output in the future ) comes from Savings

Capital-building requires:

• Sacrifices in the Present• Patience• Ability to Set Goals• Imagination (Future Scenarios)

Example: breeding cattle rather than eating it immediately

Time Preferences and Interest Rates

• Time preference determines propensity to save• People with a high time preference demand a

high compensation to delay current consumption• People with a low time preference demand a

relatively low compensation to delay current consumption

• This compensation is the INTEREST RATE (= “Price for Savings / Price for Time”)

Rate of Interest

• The interest rate links the future to the present. It allows individuals to evaluate the value today – the present value – of future income and cost. In essence, it is the market price of earlier availability.

Time Preferences and Interest Rates

• Example: People with a high time preference will only delay the consumption of 100 blueberries for a year if they get back 110 blueberries after one year. INTEREST RATE = 10 %

• People with a lower time preference would be willing to delay consumption for an additional 5 blueberries. INTEREST RATE = 5 %

Time Preferences and Interest Rates

Banks offer a higher interest rate and return to the depositor when there is certainty over the length of time that the bank can have access to the depositor's money to re-lend to other borrowers (and therefore make a profit)

Rate of Interest

Thought Experiment• Will rate of interest be high or low if:

1) Asteroid will hit the earth tomorrow? 2) New invention allows humans to live forever?

The Interest Rate Mechanism• Banks are in the ideal position to determine the best

interest rates to pay depositors and to charge borrowers:

• On the lending side they offer the lowest interest rate to the most secure borrowers (those with the highest ability to repay the loan)

• For less trustworthy borrowers they charge a higher rate to compensate for the added risk

The Interest Rate Mechanism• These loan rates then determine how much interest the

bank can pay depositors• Entire interest rate system fluctuates according to market

conditions. If there are a lot of savings (caused for example by productivity gains etc…) banks are willing to drop the rates charged on loans.

• With little need to attract new savings, such an environment would also lead to lower payments to depositors, which would discourage savings.

The Interest Rate Mechanism

• When there are few savings, banks have to be extra careful with loans.

• They charge higher rates to borrowers and offer higher rates to depositors to encourage more savings.

• Higher rates would discourage borrowing and slow business growth. But the higher rates also encourage savings. Eventually coffers would build up again and rates would then start to drop.

Natural Rate of Interest• This cyclical Interest Rate Mechanism

would produce a rate of interest that stabilizes the market = “Natural Rate of Interest”

• Knut Wicksell (1851 – 1926)

• The rate of interest at which the demand for funds and the supply of savings exactly agree

The Interest Rate Mechanism

• ECB Refinancing RateThe main refinancing rate or minimum bid rate is the interest rate which banks do have to pay when they borrow money from the ECB. Banks do so when they are short on liquidities. There is a strong response of interbank interest rates (like the Euribor) to changes in the ECB refinancing rate.

The Interest Rate Mechanism

• EURIBORThe Euro Interbank Offered Rate (Euribor) is the average interest rate atwhich 57 euro area banks are prepared to extend loans to each other in euro.

“Setting Interest Rates” - Price Fixing

• Credit expansion unsupported by savings• Credit expansion by the banks makes it appear

as if the supply of "saved funds" ready for investment has increased, for the effect is the same: the supply of funds for investment purposes increases, and the interest rate is lowered.

The interest rate as a signal for entrepreneurs

• The rate of interest tells entrepreneurs whether a particular investment is worth making or not.

• Low interest rate indicates that people have enough in the present and want to consume more in the future

• Entrepreneurs invest especially in “interest-rate sensitive“ sectors (i.e. housing…).

The interest rate as a signal for consumers

• Low interest rates make saving unattractive – encourage consumption

• So an artificially low interest rate gives contradictory signals to entrepreneurs and consumers:

• For consumers saving does not pay off anymore – entrepreneurs think that savings have increased

Consequence: Misallocation of resources

• Goods that come to the market cannot be purchased because the real savings are not available

• Ludwig von Mises (1881 – 1973)• Business Cycles as the inevitable

consequence of excessive growth in bank credit

Example “Out of Gas”

Example “Out of Gas”

• Driver = Entrepreneur• Gas = Sum of the resources available in the

economy• Trip across Desert = Period of Production• Passengers = Consumers• Air Conditioning = Present Consumption• Speed of Bus = Amount of Investment Spending

Goods that come to the market cannot be purchased because the real savings are not available.

Continued Credit Expansion?

Curing Hangover with Alcohol?

Continued Credit Expansion?

• Who can benfit? Who gets the money first?• New money is not distributed evenly (like a

helicopter spreading cash equally to all citizens)

• Those who get the money first benefit more than those who get the money last (the latter have to buy at an already increased price level)

“Hangover” Theory• Metaphor: The Central Bank’s job is to take away the

punch bowl once the “party gets going”. Otherwise, later at the party, it will become apparent that too many guys have planned on taking the same girl home.

• This means: There are too few resources available for all the plans to succeed. The most crucial – and most general – unavailable factor is a continuing flow of investment funds.

• Such a boom cannot be sustained indefinitely without eventual price inflation

End of the Boom

• Shoe-shine boy phenomenon:

• “When even shoeshine boys are giving you stock tips, it’s time to sell” (Joseph P. Kennedy)

End of the Boom – 2 Scenarios1. Inflation: Even if the banks wanted to, they could not

carry on with credit expansion indefinitely, not even if they were being forced to do so by the strongest pressure from outside. The continuing increase in the quantity of money leads to continual price increases. Inflation can continue only so long as the opinion persists that it will stop in the foreseeable future. However, once the conviction gains a foothold that the inflation will not come to a halt, then a panic breaks out.

2. Deflation: Central Bank has to raise interest rates to fight inflation. Liquidation of Bad Debt

Inflation benefits debtors, Deflation benfits holders of cash

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