“If firms are optimistic then they will formulate investment plans and build capital and productive capacity reflecting their long-term expectations of a return,” Bill Mitchell has written.
So what causes a change in expectations of future returns?
It’s at this step that Austrians and MMTers part ways.
In the Keynesian tradition, Mitchell’s answer is “animal spirits.”
Austrians would say: “interest rates.”
This division is very interesting and deserves more explanation.
Austrians think interest rates drive boom and bust cycles. The first step in this is the idea that bank lending is constrained by savings. That is, banks can only lend out some multiple of their deposit and capital base limited by the reserve requirements. Bank lending is fractionally reserve-constrained.
In this kind of system, low interest rates are evidence of high savings and low consumption, which in turn indicates that consumers will be able to access unconsumed income in the future. In other words, falling interest rates indicate higher future capital.
In response to this, businesses lower investment in “lower-order goods”—that is, things closer to the retail consumer. They raise investment in “higher-order goods”—that is, longer-term projects that businessmen think will be profitable because of all that future spending or lending that is possible, thanks to the unconsumed income today.
When the central bank sets interest rates “artificially” low, this sends a false signal to the economy. It makes it seem as if savings are rising more than they are. Businesses react as if there will be unconsumed income available for consumption or further investment in the future, so they make investment in the longer-term projects. But it turns out that the unconsumed income needed to make those projects possible in the future just isn’t available.
The MMTers look at this as a quaint view of the economy.
“Look! You Austrian guys are worried about central bank manipulation—but you don’t know the half of it. It’s manipulation all the way down,” they could say.
The MMTers would say that the Austrian view of fractional reserve banking is not really applicable in this day and age. The activity that Murray Rothbard described as “making loans out of thin air” and regarded as a form of counterfeiting is actually much more pervasive than he understood.
In the modern day and age, banks lend without regard to their reserves. The loan officer never calls the Federal Reserve to check whether reserves are adequate. Instead, banks make loans just the way other businesses invest in long-term projects—with an eye to profit. That is, banks lend according to their view of the likelihood of making a profit based on the risk factors of borrowers and the risk-premium the bank can charge them. Those new bank loans create new deposits in the banking system.
Of course, bank loans do need to be financed in some way, because of the reserve requirements that banks must meet every other Wednesday. But a bank doesn’t need a depositor to drop by on Tuesday afternoon with a check or a new investor to arrive with a briefcase full of new capital. They can meet the reserve requirement by borrowing on the Fed Funds market. And there are always enough reserves to borrow because the bank created additional reserves by making the loan in the first place. In a pinch, they can borrow from the discount window of the Federal Reserve.
“Okay! Enough already! I get it,” the Austrian might reply. “Our banking system is even crazier than I imagined. What’s your point?”
The point is that interest rates no longer reflect savings rates. The interest rate signal is broken by the operations of the modern monetary system. Increases in savings don’t show up as falling interest rates, and decreases don’t show up as rising interest rates.
Both Austrians and MMTers acknowledge, it seems to me, that this results in calculational chaos. The economy can easily slip out of whack because businesses misread how much demand or supply of savings to spend there will be in the future. This means they tend either invest too little or too much at different places in the capital structure. It all really comes down to “animal spirits” because the old Austrian economy-predicting interest rate is gone, gone, gone.