What I deny is that the artificially stimulated investments have any tendency to become malinvestments. Supposedly, since the central bank’s inflation cannot continue indefinitely, it is eventually necessary to let interest rates rise back to the natural rate, which then reveals the underlying unprofitability of the artificially stimulated investments. The objection is simple: Given that interest rates are artificially and unsustainably low, why would any businessman make his profitability calculations based on the assumption that the low interest rates will prevail indefinitely? No, what would happen is that entrepreneurs would realize that interest rates are only temporarily low, and take this into account.
All one needs to do is look at the logic of a home buyer during the inflationary housing boom to see how the low rates caused malinvestment. As rates were artificially pushed down by the Fed, consumers were provided the opportunity to buy property on credit at apparently very low rates. As home buyers saw what they perceived to be a great buying opportunity, housing prices began to rise as more people entered the housing market looking to buy property on credit under the artificially low rates.
From a consumer perspective, housing looked like a great investment during the boom. They could obtain cheap money to buy a home that appreciated at a rapid rate, and then take out a home equity line of credit based on that appreciation to boot! All the mainstream media pundits were declaring that housing prices would rise forever and that it was a great time to buy!
How do you suppose businesses reacted to the changing consumer demand? Did they say, “well gosh, I know these rates are artificially low, so I’m not going to build any more houses.” ???? HELL NO! They saw consumers with access to a lot of cheap credit and they set about building more homes than the economy could support.
Can’t you see the flaw in your logic Caplan? Do you think entrepreneurs are going to forgo immediate profits because they think rates will rise at some indefinite point in the future? How long has the Fed held rates below market levels now? Decades? When are the rates going to rise? Do you think entrepreneurs are making their business decisions based on how the market will set rates? OF COURSE NOT! They are looking at what the Fed is going to do! Why do you think the market gyrates like a top every time Bernanke opens his mouth?
If entrepreneurs think Bernanke is going to keep rates low for a long long time, wouldn’t that impact how they go about their business?