Business Cycles, Interest Rates, and Savings Rates: The Paradox

The inflation that has impacted the US economy over the last couple of years has really brought to the fore the effect that loose monetary policy can have on the economy. As money supply figures shot up in the aftermath of the federal government’s stimulus spending and the Federal Reserve’s balance sheet expansion, inflation followed. And it shows no signs of abating anytime soon.

But while inflation is the public face of loose monetary policy, it’s the other effects of that monetary policy that are more subtle and hidden that could actually be more damaging. Let’s take a look at some of them.

Monetary Policy and Malinvestment

According to the Austrian theory of the business cycle, monetary policy induces real changes in the economy due to its manipulation of interest rates. Interest rates are the most important prices in the economy, as they coordinate the flow of funds from savers and investors to borrowers.

The higher interest rates are, the more expensive it is to borrow money, and the lower interest rates are, the less expensive it is to borrow money.

When interest rates increase, it incentivizes savings, since savers can now make more by saving their money. When interest rates decrease, it disincentivizes savings, as there’s no real reason not to spend that money.

For borrowers, lower interest rates encourage borrowing and higher rates discourage borrowing. Lower interest rates make long-term and more capital-intensive projects cheaper to finance. Something that might not be profitable at a 6% interest rate might all of sudden become feasible at a 3% interest rate.

When the Federal Reserve manipulates interest rates through its monetary policy, it is signaling to borrowers. When it pushes interest rates lower, it is flashing a big signal that says “BORROW MONEY NOW!!!”

What happens is that borrowers take on larger debt loads to fund their projects. But when their projects come to fruition, there’s no demand for them because the lower interest rates weren’t the result of people deferring spending and saving their money, but through injections of credit from the central bank. Consumers spent their money long ago, and they don’t have the spending power anymore to buy things.

When this happens, it results in the bust part of the boom and bust cycle. Interest rates that were manipulated caused resources to be malinvested in sectors of the economy that didn’t actually satisfy consumers’ wishes. Once that becomes apparent, those resources have to be liquidated and put to better use elsewhere. This is where we see businesses laying off workers, houses going unsold, and cars piling up on dealership lots. Once the malinvested resources have been cleared, then the economy can start returning to normal.

There’s a great deal more to read about when it comes to Austrian business cycle theory, but as interesting as malinvestment and business cycle theory are, there’s one issue affecting households today that is quite concerning.

Why Aren’t People Saving?

Austrian business cycle theory tends to focus on how monetary policy affects businesses, hence “business cycle.” But what about individuals and households? How does loose monetary policy affect consumer behavior?

We know that low interest rates disincentivize saving and incentivize spending. And after decades of low interest rates, perhaps we’ve come to expect that spending as normal. But now interest rates are rising, and have been for some time. Yet savings rates aren’t rising along with them. Why not?

You would expect that with interest rates on Treasury bills rising to over 5%, more people would save money. And while the personal savings rate has started to finally eke upwards in recent months, it fell precipitously from around 26% in February of 2021 to under 3% in June of 2022. Even accounting for the ending of stimulus payments, the current personal savings rate of 4.7% is the lowest that it’s been since August of 2009.

Ironically, as the Federal Reserve began to raise interest rates from 2004 to 2006, the personal savings rate fell, from 4.9% in January of 2004 to 2,8% in November of 2007. Then the savings rate climbed, pulling to 5.6% in September of 2009 and never dropping lower than that until January of 2022, despite a decade of near-zero interest rates. And now the personal savings rate has fallen again, once again as interest rates are rising.

How bizarre is it that households seem to be doing exactly the opposite of what you would expect them to do, decreasing their savings when interest rates rise and increasing their savings when interest rates are low? It seems completely backwards, but it begins to make sense when you think of how manipulating interest rates can affect behavior.

After all, if businesses are getting things backward and investing in capital-intensive projects when economic conditions aren’t favorable, because they’re getting the wrong signal from interest rates, wouldn’t you expect households to make mistakes too? Maybe they’re getting the signal from rising interest rates that the economy is red hot and they need to spend, and from falling interest rates that the economy is in trouble and they need to conserve resources?

Who knows why they’re doing it, it just is the case that they are doing it. And it’s yet another example of how monetary intervention distorts patterns of consumption, savings, and economic behavior.

What to Do?

So what, you may be asking, how does this impact me?

Well, for starters, if you’re one of those people who hasn’t been taking advantage of higher interest rates to save money, or at least to help protect yourself against inflation, maybe you want to take a second look at what you’re doing. Whether you buy Treasury bills, sock your money away in retirement savings, or buy gold and silver, higher interest rates are supposed to be an incentive to higher savings.

Secondly, there’s at least some truth to the saying that if everyone is doing one thing, do the opposite. When everyone is jumping on the bandwagon, maybe that’s the time to get off. And when everyone rushes to the exits, that’s often when it makes sense to jump in.

Right now the dominant narrative seems to be that the economy is doing well, so keep on spending, even if that narrative is belied by economic data that suggests otherwise. So if everyone else is spending money and drawing down their savings, maybe it’s best to do the opposite. After all, if the economy enters recession this year you’re going to want to make sure that you have plenty of savings stored up to ride things out.