Volume 15, Number 4 (Winter 2012)
Austrian business cycle theory (ABCT) has focused on the effect of interest rates set below the natural rate, leading to unwarranted attempts by businessmen to make more elaborate roundabout structures than can be completed by the available foregone consumption. This distorting effect is the main theme of the Austrian capital-based theory of the trade cycle.
But interest rates pushed below the natural rate can have another serious damaging effect. They can distort the appreciation of risk. Austrian economists have claimed that interest rates include a risk premium in addition to valuing future over present consumption. It follows that interest rates below the natural rate can create an unwarranted bullishness that leads to systemic “appraisal optimism.” Error prone “marginal entrepreneurs” receive resources which would not have been available to them in ordinary circumstances.
This mistaken optimism leads to reductions in precautionary assets or “reserve assets” (to use Ludwig Lachmann’s term), which businesses hold against untoward events. The reduction in precautionary assets helps explain how production is possible above the sustainable production frontier (SPF) for lengthy periods during the boom.
The quantity of precautionary assets also explains to what degree businessmen select projects which are risky or time consuming. For any given, the quantity of precautionary assets determines whether businessmen will make more risky or more time consuming investments.
