Because Money Serves as the Link Connecting Savings and Investment Decisions, There Could Arise Imbalances in the Savings-Investment Process

In 1898, Wicksell published Interest and Prices. He adapted Böhm-Bawerk’s theory of capital and time-consuming processes of production and took it a step further. Wicksell explained that in actual markets, goods do not trade directly one for the other. Rather, money serves as the intermediary in all transactions, including the transfer of savings to potential borrowers and investors. Individuals save in the form of money income not spent on consumption. They then leave their money savings on deposit with banks, which serve as the financial intermediaries in the market’s intertemporal transactions.

Banks pool the money savings of numerous people and lend those savings to credit-worthy borrowers at the rates of interest that come to prevail in the market and that balance the supply of the savings with the investment demand for it. The borrowers then use the money savings to enter the market and demand the use of resources, capital, and labor by offering money prices for their purchase and hire. Thus, the decrease in the money demand and the lower prices for consumer goods due to savings — and the increased demand and the higher money prices for producer goods due to investment borrowing — act as the market’s method to shift and reallocate resources and labor from consumption purposes to capital-using production purposes.

But Wicksell pointed out that precisely because money served as the intermediary link in connecting savings decisions with investment decisions, there could result a peculiar and perverse imbalance in the savings-investment process. Suppose that the savings in the society was just sufficient to sustain the undertaking and completion of periods of production of one year in length. Now suppose that the government monetary authority in that society were to increase the amount of money available to the banks for lending purposes. To attract borrowers to take the additional lendable funds out of the market, the banks would lower the rates of interest at which they offered to lend to borrowers.

The lower market rates of interest due to the monetary expansion would raise the present value of investment projects with longer time-horizons until their completion. Now suppose that borrowers were consequently to undertake investment projects that involved a period of production of two years in length. Because of their increased money demands for resources and labor for two-year investment projects, some of the factors of production would be drawn away from one-year investment projects. As a result, at the end of the first year, fewer consumer goods would be available for sale to consumers. With fewer consumer goods on the market at the end of the first year, the prices of consumer goods would rise and consumers would have to cut back their purchases of consumer goods in the face of the higher prices. Consumers, Wicksell said, would be forced to save, i.e., they would have to consume less in the present and wait until the second year had passed and the two-year investment projects had been completed to have any greater supply of goods to buy and consume.

At the same time, the greater supply of money offered for resources and goods on the market would be tending to increase their prices and, as a consequence, the society would experience a general price inflation during this process. If the government monetary authority were to repeat its increase of the money supply time-period after time-period, there would be set in motion what Wicksell called an unending “cumulative process” of rising prices.

—Richard M. Ebeling, “The Austrian Theory of the Business Cycle,” in Monetary Central Planning and the State (Fairfax, VA: Future of Freedom Foundation, 2015), Kindle e-book.