This primer reviews and explains the Austrian Economic concept of Intertemporal Disequilibrium and its implications for the economy.

1. Intertemporal Disequilibrium Primer
Brian Pellegrini, March 14, 2012
The Theory
In short, intertemporal disequilibrium is a misalignment between the investing plans of entrepreneurs
and spending plans of consumers across time. It is important to remember that, in real world
capitalism, action takes place in the context of time passing and new expectations forming as the
passage of time reveals new information. The relationship between consuming and investing is
governed by real interest rates. The rate that achieves equilibrium of consumption and investment
across time is called the “natural rate”. The natural rate is controlled by the weighted average return of
all the capital investments in the economy.
Disequilibrium develops when the actual rate of interest deviates from the natural rate for a long
enough period for expectations to change. In the attached notes Bernard explores this process in
detail. He covers the causes of the situation, the effectiveness (or lack thereof) of monetary policy in
addressing the problem and the implications for future economic developments.
Real World Observations
In the late 1990s the level of expected return on investment rose significantly with the introduction of
the internet and the reduction in IT costs. The Austrian response would be to match this expected
increase in the natural rate with an increase in the actual real rate. Because the Fed targets inflation
and there was no alarming increase in inflation (due to gains in productivity), rates did not increase.
Increasing rates would have kept the total level of investment constant, but would have shifted the mix
of investment into the higher return tech sectors, thus keeping the total stock of capital in the economy
at the base case. With the new higher productivity capital in place income would rise so, once the new
investments came online, the increase in the level of consumption would be justified.
In the real world, where rates did not rise, the total level of investment rose because the economy-wide
rate of return on investment had risen. This caused both the stock bubble and overinvestment in capital
which would eventually create an oversupply problem. The supply comes online at some point in the
future. Moreover, the increase in demand from investment caused consumers to perceive inflated
expected future income. They took advantage of low interest rates and high expected income growth to
borrow consumption from the future for use today. It is important to remember that initially investment
does not create supply, but rather demand. When new supply comes online the balance between
supply and demand swings dramatically to a state of oversupply.
When the future arrived and oversupply was apparent, expected return on investment fell and the tech
bubble popped causing a market crash. The Fed’s response was to pull consumption and investment
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2. forward from the future by further reducing real rates. This caused overconsumption fueled by
imaginary gains from overinvestment in housing stock. Once rates began to rise, consumption and
investment stopped being brought forward from the future. Once again expected return on investment
fell as an oversupply developed again and we had an even larger market crash in 2008.
Thus we see the result of disequilibrium. The Fed must keep a Ponzi game going constantly bringing
consumption and investment forward by pushing interest rates lower and lower. Once real rates stop
going down (even if they are at a low level or even negative), the stock of capital is revealed as being too
high and a “liquidation” process – of the sort that produced the Great Depression in the early 1930s – is
set in motion.
* Connolly Insight, LP.
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