A lot of people are unclear on the concept of "malinvestment."
I'd like to start with an expanded version of a response I posted earlier in order to try and clarify the concept. Intelligent comments and constructive criticism appreciated.
Begin by considering two concepts:
The value of a prices, no pun intended, is that they provide signals to market participants: when, where, in what quantity, and towards what ends should investments be directed. These signals are valuable information that market participants use in directing the resources at their disposal, whether they be cash, credit, finished products, works-in-progress, etc. Any interference with prices, therefore sends inaccurate signals to investors, entrepreneurs, consumers, borrowers, and lenders.
When money is injected into the system, it causes prices to change without a corresponding change in time preference which would be necessary to meet the "demand" contrived by the inflation. The takeaway here is that if time preferences haven't changed, fiat injections cause a disconnect between prices and time preference.
New money, especially fiat money, typically manifests itself as demand for consumption goods. Keeping in mind that "consumption" is just a polite and roundabout way of saying that you're destroying something valuable, since this consumption wasn't matched with a previous investment in productivity, it's likely to be a net value destroyer.
What happens when new money is introduced, is that demand appears to have increased, manifested by higher prices. These prices tell people "make more stuff", this is how it works: People see a higher price being paid for certain goods, and this appears to indicate that there is perhaps profit to be made in that market. Responding to the apparent signal, they begin now to overwork their assets, or perhaps to invest in assets that will enable them to be more productive tomorrow.
What has not changed is the present productive capacity.
Prices rose, however, because of the money; the higher prices being merely reflections of the increased money supply, and not of any fundamental change in consumer preferences. This money eventually works its way through the system, and people discover that they over-utilized their productive assets yesterday (and therefore can't produce as much today) or that they invested in assets in an attempt to match increase capacity to accommodate a phantom increase in demand. When this fact is eventually revealed, many investments are revealed as unprofitable and must be liquidated, and in either case we are worse off.
It requires previously accumulated capital (higher order goods) to facilitate the production of more consumer products (lower order goods) without depleting the existing capital stock. In order to have more today, it is imperative to have invested in productivity, made some sacrifice towards that end, yesterday.
This process does not work in reverse.
Without that previously accumulated capital, a boom/bust phase is inevitable.
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David Z
"The issue is always the same, the government or the market. There is no third solution."
Prashanth Perumal: What about this actually makes it an unsustainable boom? Or am I failing to find something obvious here?
What about this actually makes it an unsustainable boom? Or am I failing to find something obvious here?
Prices need to convey meaningful information about the relative availability of goods & services. By increasing the money supply (whether in the hands of a single individual or many), the resultant prices convey less-accurate information.
How do others in the economy respond?
etc.
hoffmanjohn:It is harder to expand the money supply during poor economic periods because member banks may sit on what they have instead of taking out a risky loan.
The problem is, that lowering interest cuts the profit motive for the lending. It also lessens the incentive for people to gt their money back to the bank for it to get circulating again. The notion that cutting interest will expand the money supply is absolutely invalid, and demonstrates how extremely short sighted theories get entrenched into our colective psyche
hoffmanjohn:For example population during the early stages of capitalism were perhaps one of the causes for the great inflations of that era.
What kind of inflation are you talking about. Do you have any specific information from back there, or are you just validating rumor by repeating it.
Austroglide:I'm confused as to what "investment in higher-order industries" means.
Goods for the production of goods for the production of goods ....
David Z:When money is injected into the system, it causes prices to change without a corresponding change in time preference which would be necessary to meet the "demand" contrived by the inflation. The takeaway here is that if time preferences haven't changed, fiat injections cause a disconnect between prices and time preference.
I don't get this. Can somebody explain this with an example?
David Z: People see a higher price being paid for certain goods, and this appears to indicate that there is perhaps profit to be made in that market. Responding to the apparent signal, they begin now to overwork their assets, or perhaps to invest in assets that will enable them to be more productive tomorrow. What has not changed is the present productive capacity.
People see a higher price being paid for certain goods, and this appears to indicate that there is perhaps profit to be made in that market. Responding to the apparent signal, they begin now to overwork their assets, or perhaps to invest in assets that will enable them to be more productive tomorrow.
I don't know where you got this from. Recessions are usually characterized by more roundabout methods of production. So productive capacity has in fact increased.
Prashanth Perumal:I don't get this. Can somebody explain this with an example?
Assume that the new money arrives at once and in the hands of a single individual.
Because he has the newly-created money, for any good/service he might buy, the total quantity that will be demanded has changed (if even only marginally), but the quantity of available goods and services has not increased. This individual now has the ability to pay more than the previously prevailing market prices, which in-fact he (or someone else) must do, in order to effect their individual demand.
Prashanth Perumal:Recessions are usually characterized by...
In the passage of mine which you quote, I'm talking about booms, not recessions. The recession happens as the malinvestments of the boom phase are discovered/revealed.
Lee Kelly:And what if money is injected into the system as a consequence of a changing time preference?
Although a change in time preference (collective or otherwise) may influence interest rates (i.e., price of future consumption/present consumption), it doesn't augment the money supply.
David Z: Assume that the new money arrives at once and in the hands of a single individual. Because he has the newly-created money, for any good/service he might buy, the total quantity that will be demanded has changed (if even only marginally), but the quantity of available goods and services has not increased. This individual now has the ability to pay more than the previously prevailing market prices, which in-fact he (or someone else) must do, in order to effect their individual demand.
When the new money enters into the hands of a single individual, he will be able to get more goods than otherwise would since prices are yet to adjust to the new quantity of money in the economy. In short, resources are redistributed.
David Z:In the passage of mine which you quote, I'm talking about booms, not recessions. The recession happens as the malinvestments of the boom phase are discovered/revealed.
The boom period is when these round-about methods of production are carried out, no? Basically society is made to save forcefully, which will increase investments.
Prashanth Perumal:The boom period is when these round-about methods of production are carried out, no? Basically society is made to save forcefully, which will increase investments.
It is precisely because during the boom period (to be exact, before the boom period) the methods of production ought to have been lengthened into more roundabout modes. They were not.
Had the "growth" been one of generally increased production rather than one of increased quantity demanded, prices would've fallen rather than risen, and the benefit of that organic growth would've been dispersed. However, because the "growth" is phony, the result of the increase MS which fuels quantity demanded, this is not the case, and there is redistribution of wealth etc.
David Z:Although a change in time preference (collective or otherwise) may influence interest rates (i.e., price of future consumption/present consumption), it doesn't augment the money supply.
If people start spending less on consumption, and banks start expanding credit proportionately, will malinvestment follow?
Lee Kelly:If people start spending less on consumption, and banks start expanding credit proportionately, will malinvestment follow?
No. When you spend less on present consumption and save more for the future (capital investment) what you are doing is this: deferring some fraction of your consumption immediately, in favor of more consumption in the future.
So when people begin spending less money, factors currently or previously devoted to immediate production can be re-purposed and re-allocated towards a more roundabout (lengthier) productive process with greater yield.
On the contrary, when you have all the factors running at or very near full capacity (during an inflationary boom), and people start spending more and investing less, what happens is that not enough is saved to sustain the same level of consumption. People want more, and they want it now. Well, where can they get it from? Above, we saw how you can defer present consumption, but this is clearly out-of-the-question if unemployment is low and resources are generally not idle. They can't "borrow from the future" in order to sustain consumption today, can they? Of course not; eventually this is revealed as systemic error.
David Z:No. When you spend less on present consumption and save more for the future (capital investment) what you are doing is this: deferring some fraction of your consumption immediately, in favor of more consumption in the future.
So if monetary expansion via credit markets is offset by a reduction in present consumption, systemic malinvestment will not be the consequence?
That's basically the position of free bankers.
I suggest that since the bust, spending on present consumption has declined significantly. Do you think the Fed's recent monetary policy since then has been appropriate?
Note: please understand that I would rather not have a central bank at all, but since we are stuck with one, there is presumably a least bad monetary policy.