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.
Snowflake:You're saying that investment = saving.
Yes, loan markets clear. Leave aside cases where banks get nervous and are more interested in holding reserves.
Snowflake:Also, its not investment/saving by the people who earned the money, its by you who didnt produce anything.
I am tired of this. I am not justifying credit expansion in any means. I am just seeing through the effects of credit expansion.
Prashanth Perumal:It doesn't matter. Consumers have lesser purchasing power now. So they really can't bid against businessmen who now have more purchasing power.
They're not necessarily bidding for the same resources at once. He needs fuel and finds that the fuel market has cleared, so he pays a little "extra" to get fuel. He needs machinery, but there is none not already in use, so he pays "extra" to buy it from someone else. He needs to hire employees he finds that the labor market has already cleared, he must offer someone "extra" to lure them away from their current employ.
All this "extra" is fraudulent. It seems we agree on this. (In fact, I'm not sure that we disagree on any of this...) These individuals or companies benefit in the short run at everyone else's expense.
Everything begins to cost more. But most people in most lines of work don't get a raise or a bonus. The "extra" is cannibalized mostly. The rest of the non-institutional individuals have less purchasing power; a standard indifference curve being phase-shifted leftwards. They now buy less, even though their bank balances haven't changed. Their consumption patterns change; where they previously bought a 34" television, maybe now only 27". Previously they bought meat from a deli, now from a grocery store, etc.
Now think of the businessman who bought the machinery from another, by paying a little "extra" with this new money. The other guy only sold it to him based on the then prevailing rates; he says, "I can do without a drill press for a few weeks if this guy will pay me an extra 10% over my cost, I'll just order a new one and ramp up production when it arrives..." But by the time it arrives, prices for the rest of his inputs have risen enough (or more) that the "extra 10%" is now revealed as illusory: there is no "extra"!. So we see capital decumulation/destruction and resource misallocation, or, malinvestment in the Austrian vernacular.
Prashanth Perumal:I am tired of this. I am not justifying credit expansion in any means. I am just seeing through the effects of credit expansion.
I am new to this forum although I've been reading mises.org for years.
I think the challenge for us is to make these issues more palatable to the average person with a short attention span. I just created a blog with this goal in mind http://austrianeconomicsinastory.blogspot.com/ There are only 2 posts up there so far but I hope to add to it as time permits. I think if we can get these issues into an interesting short story, summary, or antecdote we have a real shot of having a receptive audience. While it's certainly essential to have scholars doing the heavy lifting I think its important to find different ways to get these ideas to the masses.
The post below seemed relevent to this threads discussion and yes i know its not a short story, but most of the other posts will be.
http://freemarketeconomicsinastory.blogspot.com/
the higher prices being merely reflections of the increased money supply, and not of any fundamental change in consumer preferences. - This is an error. Not all prices will rise simultaneously, especially if the new funds are being 'targeted' to specific sectors of the economy. Thus you can create a 'housing boom' or a 'stock market bubble' etc, while many other prices remain fairly stable. It is the early receivers of the new money (often government) who direct the funds into specific sectors.
If you had a counterfeiting machine and used it to quadruple your income, would you necessarily use 4 times as much food, gas, water, electricity, etc. Or might the extra money ALL be funneled to other uses that you weren't already satisfying?
DavidZ,
the theory you have just described is very reasonable, but I believe it is not the Austrian Business Cycle Theory. (note it does not require the money to enter the system via the loan market, and does not mention interest rates; it works with ordinary prices).
it is really a mainstream theory called the "monetary misperception theory", illustrated e.g. in Landsburg's macro text. (where he says that for a few years in the seventies mainstream economists found it promising, then rejected because of some evidence I don't recall. Also Mankiw discussed it in a paper I don't recall.)
I have a question about Austrian business cycle theory. The main disagreement with it seems to be that low interest rates are not to be blamed for malinvestment. I was thinking about the criteria of a business failing the other day. A business does not fail when it makes a loss, but when it's rate of return is less than what investors could get by putting their money on the bank. But what you can get for putting your money in the bank is directly affected by interest rates, obviously. That means that when a central bank artificially lowers interest rates, a lot of businesses appear to be profitable, because their return is higher than just putting your money on the bank. Lowering interest rates also lowers the bar for when a business is to be considered profitable. It seems that lower interest rates per definition leads to malinvestment.
There are two important questions about business cycles that need to be answered. 1 - Why are there clusters of business errors occurring at the same time? 2 - Why do such events occur repetitively?
Lowering interest rates by expanding the money supply will lead to price inflation and push up interest rates. So the change in the rate is an unexpected occurrence. Long-term investments, like a skyscraper, cannot start earning revenue until they are completed, which has to divert resources from other sectors. At a high rate of interest, such projects are simply unattractive. Something that takes 10 years to complete might turn a profit after paying back debt in 5 years at one interest rate and 50 years at another. Once such investments are abandoned, they are difficult to liquidate. A half-finished coal mine isn't going to make a nice Starbucks. So then the banks that made the loans have to be more conservative in lending to absorb the loss, or go bankrupt. So basically these projects have to be stopped and the laborers and raw materials diverted back to maintaining and using the existing capital goods to produce consumer goods. This will lower input and consumer prices.
If interest rates are lowered via increased savings, this comes from lowered consumption purchases - so the profit rate is lowered for consumption good businesses. The rates for long-term capital goods projects' profit rates are raised, as they are designed to reduce production costs in the future, raising profit rates for consumer good businesses. Sure there are failures, and they might be greater in a low interest rate environment, but there is no cyclical nature in the macro-sense.
Check my blog, if you're a loser
(per the principle of revealed preference)
Doesn't Austrian Economics reject the idea of an indifference curve? Which is one of the things I actually disagree with the school about.
Yes, that sounds right, I'd specifically say the price that is distorted, relative to all other prices, is the interest rate, which is affected immediately upon money creation. It takes time before other prices in the economy rise therefore giving the immediate illusion to the borrower that a project he thinks he can afford will not be affordable as soon as prices realign to their former relationship to the price of money (the interest rate).
Another way of thinking about it is there are a certain amount of resources (don't think in money terms - think in terms of labor, machines, natural resources) that can be used for the production of present goods (gas in the car, food on the table) or can be used for future goods (investment in an agriculture company that creates 5x the yield of corn/rice) that eventually leads to more present goods sometime in the future - but in the present, there is a sacrifice of those resouces for greater future benefit.
Printing money does not change the amount of resources society has set aside for present v future use. It merely deludes the businessman into thinking there are more resources available for future use then there actually are.
For a fuller explanation see my blog post here: http://www.acceptancetake.com/the-unnoticed-evil-of-fractional-reserve-banking/.
I'd really appreciate feedback, critical and praiseworthy commentary is much appreciated.
I don't know about the Austrian school's position on indifference curves, but I'd guess that you'd be correct because indifference curves are cardinal instead of ordinal. In other words, a slight curved line is drawn out with specfic points 3.2 goods of A and 3.6 goods of B vs 4 goods of A 3.2 of B. If you could measure this indifference curve, that is you test every point for a single individual, then you could have, essentially, a cardinal curve, but barring some testing, all you could do is use is ordinal measurements. If I know, for example, that I'm perfectly satisfied with either 3.2 of A and 3.6 of B vs 4 of A and 3.2 of B, then all I can have is two dots on a graph - no line being connected - and say there two points bring me equal satisfaction.
If I know, for example, that I'm perfectly satisfied with either 3.2 of A and 3.6 of B vs 4 of A and 3.2 of B, then all I can have is two dots on a graph - no line being connected - and say there two points bring me equal satisfaction.
That's still cardinal. Ordinal values cannot be equal.
faber est suae quisque fortunae
((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.))
Here you assume that all savings is real and not nominal. Am I correct?
((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.))
Here you talk about economy running at full capacity. You did talk about fiat injections and how they are inflationary. I guess not when economy is not at full capacity. Is this your opinion?
May be we can say that what is really causing monetary inflation is overspending, not money supply. If demand doesn't match real supply then that is inflationary. Am I correct?
You seem to build on Say's law. Do you think market always clears? The money that was paid for the investment will consume the production of that investment? What if some of the workers who build the factory just hoard the money? (in this case money can be pieces of gold)