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On Malinvestment, How? and Why?

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David Z posted on Wed, Dec 17 2008 3:13 PM

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:

  1. An interest rate is fundamentally an inter-temporal price: present goods in terms of future goods.
  2. Consumption is always the destruction of previously accumulated wealth.

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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Prashanth Perumal:

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?

  1. Higher relative prices signal "shortage" which may cause businesses to increase production when it's not really justified (per Say's Law).
  2. Other individuals no longer buy at the higher prices, choosing instead to buy something else less satisfying to them (per the principle of revealed preference).
  3. Profits in certain industries most impacted withdraw productive talent and capital from other, otherwise profitable ventures (there isn't any more to go around, so prices for all factors increase...
  4. If the interest rate decreases, individuals contribute less to savings (investment in productivity) and more to consumption which exacerbates the problem.
  5. The productive capital necessary to sustain this level of consumption needs to have been put in motion ex ante.  It's too late, now.

etc.

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Say's Law...The money that was paid for the investment will consume the production of that investment...

Say's Law does not claim that "the money that was paid for the investment will consume the production of that investment".

Have you been taught that that is Say's Law? Or is it your considered summary of the law, having read Say's work?

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David Z: I think this was a point I overlooked (or flubbed) in the intial post.  It is assumed that new money is typically spent on higher-order capital goods, the money enteres the system through the banks, and is loaned to businesses.  Even individuals who benefit from this new money typically aren't taking out a $100 loan to buy new jeans at Macy's, they're taking out $190,000 to buy a house, or $22,000 to buy a car, etc.  At the same time, however, real investment (deferred consumption) declines because of an artificially low interest rate, and real, immediate consumption rises.

But demand for higher order goods is determined by the expected profits of consumer goods. The expected profits of consumer goods is determined by the demand for consumer goods. How then can new money be spent on higher order goods if new money isn't also spent on consumer goods?

Let's create an order of production list:

1. A lumber company grows and chop down trees

2. A separate company cuts and refines the wood

3. Another company assembles cabinets with the wood

4. Yet another company installs the cabinets in new houses

I gather that this list presents goods from higher to lower order. Is the claim that artificially low interest rates cause investors to invest disproportionately in #1? Why would they invest in #1 as opposed to the others? I would think the lumber company would only attract additional investment if they expected additional demand from the refining company, who in turn would only demand more wood if the assembling company increased their demand.

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David Z: If the interest rate decreases, individuals contribute less to savings (investment in productivity) and more to consumption which exacerbates the problem.

So savings includes all types of investment? Why would someone invest less in the stock market because interest rates were lower? Don't people invest in the stock market due to the rate of profit and not the rate of interest?

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people will loan less than they otherwise would.  they may speculate more (or hold cash which can be considered a very risk-free method of speculation), or buy more consumer goods.

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OK, as I see it there are four things to do with your money: consume it, invest it (e.g., buy stock, start a small business), lend it (or put it in the bank who then lends it out), or hoard it.

So if interest rates were low, you would be less likely to put your money in the bank. So then you have to do one of the other three things. Somehow, in a way that is entirely unclear to me, this leads to malinvestment. So what is the Austrian solution? Require the banks to have 100% reserves. If banks had 100% reserves, then the interest you'd receive from having your money in the bank would be zero, or probably even less than zero. So why would this not have the same (or worse) deleterious effects as a low interest rate? Wouldn't this drive up consumption as well?

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Andrew replied on Mon, Mar 19 2012 9:32 PM

 

It leads to malinvestment by taking resources to be used for future consumption and putting them in projects the require too many resources than actually exist.  Try not to think about money - it can get confusing - just imagine a pool of scare resources society has set aside that can be used for longer term objectives - like building some widget that will increase food yields by 300%.  
 
The interest rate is the market's regulator as to whether people should invest their resouces for future consumption or just use them in the present.
 
When the Fed injects new money into the banking system, the rate of interest is lower than it would be on the free market.  That signals to entrepreneurs, in the form of interest rates, that there are enough societal resoruces to take on longer projects - when, if enough time passed, interest rates would adjust back to the true free market level.  It also signals to consumers that their investments aren't as needed - they will get less of a return on their money on average.  
 
Think of it this way - if entrepreneurs/businessmen can get money more cheaply from borrowing, why would they bother to sell equity?  Yes, invidividual investors might shuffle stocks around - but that doesn't mean more investor money is actually being used on a long term project.  
 
Even if investors decided to invest more with lower interest rates, as long as the Federal Reserve is adding money into the system, the interest rate will still send a false signal as to how many resources are available.  Even if the amount of societal resources available for future consumption increases, the added amount of money will make it seem like their are still more resources available than there actually are.
 
The Austrian solution, well there is some disagreement from within, but I agree with the Austrians that yes, we should have 100% reserves.  The problem isn't low interest rates - the problem is a not free market interest rate.  And, if we had a 100% system, some people would choose to pay for safeguarding some of there money, while the rest of their money could be invested in safe bonds or time deposits with the bank.  
 
If the rate is just the free market - the 0% interest rate would be a signal that the market has plenty of investment, and yes, it would encourage consumers to consume - but that would not be an unsustainble form of consumption.
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also, keep in mind the only time money is "injected" into the stock market is during an IPO.  none of the money traded daily between a seller of stock and a buyer goes directly into increasing the length of the production process.  This is where corporate bonds are much more important, and they rely on interest rates.

as far as 100% reserves and the interest on a bank deposit, yes and no.  yes, banks would have to charge you to safekeep your money and provide you with money substitutes.  but no, there would still be time deposits, which are small loans to the bank, which would pay you interest.  so it would simply divide the different functions of banks (demand deposit or warehousing and borrowing at interest).  Currently they are conflated, which leads to greater banking instability, which leads to centralized banking, gov't provided deposit insurance, and fiat currency...which leads to violent business cycles.  if banks gathered their funds primarily from time deposits, they could easily match the maturity of their loans to their borrowed funds - something impossible with today's conflated system.

here's a good small-scale example of how the business cycle can work. http://mises.org/daily/3155

prices are used for economic calculability.  the interest rate is one of them.  An investment that won't generate income for 10 years might take 20 years to be profitable at one interest rate but 100 years at a higher rate.  The thing about the business cycle is that the more entrepreneurs are misled by the current interest rate created by means of credit expansion, the more upward pressure is put on consumer price inflation and interest rates.

So if entrepreneurs know the rate is artificial and will not last, they could plan accordingly.  BUT they have no idea what the natural rate should be, and they do not know if or when rates will rise or how long gov't and banks will try to keep rates low, etc.  Simply put, there is much more uncertainty.

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Andrew: It leads to malinvestment by taking resources to be used for future consumption and putting them in projects the require too many resources than actually exist.  Try not to think about money - it can get confusing - just imagine a pool of scare resources society has set aside that can be used for longer term objectives - like building some widget that will increase food yields by 300%.
OK, can we flesh one example out? Maybe we can limit the resources to labor, for simplicity. So this widget for increasing food yields requires a certain amount of constant labor. Let's say it takes five years to make. So that's five years these laborers have to work on this widget when they could be producing something else, like a smaller yield of current food.
 
The first proposition seems to be that low interest rates cause businesses to take on these longer projects. This is because it tells them that there are more resources--i.e. that there are more laborers. But why does the belief that there are more laborers induce them to invest in a five year project instead of a one year project?
 
The second proposition is that there aren't actually enough resources for this project. So what does that mean in practice? That there aren't enough laborers for the project? Wouldn't the business know this as soon as it goes to hire the laborers? Do the laborers drop off after a couple years for some reason I'm not aware of? Or does it mean that there aren't enough consumers for the product once its finally finished?
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also, keep in mind the only time money is "injected" into the stock market is during an IPO.  none of the money traded daily between a seller of stock and a buyer goes directly into increasing the length of the production process.  This is where corporate bonds are much more important, and they rely on interest rates.

Interesting. I think I heard something about that once before. I'll have to research it.

as far as 100% reserves and the interest on a bank deposit, yes and no.  yes, banks would have to charge you to safekeep your money and provide you with money substitutes.  but no, there would still be time deposits, which are small loans to the bank, which would pay you interest.  so it would simply divide the different functions of banks (demand deposit or warehousing and borrowing at interest).  Currently they are conflated, which leads to greater banking instability, which leads to centralized banking, gov't provided deposit insurance, and fiat currency...which leads to violent business cycles.  if banks gathered their funds primarily from time deposits, they could easily match the maturity of their loans to their borrowed funds - something impossible with today's conflated system.

I see. Time deposits would be lent out and you couldn't get your money back until a certain time. In a sense, the banks would simultaneously be 100% reserve and 0% reserve.

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Andrew replied on Tue, Mar 20 2012 10:55 PM

Because the five year project has a higher ROI than the one year project - otherwise they wouldn't do it.  Investments are often like that - projects that take a long time to produce yield more than doing something you can do immediately - think of starting a business for example.  

If we lived in a simple economy where there was one lender and one industry and only a few people it would be obvious like you say.

In the real world, all the businesses start off just fine.  Eventually, though, yes - some of them will realize that they actually don't have enough money (labor) to finish their project.  The reason for this is that the new cost of labor (when interest rates finally go back to free market rates) is too high for some business - which then close.  

It doesn't mean the individual project is unsustainable - only certains parts of long term investments found somewhere in the entire economy.  There were literally not enough laborers to begin with.  Had the laborers demanded their free market wage (i.e. the interest rate had adjusted upwards or the real interest rate stayed the same) then the business cycle wouldn't have begun in the first place.  Of course, in the real world, it's not just labor - it's a whole convoluted, extremely complex system of prices that not even the great rational expectator Bryan Caplan could adjust for.  

The price being paid for the workers is unsustaniable from the beginning - but it's just about impossible to know that from an individual entrepreneur's perspective.  

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Andrew replied on Tue, Mar 20 2012 10:57 PM

So, there's literally not enough capital to begin with - not enough investments/savings whatever you want to call it.  Sure, in the beggining I can start a ton of projects and they all hum along just fine.  Eventually though, some of them defintely won't be able to be finished because the pool will be gone.  

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Andrew replied on Tue, Mar 20 2012 11:01 PM

Artificially loweing an interest rate is like a Communist taking a pool of capital and saying we're not going to have a free market price anymore - it's going to be lower for the greater good.  Ok, but then supply of the capital falls because people get less of a return and demand increases.  Now you have shortages of capital.  The only way to allocate under that system is to use rationing.  Since we have no rationing of capital in our quasi-capitalistic system, the system uses up all that capital, and then interest rates have to spike to encourage more savings - the problem with that is some of the capitalists long term projects can't survive with these new price structures.  

It's really quite simple - it's just price fixing of capital - so you're going to have shortages - and when you have shortages the market can't complete its projects.

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yes, what's interesting about it is that the money aspect of the capital is created out of thin air, so there cannot be a supply shortage of money in theory.  the problem is that this money affords less and less real resources that cannot be willed into existence.

when long-term investments start, they pull in labor from other areas in the production structure, many of which were previously working closer in time (further down the production structure) to producing finished consumer goods.  to do this, they must offer higher wages.  but because there was no fall in demand for consumer goods and in fact there is an increase in demand because the workers are getting paid more but have the same consumption/saving ratio, and there is also less supply of consumer goods since less workers are producing them, the price of consumer goods goes up, making these businesses more profitable.  So then businesses closer to the end of the production structure seek to expand (or at least fill vacancies), and they start raising wages and hiring.  So there is a tug-of-war for resources across the production structure.  A long-term investment today means a expansion of current businesses tomorrow, long before the long-term investment is ever completed, let alone close to paying off its debt and becoming profitable.

Normally, prices would tell businesses where such resources are most profitably employed, and profits would even out when there was a perfect balance of resources (assuming there is no uncertainty and risk opportunities).  In this case, prices are initially telling businesses to extend the capital structure, then later to expand the end of the capital structure.  Price inflation enters the picture and soon after interest rates rise.  Then it becomes clear that long term investments are not profitable and the resources should be permanently released and placed towards the end of the production structure.

if during this cycle, capital was consumed in the shuffle of resources, there may be breakdowns in the production structure that cannot be glossed over.  this explains why you get a spike in unemployment, not a simple flow of resources back to where they were.  see Murphy's sushi example.  additionally, much of the long-term projects are pure waste.  you cannot liquidate a half-completed mine and hope to recoup much of what you spent.  These errors ripple through the economy, disrupting the plans of others.  for instance, the bank that made the loan now has to take a loss, which may mean it has to discontinue funding to other businesses.

If asset prices increase at a greater rate than the interest rate is, you get asset bubbles.  People are better off speculating on assets than lending their money.  Eventually big players start borrowing lots of money to speculate on assets.  But the same thing happens.  Eventually the credit inflation turns into consumer price inflation and there is political pressure to allow interest rates to rise, which cause the bubbles to pop.

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"The second proposition is that there aren't actually enough resources for this project. So what does that mean in practice? That there aren't enough laborers for the project? Wouldn't the business know this as soon as it goes to hire the laborers? Do the laborers drop off after a couple years for some reason I'm not aware of? Or does it mean that there aren't enough consumers for the product once its finally finished?"

the laborers for the 5 year project come from other sectors of the economy.  to lure them away from their current occupation, the 5 year project offers them better wages.  but as they start paying them, the new money is now circulating freely in the economy.  the workers are now spending more on consumer goods than they were.  additionally there is less supply of finished real goods being produced.  this creates larger profits for current consumer goods, and those businesses attempt to fill vacancies and expand by offering even higher wages than the 5 year project.  There is a tug of war for resources.

As the price of resources increases, long-term investments need to pay more than they planned for resources.  so they have to borrow even more.  which puts pressure to increase interest rates, just as banks receiving less time deposits and corporations receiving less capital by means of bond issuance.  also, price inflation puts upward pressure on interest rates.  eventually, the interest rate will get so high that a long-term project may not show profitability for 100 years, where it was initially 10.  it might even be insolvent from the get-go.  never underestimate the power of compound interest.

in short, the game of tug-o-war was rigged from the get-go in favor of the initial production structure and against the 5 year project.  to the extent the 5 year project can win at all, it can only do so because many employees' wages lag behind price inflation, so they are forced to reduce their real consumption.  so it's basically forced saving, and the people unwillingly doing the saving are not the beneficiaries of their saving - the entrepreneurs borrowing the capital from thin air are.

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Andrew: Because the five year project has a higher ROI than the one year project - otherwise they wouldn't do it.  Investments are often like that - projects that take a long time to produce yield more than doing something you can do immediately - think of starting a business for example.

Do lower interest rates increase the ROI of longer projects relative to shorter projects? This is a part I am still unclear on.  Suppose I'm an investor and have the choice of either investing in a one-year project or a five-year project. If I choose the five-year project, I will have to take out a loan of $1 million each year and won't start earning money on the investment until the end of five years. On the other hand, I could take out a loan of $1 million and pursue the one-year project. After one year and when my ROI pays for the continuance of this project, I could then borrow another $1 million and start another one-year project. It's clear why the five-year project has a higher ROI from this perspective, but what impact does the interest rate have on my choice?

On a related point, does this mean that a lot fewer long-term projects would be pursued in a free market?

It doesn't mean the individual project is unsustainable - only certains parts of long term investments found somewhere in the entire economy.  There were literally not enough laborers to begin with.  Had the laborers demanded their free market wage (i.e. the interest rate had adjusted upwards or the real interest rate stayed the same) then the business cycle wouldn't have begun in the first place.  Of course, in the real world, it's not just labor - it's a whole convoluted, extremely complex system of prices that not even the great rational expectator Bryan Caplan could adjust for.

That makes some sense. The business has to borrow money each year, and the rate of interest starts to go up unexpectedly. Is it assumed that the interest rate would be stable in a free market?

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