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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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Admittedly, I'm not an expert on how the financial system works and what the correct terminology is. So you can correct me if I'm wrong or if this has been covered before. But my impression was that there was a difference between a long-term loan and a long-term investment. A long-term loan is one that doesn't have to be paid back in full for a long time. One takes out a long-term loan to buy a house. The lower the rate of interest, the more likely someone is to take out a loan to buy a house. A long-term investment, on the other hand, is a production process with a long turnover period--that is, it takes a long time to develop the product and make a profit. This is what I thought was meant by "roundaboutness." But just because a house is bought with a long-term loan doesn't mean that the construction of houses is more roundabout than the construction of something else, say pharmaceuticals, which require years of research . So while an artificially low interest rate may divert resources from pharmaceuticals to housing, this is not because the production of housing is more roundabout. Rather it is because the end product is more expensive and thus requires a greater level of consumer loans.

I just Googled to see how long it takes to build a house. Most sources said 3-4 months. By contrast, crops might take a year to grow, livestock even longer. If low interest rates serve to increase investment in roundabout production, it seems that agriculture should be hurt more than housing.

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FOTH,

Say there is a seed of a tree that takes a thousand years to grow. You put in the ground in two minutes, then it takes care of itself. Do you think that buying that seed and planting is...

1. A long term investment?

2. A more roundabout means of production than housing? pharmecuticals? livestock? other crops?

3. Is a loan taken to buy the seed a long term loan?

4. Will changes in the interets rate affect seed planting more or less than housing? pharmecuticals? livestock? other crops?

there are no right and wrong answers here. [Laughing. Of course there are.]

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Arman replied on Sun, Jun 10 2012 2:11 PM

Just part of the reason that lowering interest rates will not prove to be stimulus to the economy.  Keynes felt that lower interest would stimulate demand, but wholly negated the fact that lower interest rates are extremely detrimental to supply, and the supply is much more elastic than anyone considers. This current crises started with a lowering of the interest rates (NOT the various businesses that folded in the ensuing cash contraction). It continues to be exacerbated by further lowering of rates and the foolish "stay the course" mantra. It frustrates me to no end the fact that people graduate with economics degrees without a bloody clue as to how the macro economy works; and then they teach economics and advise administrations. If you don't consider yourself an expert, then you do not suffer the mind numbing indoctrination that students and future professors suffer at the hands of “educated” experts. I have found that an economics education is nearly impossible to put behind you, regardless how ridiculous the curriculum.

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Those are goods questions. Part of my question pertains to the definition of those words, so I'm not sure how well I can answer. But I'll try.

1. If I'm planning on selling the tree/planted seed, then yes. Since I'm not going to live a thousand years, my only hope is to sell the planted seed before I die. However, it doesn't seem like its value would be much more than when I bought it because I didn't add much labor to it.  

2. It has a low turnover rate, so if that is what is meant by "roundabout," then yes.

3. Depends on the conditions of the loan. One could buy the seed with a short-term loan or a long-term loan.

4. I doubt anyone would take out a loan to plant one seed, so in that case, less. But assuming I spend a lot on seeds and need loans, I don't think anything could be concluded apodictically.  First of all, since the loans that are spent on housing are consumer loans, they are independent of the length of the production process. If we are going to assume someone will take out a thousand year loan to plant seeds, we might as well assume that someone else might take out a thousand year loan to buy a house.

Second of all, it seems that we are assuming that loans are used to fund short-term and long-term projects in equal proportions. Businesses are always making profits. Where does that money go? It seems to me that the wiser move for a business would be to throw revenues into long-term projects and take out loans for short-term expenditures. Suppose my agricultural business turns over $10,000 in one year. Instead of taking out a long-term loan to buy the seeds for the thousand year trees, it might make more sense to use that $10,000 to buy the seeds and take out a short-term loan of $10,000 to meet my agricultural expenditures for the following year. True, an increase in the interest rate may make it more unfeasible for me to do that, but no more than it would make it more unfeasible for me to increase my investments in short-term projects, such as growing more crops.

Thus, there is no connection between the length of a loan and the length of the production process. If anything, the deciding factor seems to be the amount of capital one has. Those with a lot of capital can get short-term loans. Those with little capital, such as consumers and new businesses, need long-term loans.

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FOTH,

The point I was trying to bring out with those questions is that length of time for final product to show up is not a measure of "roundaboutness". The latter is measured by how many things have to be produced before you can produce the final product. That seed pretty much is good to go right away. Its production has no roundaboutness.

A woven basket in a primitive society would have one level of roundaboutness if they first sharpened rocks to make knives to cut the reeds, then weaved them by hand. In a modern society, that knife would be made in a factory, which would need machinery to be built specially for it first, and those machines might themselves need machines to make them, and those latter machines might need still other machines to make them as well,  etc. So many levels of production would be needed before that basket would be woven.

ABCT is predicated on the assumption that the higher level machines, the ones that you need first before to make the others, are usually built when interest rates are low, because a lot of time and money is needed to make them, more than for the lower levels of production. Sadly, I forget why this is so. How quickly we forget.

 

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ABCT is predicated on the assumption that the higher level machines, the ones that you need first before to make the others, are usually built when interest rates are low, because a lot of time and money is needed to make them, more than for the lower levels of production. Sadly, I forget why this is so. How quickly we forget.

So for the ABCT, the deciding factor isn't how roundabout something is but that the high order goods are expensive? So an industry with a low level of roundaboutness but an expensive high order good would be more adversely affected by the changes in interest rates than an industry with a high level of roundaboutness but an inexpensive high order good?

This doesn't seem to explain the relative "malinvestment" in housing vs. other industries. I see no reason to presume that the machines necessary to build bricks, nails, and the other materials for housing are more expensive than the machines necessary to can food, for example. In fact, the situation with housing seems to be precisely the opposite. What makes housing different than other industries is the relative expensiveness of the end product.

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In the US (and other recent) housing bubbles, government agencies and policies actively directed the credit into housing.  The fundamental insights of the ABCT - the boom-bust being a result of the effects of unsustainable credit expansion on interest rates - are all there.  In a market that was completely free apart from the credit expansion, we would expect the credit to effect higher order goods more than lower order goods.  In the specific case of the housing bubble, government policies sought to directly funnel that credit into housing.  This credit expansion was not sustained, interest rates rose, and the bubble popped.

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Arman replied on Sun, Jun 10 2012 7:22 PM

The dredit expansion was stable and sustainable until Bernanke started cutting at interest rates.

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What do you mean?  In what period?  In the early 00's, interest rates were artificially pushed below 2%.  Do you think this could have continued forever without massive inflation? 

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For the case of the seeds, it makes sense that you can borrow short-term for the initial seed purchase, plant it and pay off the debt using a separate revenue stream before the seed ever produces a marketable product. This doesn't hold for most actual long-term investments, where there needs to be a continuous stream of costs, not just the initial fixed cost. Consider building a factory. Not only are the natural resource costs spread over time, but labor costs, rent for land, possibly others. Most business expenses are not financed in one giant loan at a fixed rate but through a credit line that is subject to swings in the interest rate. Even if they were financed by the former, many businesses would not accurately predict and factor in the inflation that the artificially low rates produce, thus requiring more capital than they initially estimate. So they are sensitive to the interest rate. the recent housing bust showed most of the foreclosures in ARMs - also subject to rates. also walter block has written about why a mismatch in savings and long-term consumer goods financing can cause a business cycle. If one already has enough capital saved to finance a loan, it makes no sense to take the loan in the first place. You're paying interest for no good reason. Rather, the smart financial move would be to do the opposite - loan out any capital not needed immediately for profit. You could make loans of several maturities to maximize the revenue earned knowing when you need the cash to finance your investment. While a single house may take 3-4 months to build, timber harvesting equipment, construction equipment, business structures, trucks for transport, etc. take either a long time to produce or to convert from one industry to another, or move from one location to another. credit expansion causes inflation and this can manifest in speculative assets such as stocks, commodities, real estate. govt policy channeling credit to start the bubble can get it going then low rates and high credit growth rates keep it going.

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the rates were actually negative in real terms encorging debt financed speculation rather than saving, value investing, and loaning.

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Arman replied on Sun, Jun 10 2012 10:10 PM

Keynes felt that lower interest would stimulate demand, but wholly negated the fact that lower interest rates are extremely detrimental to supply, and the supply is much more elastic than anyone considers. This current crises started with a lowering of the interest rates (NOT the various businesses that folded in the ensuing cash contraction). It continues to be exacerbated by further lowering of rates and the foolish "stay the course" mantra. It frustrates me to no end the fact that people graduate with economics degrees without a bloody clue as to how the macro economy works; and then they teach economics and advise administrations. If you don't consider yourself an expert, then you do not suffer the mind numbing indoctrination that students and future professors suffer at the hands of “educated” experts. I have found that an economics education is nearly impossible to put behind you, regardless how ridiculous the curriculum.
Now, push nominal rates up, and you ALWAYS get inflation sufficient to put real rates down.  So spin spin spin Keynesians and, oh, well, we really should be looking at real rates... like real rates, a calculation derived from the measured inflation rate is a factor to cause the inflation rate, Frig economics is messed. "the lower that x-y is, the larger y is", duh.
Lower nominal rates kills supply (doing next t nothing to demand). Money is loaned on nominal rate, and the decision to lend and create money circulation does not consider how such lending may increase inflation and reduce the real value of the return payment.

 

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Aristippus: In the US (and other recent) housing bubbles, government agencies and policies actively directed the credit into housing.  The fundamental insights of the ABCT - the boom-bust being a result of the effects of unsustainable credit expansion on interest rates - are all there.  In a market that was completely free apart from the credit expansion, we would expect the credit to effect higher order goods more than lower order goods.  In the specific case of the housing bubble, government policies sought to directly funnel that credit into housing.  This credit expansion was not sustained, interest rates rose, and the bubble popped.

If the housing bubble was caused by the government directing credit there, then that fact doesn't do anything to support the claim that credit expansion in general leads to increased investment in higher order goods or more roundabout methods of production. The government could direct credit to housing in a 100% reserve banking system. The claim by the Marxian I quoted remains unrefuted. Why do you suppose the credit would affect higher order goods more than lower order ones?

 

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meambobbo: For the case of the seeds, it makes sense that you can borrow short-term for the initial seed purchase, plant it and pay off the debt using a separate revenue stream before the seed ever produces a marketable product. This doesn't hold for most actual long-term investments, where there needs to be a continuous stream of costs, not just the initial fixed cost. Consider building a factory. Not only are the natural resource costs spread over time, but labor costs, rent for land, possibly others.

Why would spreading the costs over time matter? If instead of requiring $10,000 up front, it required $1000 each year for 10 years, then I'm still advancing the same amount, which I have from my farm business. In fact, wouldn't spreading the costs make the loans less necessary, since I could fund the project through the profits from my farm business?

Most business expenses are not financed in one giant loan at a fixed rate but through a credit line that is subject to swings in the interest rate.

Yes, that's close to what I'm saying. But this of course is not the case with housing loans, which (correct me if I'm wrong) are giant loans at a fixed rate. And if most business expenses are financed by loans, then where do their revenues go?

Even if they were financed by the former, many businesses would not accurately predict and factor in the inflation that the artificially low rates produce, thus requiring more capital than they initially estimate.

This is assuming that the interest rate keeps going down, right? But when you talked about a series of short-term loans, the problem was that the interest rate went up unexpectedly. Shouldn't we compare the same periods of time? It seems to me if the interest rate went up unexpectedly, then the rate of inflation would go down unexpectedly. So those with long-term loans might require less capital than initially expected.

(I'm not sure of this last part--just trying to think things through.)

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Why would spreading the costs over time matter? If instead of requiring $10,000 up front, it required $1000 each year for 10 years, then I'm still advancing the same amount, which I have from my farm business. In fact, wouldn't spreading the costs make the loans less necessary, since I could fund the project through the profits from my farm business?

Right, which is why I don't think we should focus on the example where all the cost is up-front.  We should focus on the main example, which is best described as making a factory.  It is possible one has a stream of capital capable of fulfilling the costs over time and would not require a loan.  This would actually indicate a balance in time preference, so there would not be any business cycle.

Or it is possible that other people have farms that are earning profits which they save.  And they take their profit streams and lend long.  Then those who want to build a factory but don't have the capital can borrow long to do so, requiring the factory's revenue to pay off the loan.

Both the decision to lend and borrow are determined by the interest rate.  At a lower rate, profitable businesses may choose not to lend their profits but to expand their business or speculate on commodities.  Entrepreneurs will borrow more to invest.

Yes, that's close to what I'm saying. But this of course is not the case with housing loans, which (correct me if I'm wrong) are giant loans at a fixed rate. And if most business expenses are financed by loans, then where do their revenues go?

You ignored my point about adjustable-rate mortgages, which exploded in volume during the housing boom and which were the majority of the delinquent loans as the bust came in.

I never said most business expenses are financed by loans.  Long-term investments often are, especially when there are low interest rates.  Businesses that are making profits can either reinvest their earnings or save cash or lend them.  This is also determined by the interest rate and calculated returns on investments and other forecasting.

This is assuming that the interest rate keeps going down, right? But when you talked about a series of short-term loans, the problem was that the interest rate went up unexpectedly. Shouldn't we compare the same periods of time? It seems to me if the interest rate went up unexpectedly, then the rate of inflation would go down unexpectedly. So those with long-term loans might require less capital than initially expected.

No, the interest rate doesn't need to keep going down.  Even held steady, there would be a business cycle.  The reason is that it takes greater and greater volumes of credit expansion to maintain that artificially low interest rate.  Let's assume investment A and investment B are virtually identical, competing for the same group of workers.  Let's say A starts one month ahead of B, and has plans for 5 years of the same steady payroll costs.  It borrows $1,000,000 every month to meet these costs.  Well, then B comes on the scene.  It has to offer more to convince labor to leave A for B.  So it borrows $1,005,000.  Now A is short labor.  It has to borrow $1,010,000 to get the labor back.  So then B outbids, etc etc.  Notice the loan volume is increasing each time, putting UPWARD pressure on the interest rate.  The bank(s) can only maintain the interest rate if more and more individuals increase their savings rates and inject more and more capital into the bank(s) OR if the bank(s) increase the amount of money created out of thin air each time.

Since the workers are maintaining their time preferences as well, rather than saving a greater proportion of their paychecks, consumer prices are increasing, and consumer goods industries are also bidding up labor costs.  The only way to arrest inflation is to allow the interest rate to rise to its natural level.

Now to answer your key question: Why does a lower interest rate stimulate long-term investment vs. short-term?

1) Roundabout processes are assumed to be more productive.  This means the same amount of materials or labor can produce more goods or services.  IE - given the same amount of labor, a factory can produce the far more of some good as can be made using hand tools.  Another way to view this is that roundabout processes have a far lower cost per unit, and thus a much higher profit margin.

Of course, it's not the roundabout-ness of the process that makes it more productive.  It's obvious that you can add non-productive steps to a production process and it is both more roundabout AND less productive.  Just take it as pure coincidence that many goods are more productively produced by more roundabout processes involving higher order capital.

2) Thus, creating a more roundabout production process often represents a profit opportunity.  The economic factor in deciding whether to engage in these investments is largely driven by time preference.  If an investment requires $10,000,000 of cost per year and 10 years before ever generating revenue, that means you actually have $172,691,506.20 in debt at a 7.5% at that date vs $143,941,482.15 at 4%.

At 7.5%, the INTEREST alone on that debt may out-strip your annual profit.  So it is IMPOSSIBLE to pay it down - the whole investment is insolvent.  At 4%, it is possible to pay it down, with the same annual profits.  If you started a project at 4% but had to roll the debt over to 7.5%, you may end up insolvent.

Even if the project is solvent at both rates, it will still take exponentially longer to pay off at 7.5% vs. 4%.  The principal is larger on the day you start actually paying it down, and the interest rate is higher.  This means the interest paid is much larger, and it continues to grow and grow until it is fully paid off.  So even if a project is solvent, an entrepreneur may not be willing to wait so long into the future to actually have a net positive asset.

3) Numerous short-term investment do not equal one long-term investment.  For instance, you can't build half an oil well, put it to work and earn revenue to pay off a short-term loan, then take another short-term loan to build the other half.  You need the whole thing to do anything.  Similarly you can't dig a coal mine halfway to the coal, or make a half of a factory.

Such investments also cannot be liquidated when the interest rate rises making the investment unprofitable until very far into the future if at all.  This compounds the bust portion of the business cycle.

4) Short-term investments are generally not to expand the production structure to make it more roundabout.  For instance, rather than build a new factory, you might hire a crew for an extra shift or make small alterations to allow more workers to operate on the line without necessarily increase the productivity of each laborer.  Because these costs must be paid to make a product before you can earn revenue from your additional output, you must either invest savings/profit to do this, or borrow short-term.

Keep in mind the average profit per unit is actually diminishing by doing this.  The cost per unit remains the same, or may even increase.  While the supply of the good increases, pushing down its price.  So short term expansions may not make much sense, indepedent of where the interest rate is.  There is generally more flexibility in the interest rate on whether to pursue such an expansion or not.

...

So in a nutshell, long-term investments increase productivity, creating large profit opportunities, while short-term investments often decrease productivity but increase absolute profit.  For long-term investments, the largest factor preventing their undertaking is time preference - we have little doubt there is a large payoff in the long-run but are we willing to forego current consumption for as long as it takes to get there.  If so, we would increase savings and push more and more capital into such processes for smaller and smaller returns, represented by the interest rate.  Trying to acheive such a rate without increasing individual savings only creates the illusion of the availability of the real resources required to complete the investment.

For short-term investments, the interest rate determines the interest cost of the undertaking, but it likely plays a much smaller role than other factors.  In many cases, expansion makes no sense.  If profits are already thin, expansion may make the business unprofitable.  It wouldn't make sense to do so even at a 0% interest rate.

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