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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.

 

============================

David Z

"The issue is always the same, the government or the market.  There is no third solution."

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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.

============================

David Z

"The issue is always the same, the government or the market.  There is no third solution."

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Fool on the Hill - Interested in game theory?  Have you read any Anthony de Jasay?

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I am interested in game theory. I think I've heard of Jasay, but haven't read anything. Are there any particular works you recommend?

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Sure.  For his game theoretical works see his book Social Contract, Free Ride, and his articles Take or Leave? and Property and Jungle Law, both of which can be found in Political Philosophy, Clearly.  More broadly, his magna opera are The State and Against Politics.

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