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.
What were the misconceptions you were getting about malinvestment?
Great post... I'm going to send this thread to a few friends.
david_z:New money, especially fiat money, typically manifests itself as demand for consumption goods.
I thought that new money primarily (solely?) enters the economy through the banking sector, in the form of new loans. Based on this, I would think that demand for consumption goods would be near the bottom of the list as to prices which are first affected by the new money.
Please clarify. Thanks.
Austroglide: david_z:New money, especially fiat money, typically manifests itself as demand for consumption goods. I thought that new money primarily (solely?) enters the economy through the banking sector, in the form of new loans. Based on this, I would think that demand for consumption goods would be near the bottom of the list as to prices which are first affected by the new money. Please clarify. Thanks.
Great job by the original poster; you explained mailinvestment clearly in a brief writing. The way I understand it is that when this money comes in, as you noted, primarily through the banking system and thus loans, it is usually directed towards high order goods because these goods require loans far more often than consumer products. The production process becomes extended in these sectors where the new money is directed to and more workers are obviously needed and these workers wages are pushed up by the inflation as well. These workers are consumers as well and they begin to spend their money on consumer goods like any other person which will push prices up. Eventually you have the consumer good price increases reaching a parity with high order goods in a sense. Although the "high prices" of the high order goods seemed high at first because relatively speaking consumer goods were still down, now that the inflation has caused rising prices in consumer goods and the playing field starts to become leveled, people realize those high order goods aren't so high priced anymore and therefore are not as profitable as they previously thought. If something is not profitable people will of course not invest in it which will force these sectors to liquidate and the available capital is decreased causing a contraction. Hope that helps!
In liberty,
Chris
I figured that out. Higher prices for consumption goods arises relatively quickly. For now, I'll take Murray Rothbard at his word when he says, "Soon the newmoney percolates downward from the business borrowers to the factors of production: in wages, rents, interest." (America's Great Depression, p. 11)
Good enough.
Now, onto this statement:
david_z: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.
I think this is wrong. Yes, consumption destroys products/services which have value. But consumption is of necessity the enjoyment or realization of value as well. You cannot ignore individual time preferences. By foregoing saving in favor of present consumption, the individual who consumes now is actualizing his time preference. Seems to me, therefore, that this would mean that, in this particular case, consumption (i.e. private consumption, strictly speaking, as opposed to government consumption), not saving, MAXIMIZES "value" by maximizing utility.
Agree or disagree?
Excellent primer. I might sticky it for the benefit of newbies.
Austroglide raised a similar objection as to what I'd have, but I think it's a matter of phraseology more so than any problems in your analysis. Would it not be more correct to say any industries sensitive to interest rates (by definition the higher order goods, but also durable consumer goods like housing) are the ones prone to bubble activities, though, in light of the recent crisis?
Freedom of markets is positively correlated with the degree of evolution in any society...
Chris:These workers are consumers as well and they begin to spend their money on consumer goods like any other person which will push prices up. Eventually you have the consumer good price increases reaching a parity with high order goods in a sense. Although the "high prices" of the high order goods seemed high at first because relatively speaking consumer goods were still down, now that the inflation has caused rising prices in consumer goods and the playing field starts to become leveled, people realize those high order goods aren't so high priced anymore and therefore are not as profitable as they previously thought. If something is not profitable people will of course not invest in it which will force these sectors to liquidate and the available capital is decreased causing a contraction. Hope that helps!
I'm confused as to what "investment in higher-order industries" means.
I haven't seen many explanations of this (i.e. I haven't read a lot of Austrian stuff yet). One explanation says that the higher-order industries produce capital goods which are, in turn, used to produce yet other capital goods, etc., until finally a consumer good is produced.
Why, then, would high consumer prices be the catalyst for a shifting of resources away from the higher-order industries, when exactly these higher order industries are necessary in order to produce consumer goods (i.e. they're the first link in the production chain)?
Do you know what I mean?
Nothing specific, it just seems to be a sticking point for many people who are new to Austrian theory. You know how like most mainstream writers use the "overinvestment" theory of the business cycle, for instance. People have a hard time grasping the concept in full...
Yes, I think that is more correct. I posted this here for comments & critique, so it's much appreciated.
This is easy. A malinvestment is one dependent on artifically low interest rates or one predicated on inferring artifically low interest rates in the long term from artifically low interest rates in the short term. In our recent bubble we had short term rates as low as 1%. With a bunch of stupid laws and an insane system of motgage guarantees from the Government, underwriters would create adjustable rate and/or balloon rate mortgages. Lendees would agree to this based on the stupid concept that the interest rates would never go up. They were wrong.
As an example: A home builder builds homes for 100K each with an interest rate of 5% gives buyers a 30year fixed payment of 900. The builder purchases the materials and labor and begins construction give this data. If the interest rate rises to 6% then the payments rise to 1000. So now the builder has lots of problems. The builder has fewer potiential customers or must reduce the price and profit on each home. Furthermore, materials and labor if purchased on loan will be more expensive as well. What if the builder deferred purchases until the builder needed the materials? This is a perfect example of a bubble activity that is affect by even the smallest of interest rates.
(Garrison does a great job explaining this process in his PowerPoint (which I think is available somewhere on Mises.org)
The misdirection occurs because businesses are investing in more capital goods at the same time that consumers (e.g., employees now with higher wages, or businesses with more purchasing power) are demanding more consumption goods. (NB, I seem to have overlooked or ignored the first half of that equation in my first post. ) The consumer demand (whether for consumables or for intermediate goods) initially appears greater (as evidenced by the higher prices caused by more money competing for the same amount of existing goods/services), which apparently justifies undertaking the new investments in longer, roundabout processes. Fundamental demand hasn't changed, though.
The only time longer, more roundabout processes ought to be undertaken is when consumption is deferred for the future.
Thanks everyone for helping me clarify. I'll have a revised edition over the weekend probably.
Austroglide:But consumption is of necessity the enjoyment or realization of value as well. You cannot ignore individual time preferences.
Consumption can be both the realization of value, and the destruction of value.
No, I don't ignore individual time preference, only mean to suggest that in the absence of a functioning, unmanipulated economy, it's pretty tough to appeal to time preference. When the real rate of return on most investments is negative or zero, there's not much of a rational choice to be made.
david_z:The consumer demand (whether for consumables or for intermediate goods) initially appears greater (as evidenced by the higher prices caused by more money competing for the same amount of existing goods/services), which apparently justifies undertaking the new investments in longer, roundabout processes.
It is not simply inflation that drives up consumer demand. The artificially low interest rate reduces the amount of earned money supplied to the credit market, which is instead supplied in exchange for consumer goods.
I don't believe increased demand for consumer goods would justify investments in higher order capital. Rather, businesses would demand more of their lower-order capital and more nature-given resources such as labor, and higher-order capital investments would be liquidated to free up such resources for more lucrative opportunities in the existing production structure.
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meambobbo:The artificially low interest rate reduces the amount of earned money supplied to the credit market, which is instead supplied in exchange for consumer goods.
Excellent point! C/P, a higher interest rate encourages people to "save" or "invest", if the rate is forced lower by credit expansion, then marginal lenders/savers are crowded out of the market.