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.
david_z: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.
Conceptual question for anyone:
At what point is it necessary to stop making reference to "time preference"? Here's why I ask:
It is clear that the rate of interest in an unfettered market is a pure reflection of society's time preference, whereas the rate of interest in a fettered market is an adulterated reflection of society's time preference. Yet the increase in consumer demand attributable to inflation in a fettered market is the result of UNANTICIPATED inflation. Were the inflation anticipated, the increase in demand wouldn't follow. As a result, the time preferences in a fettered market - it could be argued - are adulterated time preferences, to be sure, but time preferences nonetheless.
EDIT: Therefore, I mean to suggest, in a fettered market the allocations being made between consumption and investment are, in one sense, quite irrational. Yet in another sense these same allocations, indeed, can be characterized as being quite rational. Conceptually speaking, therefore, distinctions along these lines seem to be very necessary.
Austroglide: At what point is it necessary to stop making reference to "time preference"?
At what point is it necessary to stop making reference to "time preference"?
Because in the fettered market, the interference completely divorces time preference from the real structure of production, it essentially begins to burn the candle at both ends. Sure, you'll have more light.
But you'll run out of candles a lot sooner.
david_z:in the fettered market, the interference completely divorces time preference from the real structure of production
I am quite reluctant to pronounce the character of this divorce to be "complete". Especially so in light of the considerations regarding inflation I describe immediately above.
There are a couple of questions here that are not part of your original post/analysis: Namely: (1) The question regarding expected inflation and how it bears conceptually upon the notion of time preference. Again, a reasonable argument can be made that the factors which constitute a general conception of "time preference" remain in place, even in the presence of inflation. Either my argument is unreasonable, or it has already been addressed elsewhere and is being taken for granted in your analysis, or you've left it out of your analysis. (2) A reasonable argument can also be made that, just because society's free-market time preference is adulterated by inflation, it doesn't follow that, therefore, this time preference has been separated TOTALLY - as you posit above - from the free-market structure of production.
I'm trying to put a fine point on these things because without a clearly-defined foundation, the results of any analysis of these issues will, in turn, necessarily be that less clear.
"completely" might've been a poor choice of words.
Under any inflationary regime, resources are allocated towards, and consumed (i.e., destroyed) by the production of goods and/or services that people ultimately don't want. To the extent that this occurs, it represents a real diminution of material wealth.
Under any inflationary regime, people are encouraged to spend more and invest/save less than that ratio which would be in accord with their true time preference. To the extent that this occurs, values are "realized" or "fulfilled" sooner than would be optimal, this too represents a real sacrifice of well-being.
david_z:Under any inflationary regime, resources are allocated towards, and consumed (i.e., destroyed) by the production of goods and/or services that people ultimately don't want.
More precisely, for any given level of real income (i.e. whether that level exists in an unfettered money market, whether that level exists in a 2% inflationary money market, or whether that level exists in a 10% inflationary money market, etc.) we can say that society has a distinct time preference.
More precisely still, for any given level of PERCEIVED real income, we can say that society has a distinct time preference. It is NECESSARY for consumers to MISPERCEIVE the inflationary income as new wealth in order for the Austrian analysis to hold: In other words, the Austrian analysis depends CENTRALLY on an increase in the prices for consumption goods RELATIVE to the prices of capital goods*. Without such a change in relative prices, the structure of production will remain unchanged.
I think it is MOST reasonable to make clear that society has a time preference, and a concomitant structure of production, for EVERY possible level of PERCEIVED REAL INCOME and, thus, for every possible level of UNEXPECTED inflation.
So , to again put the finest point possible on things, it is most accurate to draw the distinction NOT between "an inflated money market" and "a non-inflated money market", but INSTEAD between "a non-inflated money market" and "an X% inflationary money market"; or between "an X% inflationary money market" and "an (X +/- N)% inflationary money market".
END: I'm not trying to state this argument as an undeniable fact. I posit it because I think it's quite reasonable and potentially helps to clarify things quite a bit. And we should be as conceptually clear and concise as possible in these matters. Any and all criticisms, clarifications, or denials are welcome.
EDIT: It goes without saying that, at each level removed from stasis (I don't think this needs to be a 0% inflation money market, if enough time has passed for the structure of production to reach full fruition for the given level of real income in question), changes in the inflation rate actuate the deleterious processes of malinvestment, which in turn manifest themselves in changes to the "X real income" structure of production.
EDIT 2: * Were the inflation CORRECTLY pereived by wage, rent, and interest earners for what it was, no change in the RELATIVE price structure should occur.
I think this is appropriate.
Check my blog, if you're a loser
Austroglide:Austrian analysis depends CENTRALLY on an increase in the prices for consumption goods RELATIVE to the prices of capital goods*. Without such a change in relative prices, the structure of production will remain unchanged.
Such a change in relative prices is a necessary consequence of inflation. Some economic actor, somewhere in the economy receives the new money before anyone else, and before the increase in M is known. This actor then has at his disposal more money than he would otherwise have. He competes for scarce resources with others, who do not have the benefit of this new money. He bids up the prices of these scarce resources, and takes them from where, in an unfettered market, they would be optimally allocated.
Prices just rose. Everyone else plays catch-up.
Austroglide:* Were the inflation CORRECTLY pereived by wage, rent, and interest earners for what it was, no change in the RELATIVE price structure should occur.
If a person knew, or could accurately predict now what the effects of inflation would be in a given period of time, he would arbitrage the opportunity, and prices would rise instantly as a result. This is the problem theoretically with prediction: if you can do it accurately, it's self-invalidating.
If inflation didn't cause an imbalance in the price structure, there would be no reason to pursue it as a policy. It is pursued precisely because it is known (or assumed) to affect the price structure.
Agreed.
david_z: Such a change in relative prices is a necessary consequence of inflation. Some economic actor, somewhere in the economy receives the new money before anyone else, and before the increase in M is known. This actor then has at his disposal more money than he would otherwise have. He competes for scarce resources with others, who do not have the benefit of this new money. He bids up the prices of these scarce resources, and takes them from where, in an unfettered market, they would be optimally allocated. Prices just rose. Everyone else plays catch-up.
Yes, thanks. I'm having to think a lot about this - it's really messing me up at the moment.
david_z:Some economic actor, somewhere in the economy receives the new money before anyone else
What does Austrian theory tell us about where this new money is spent? Is it assumed to always be spent on final goods (i.e. consumer goods), for instance. Can it just as easily be spent on, say, higher-order capital goods?
Austroglide:What does Austrian theory tell us about where this new money is spent? Is it assumed to always be spent on final goods (i.e. consumer goods), for instance. Can it just as easily be spent on, say, higher-order capital goods?
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..
Most investment costs are for original factors of production - wages, rent, and interest. For the recipients to invest that income into more capital goods rather than use it for consumption is highly unlikely, especially if interest rates are artificially low.
Edit - actually i meant supply credit, not make an investment. This may actually be a good point and be a reason for speculative asset bubbles - they appear to be low-risk means of earning a greater return than supplying credit. As far as investments in higher order capital goods, I don't think most laborers, landlords, or creditors would have the nerve to either take such unknown risks or feel there is greater opportunity cost in learning the risk as opposed to their current income sources.
Here's what Rothbard says in American's Great Depression:
"Businessmen take their newly acquired funds and bid up the prices of capital and other producers’ goods, and this stimulates a shift of investment from the “lower” (near the consumer) to the “higher” orders of production (furthest from the consumer)—from consumer goods to capital goods industries. (p. 11)"
It makes sense that the new money - which enters the economy largely as bank credit - should finds its way first into markets for "capital and other producers' goods", as Rothbard indicates. For some reason, I was thinking incorrectly that the inflation first manifests itself in CONSUMER goods prices. Actually, the inflation first manifests itself in PRODUCER goods prices.
for sure. I definitely overlooked that in my analysis, I'm almost embarassed to admit having been so focused on the consumer-end, which doesn't really result from the inflation per se, rather from the fact that the inflation has depressed interest rates, thus encouraging consumption. This is existing money, not new money, however, both the existing money diverted from investment and the new money are spent into the economy.