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.
============================
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.
Great Post! It explains it really well, in brief.
I've posted a revised version, Malinvestment: A Primer.
Thanks everyone.
david_z: (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.
(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.
Here's what I don't understand (this is where the Austrian theory always loses me): If businesses are investing in more capital goods, isn't that increasing their productive capacity? And won't their newly increased productive capacity match supply with the newly increased demand for consumer goods? What stops this process from turning an artificial boom into a genuine one?
Justin:If businesses are investing in more capital goods, isn't that increasing their productive capacity? And won't their newly increased productive capacity match supply with the newly increased demand for consumer goods? What stops this process from turning an artificial boom into a genuine one?
Justin,
Good question. I'm just now learning this stuff for myself, but I think the following is accurate:
SHORT ANSWER: It's not that the boom causes an INCREASE in the capital stock so much as it's that the boom causes the COMPOSITION of the capital stock to be different than otherwise, and thus inappropriate. When the proverbial "punch bowl" is taken away, a certain percentage of the demand for the output of the inappropriate capital structure disappears as a result.
LONG ANSWER:
The answer to your question turns on the fact of RESOURCE SCARCITY. Were resources unlimited, society would clearly choose to consume as much as possible as soon as possible, and therefore every increase in "productive capacity" would be of benefit. But because resources are of course limited, society must ration its consumption. This requires that society be selective, in any given time period, as to which goods it will consume, in which quantities, and in which order. In turn, this selection and ordering of consumption requires a specific pattern of production.
In this light, everything boils down to society's time preference, as expressed in the rate of interest, between present consumption and future consumption (i.e. between consumption and investment) for any given level of resources at its command during a specified period of time.
The higher the magnitude of consumption which is deferred to the future, the lower is society's "time preference", the lower the rate of interest, and the "longer" becomes the structure of production. This means that productive capacity will be allocated to producing higher order capital goods (i.e. goods which are further removed, in both degree and time, from producing consumer goods). Were, instead, society's time preference higher and thus weighted less toward deferred consumption and more toward present consumption, more productive capacity would be allocated to producing capital goods of a less-high order.
In this manner, society's decision as to when to consume its scarce resources manifests itself in a specific pattern (i.e. this "specific pattern" being what Austrians call the "structure of production") in the stock of capital. That is to say, society's specific consumption decision manifests itself in a specific composition of the capital stock*.
The Fed monetary stimulus distorts the rate of interest, the price of capital, and thus distorts the preferred pattern of investment. The resulting capital structure no longer reflects society's decision as to WHEN TO CONSUME its limited resources. Once the stimulus is removed, society's decision as to when to consume will once again come to bear, and find expression in a MARKED LACK OF DEMAND for the output of the now-distorted capital structure.
*EDIT: I don't know yet how, precisely, society's time preference manifests itself in a specific production pattern. Why, for instance, a longer period of consumption deferment MUST result in more resource allocation to high-order capital goods. Thus, an explanation of the causes and effects in this regard is left out of the above analysis. However, it suffices to say that for the above analysis to hold, differing time preferences must NECESSARILY manifest themselves in differing structures of production.
EDIT 2: Also, I've unintentionally left out of the above analysis a consideration of the starting point for the time periods being discussed: Namely, does the analysis assume a starting point of an economy at full employment, or an economy at less than full employment?
EDIT 3: This is Hayek's rather ambiguous assessment (from The Austrian Theory of the Trade Cycle, http://mises.org/tradcycl/avoidinf.asp#[1] ):
"There is of course, no doubt that temporarily the production of capital goods can be increased by what is called "forced saving"--that is, credit expansion can be used to direct a greater part of the current services of resources to the production of capital goods. At the end of such a period the physical quantity of capital goods existing will be greater than it would otherwise have been. Some of this may be a lasting gain: people may get houses in return for what they were not allowed to consume. But I am not so sure that such a forced growth of the stock of industrial equipment always makes a country richer, that is, that the value of its capital stock will afterwards be greater--or by its assistance all-round productivity be increased more than would otherwise have been the case. If investment was guided by the expectation of a higher rate of continued investment (or a lower rate of interest, or a higher rate of real wages, which all come to the same thing) in the future than in fact will exist, this higher rate of investment may have done less to enhance overall productivity than a lower rate of investment would have done if it had taken more appropriate forms."
Of course, we would do well to proceed for now according to Hayek's conclusion. Prior to discovering this, however, I had thought that the Austrians argument - here in apparent contradistinction to Hayek's position - was in part that the capital structure during monetary inflation becomes highly disfigured and, therefore ultimately, much less productive.
Something clearly is still missing from this picture.
EDIT 4: But then here's Roger Garrison, in The Austrian Theory of the Trade Cycle (http://mises.org/pdf/austtrad.pdf):
"According to Tullock's [incorrect] understanding of the Austrian theory, the boom is a period during which the flow of consumer goods is sacrificed so that the capital stock can be enlarged. At the end of the boom, then, the capital stock would actually be larger, and the subsequent flow of consumer goods would be correspondingly greater. Therefore, the period identified by the Austrians as a depression would, instead, be a period marked by increased employment (labor is complementary to capital) and a higher standard of living. The [inadequate] stock-flow construction that underlies this line of reasoning does not allow for the structural unemployment that characterizes the crisis-much less for the complications in the form of the secondary depression." pp. 16-17
This stands in seeming contrast to Hayek immediately above.
Justin:Here's what I don't understand (this is where the Austrian theory always loses me): If businesses are investing in more capital goods, isn't that increasing their productive capacity? And won't their newly increased productive capacity match supply with the newly increased demand for consumer goods? What stops this process from turning an artificial boom into a genuine one?
Investing in capital goods now will increase capacity at some time in the future. But, due to the distortions (e.g., reduced interest on savings, increased wages as money flows through the system, etc.) the demand for that increased capacity is now.
Unfortunately, PRODUCTIVE CAPACITY DID NOT CHANGE.
The world didn't become any more productive ssimply because someone at the Fed pushed a few buttons. Consumers are trying to satisfay immediate needs, while businesses are investing in projects that will only pay off in the longer-term. Both of these groups are playing tug-of-war with the same scarce resources. This boom can't turn in to a genuine one, because no new resources, no new productive capacity, has been created.
EDIT 5: And here's Rothbard in The Austrian Theory of the Trade Cycle:
"Businesses, in short, happily borrow the newly expanded bank money that is coming to them at cheaper rates; they use the money to invest in capital goods, and eventually this money gets paid out in higher rents to land, and higher wages to workers in the capital goods industries. The increased business demand bids up labor costs, but businesses think they can pay these higher costs because they have been fooled by the government-and-bank intervention in the loan market and its decisively important tampering with the interest-rate signal of the marketplace. The problem comes as soon as the workers and landlords-largely the former, since most gross business income is paid out in wages-begin to spend the new bank money that they have received in the form of higher wages.
For the time-preferences of the public have not really gotten lower; the public doesn't want to save more than it has. So the workers set about to consume most of their new income, in short to reestablish the old consumer/saving proportions. This means that they redirect the spending back to the consumer goods industries, and they don't save and invest enough to buy the newly-produced machines, capital equipment, industrial raw materials, etc. This all reveals itself as a sudden sharp and continuing depression in the producers' goods industries. Once the consumers reestablished their desired consumption/investment proportions, it is thus revealed that business had invested too much in capital goods and had underinvested in consumer goods. Business had been seduced by the governmental tampering and artificial lowering of the rate of interest, and acted as if more savings were available to invest than were really there. As soon as the new bank money filtered through the system and the consumers reestablished their old proportions, it became clear that there were not enough savings to buy all the producers' goods, and that business had misinvested the limited savings available. Business had overinvested in capital goods and underinvested in consumer products." pp. 74-75
This is a clear analysis, and pretty much sums up the answer to your question.
Govt does not change interest rates. It only mimics a change. The rates, as you say above, remain as they were.
Production is the application of reason to the problem of survival. AYN RAND
1) What evidence/data is there to support that conclusion. (inflation appears in producer goods before consumer goods) Particularly in all instances of an increase in money supply, which is what you seem to be claiming in a blanket statement.
2) Is Rothbard's statement just to the great depression or in all instances where an increase in money supply causes inflation.
3) Is there data on bank lending that breaks it up between investment and private or personal loans? Seems if you have this data you can a) prove your thesis and b) compare it over time periods of government initiated increase in money supply to see if it holds true as a constant.
I wager, that there will be examples of gov pumped up money supplies leading to higher increases in consumer inflation. With the Works Progress Administration being a viable counter argument. (T-bills --> increased money supply -->wages -->consumer goods)
Ixtellor
P.S. Apologies for my straying for your chosen jargon/vocabulary, mine has been dumbed down in recent years.
If you think this is a true statement about how capitalism works, you have a simple little mind. If these previously mentioned activities take place, it goes against the idea of capitalism and those businesses must surely fail.
Ixtellor: 1) What evidence/data is there to support that conclusion. (inflation appears in producer goods before consumer goods) Particularly in all instances of an increase in money supply, which is what you seem to be claiming in a blanket statement. 2) Is Rothbard's statement just to the great depression or in all instances where an increase in money supply causes inflation. 3) Is there data on bank lending that breaks it up between investment and private or personal loans? Seems if you have this data you can a) prove your thesis and b) compare it over time periods of government initiated increase in money supply to see if it holds true as a constant. I wager, that there will be examples of gov pumped up money supplies leading to higher increases in consumer inflation. With the Works Progress Administration being a viable counter argument. (T-bills --> increased money supply -->wages -->consumer goods) Ixtellor P.S. Apologies for my straying for your chosen jargon/vocabulary, mine has been dumbed down in recent years.
I demand somebody answer Ixtellor (because I lack the knowledge to).
It helps to quote those towards which your responses/questions are directed.
Ixtellor:1) What evidence/data is there to support that conclusion. (inflation appears in producer goods before consumer goods) Particularly in all instances of an increase in money supply, which is what you seem to be claiming in a blanket statement.
That's one thesis and it's the most widely accepted as far as I'm aware.
The size of the consumer debt outstanding is less than $3 Trillion (in the U.S.), and the size of the outstanding debt in the U.S. Bond Market is $45 Trillion. You tell me where you think most of the money created by inflation is going.
That said, if you pumped money straight into checkable deposits held by non-institutional accounts, you would see something like the effect described by Hume: consumer prices everywhere would rise in short order to accommodate the new money supply, and businesses who hold the lion's share of debt would benefit immensely, being able to wipe out their existing debts while collecting the grander revenues afforded by the increased MS.
Ixtellor:I wager, that there will be examples of gov pumped up money supplies leading to higher increases in consumer inflation.
The data don't bear this out. Check with Rothbard, Skousen, Hayek, probably Friedman if I remember correctly, etc. I'm not going to regurgitate their work.
Done!
If you're talking to me, and have a specific question about something I wrote, please quote it and I'll do my best to handle your objections.
James Frear:If you think this is a true statement about how capitalism works, you have a simple little mind.
Also, don't be a dick. That request stands, regardless of who you're addressing.
david_z:It helps to quote those towards which your responses/questions are directed.
Thanks man.
david_z: Ixtellor:I wager, that there will be examples of gov pumped up money supplies leading to higher increases in consumer inflation. The data don't bear this out. Check with Rothbard, Skousen, Hayek, probably Friedman if I remember correctly, etc. I'm not going to regurgitate their work.
1) Name dropping is useless, particularly when their hand picked. Example:I am correct, check out Keynes, Krugman, Hicks, and Maede. (Hayek was a social safety netter, so can I assume you with those portions of his analysis as well?)
2) You made a blanket statement. I asked if it was true in all instances. Well here is an instance: The $168 Billion+ Bush Tax rebates. Are you stating, that the $168billion + doled out in amounts of $300/person had an impact on producer inflation prior to consumer inflation? Just glancing at 3 tables, money supply, PPI, and CPI, for the relevant time period it would seem the best you could say is that inflation occured simultaneously in both sectors, but had a more profound affect on CPI with as much as a full point higher. Which would seem to validate my whole point/wager.