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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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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.

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David Z

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david_z:

Ixtellor:
But you said "Demand will fall THEN prices will fall", but if supplies are super intellectual capitalists making good decisions, can then can't they reduce supply simultaneously with the fall in demand?

It doesn't matter how super-intellectual the capitalist is, he can't go back in time.

 

What I didn't articulate is the lag affect. The decline in demand and the shift in price are not simultaneously. The 'information' of less demand occurs first, and in many instances will not see subsequent falls in price for long periods. So if a savvy supplier has accuratly forcasted falling demand and cut back inventories, I don't see why the shifts could not occur simultaneously before the lag drop in price. I am thinking in the micro and admit at the macro level this would be highly improbably.

And now I will be greatly confused because we were talking about inflation, but for you inflation = increased MS, so does your position, which I quoted a few posts back, also apply to the micro level or are you strictly speaking at the macro level? Furthermore, is it possible that my scenario of supply being reduced prior to price deflation occur at the macrolevel in any circumstance? If you answer NO, to this second portion then I guess you "win" as I think its soo improbable as to be impossible, but you are speaking about "perfect competition world" AKA Austrian theory, where the probabilities would shift and you might just answer "YES" that it is possible, thus...    I forget what my point was.

Ixtellor

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I think we're not clear any longer, let me try to reiterate mt previous point:

  1. Yesterday, we accumulated inventories for future distribution and sale.  In the case of individuals, we have money stockpiled for future consumption.
  2. Today, we all realize that all prices rose (I'm discussing your question about what happens if all prices were to rise, a situation which I believe to be implausible, but I'm working with it) in a more-or-less uniform manner.

Now, there are two things of which we can be certain:

  1. The amount of inventories did not change.
  2. The amount of money did not change.

From which it follows that previous levels of consumption can not be accommodated given the now higher prices, and a greater amount (than forecasted) of existing inventories can not be sold at the prevailing prices.

Today, the businesses can make adjustments which will affect tomorrow, and they will, because A) their replacement costs are now higher and B) they have more carry-over inventory.  Today the individuals can exercise new consumption preferences, but in order to eat the same quality and quantity of food, he has less money to spend on movie tickets, video games, sporting events, etc.

But it seems that you're asking not about the above situation, but rather: What if the reason prices rose, is because businesses accurately predicted that consumers would spend less on present consumption, and therefore decreased the supply available for sale?

But businesses can't just raise prices like that.  Reducing output doesn't give you carte blanche to raise prices, unless you're a monopoly.  Some businesses would be more able than others to accommodate a reduction in demand without substantially raising prices.  These businesses survive, and others do not.

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David Z

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If you answer NO, to this second portion then I guess you "win" as I think its soo improbable as to be impossible, but you are speaking about "perfect competition world" AKA Austrian theory, where the probabilities would shift and you might just answer "YES" that it is possible, thus...    I forget what my point was.

You really need to read up on Austrian theory. Austrians are against perfect competition except as a useful theoretical device, which they call the "evenly rotating economy", used to distinguish interest from money. Otherwise, they hold to dynamic, disequilibrium models and maintain that equilibrium is never reached, even if there is a tendency towards it (by entrepreneurial activity.) They would certainly not hold to anything like the ERE when the interest rate is being held down and the tendency towards equilibrium deliberately averted, even if they were willing to extend its applicability beyond conceptual clarification.

Freedom of markets is positively correlated with the degree of evolution in any society...

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printing more money or lowering interest rates does not always increase the money supply. It is harder to expand the money supply during poor economic periods because member banks may sit on what they have instead of taking out a risky loan.

 

Furthermore inflation=the general rise in prices because inflation is caused by more then just an expansion in the money supply. For example population during the early stages of capitalism were perhaps one of the causes for the great inflations of that era.

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hoffmanjohn:
printing more money or lowering interest rates does not always increase the money supply. 

Umm what?

 

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Despite his nonsense, it's worth reading up on the Austrian deflationists like Shostak, North or Shedlock, to see why simply lowering interest rates or printing money may not cause general price increases.

Freedom of markets is positively correlated with the degree of evolution in any society...

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eliotn replied on Fri, Feb 6 2009 10:31 AM

Jon Irenicus:
Austrians are against perfect competition except as a useful theoretical device, which they call the "evenly rotating economy", used to distinguish interest from money.

Wait, I thought the ERE was just equivelent to "no change" or unattainable equilibrium.  How is it equal to perfect competition?

Schools are labour camps.

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eliotn replied on Fri, Feb 6 2009 10:35 AM

hoffmanjohn:
Furthermore inflation=the general rise in prices because inflation is caused by more then just an expansion in the money supply. For example population during the early stages of capitalism were perhaps one of the causes for the great inflations of that era.

Inflation (as you describe) is caused by (cerebus perebus):

1. Expansion in the money supply.
2. Less amount of goods and services.
3. Less demand to hold money.

Schools are labour camps.

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Wait, I thought the ERE was just equivelent to "no change" or unattainable equilibrium. How is it equal to perfect competition?

Perfect information and a static equilibrium. They both share that assumption.

Freedom of markets is positively correlated with the degree of evolution in any society...

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inflation is cause by a number of things which can range anywhere from population increases,war,spending,and increases in the demand for money.

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hoffmanjohn:

inflation is cause by a number of things which can range anywhere from population increases,war,spending,and increases in the demand for money.

 

Hoff, I beat you to this forum. Read all my posts, and they already answered all your questions. They define inflation using the neoclassic definition and they don't deviate from it. Adapt. You are talking about price increases, and they are talking about MS.

 

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The definition of "inflation" as an increase in the money supply has been around a very long time, just as the definition of "monopoly" being a state granted privilege has also been around a long time.  we're merely using these terms in their correct and original context.

"When you're young you worry about people stealing your ideas, when you're old you worry that they won't." - David Friedman
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david_z:
The Austrian position, IMO as it pertains to a decline in AD

But isnt the Austrian distinction between short- and long-run demand more important than aggregate?

 

Production is the application of reason to the problem of survival.  AYN RAND

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Technically, it's about inter-temporal resource allocations.  But if one is going to argue that "aggregate demand has fallen", then the Austrian response is likely to be that AD has fallen because at some time antecedent to the present, resources were improperly allocated inter-temporally.  A decline in AD the likes of which evidences (I don't believe it causes) a recession/depression is a systematic failure, it's more than just entrepreneurial error.

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Why should i restrict  my definition of inflation to there narrow standards?

 

 

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