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.
hoffmanjohn:Why should i restrict my definition of inflation to there narrow standards?
Ummm, because that's what we're talking about. We're talking about "money supply expansion", which I call "inflation." If you don't like it, you're free to go somewhere else, but for the sake of this discussion, inflation = money supply expansion.
If you want to use different definitions, please by all means, start a new thread, but don't hijack this one.
Because it's not your forum. When we visit Keynes-land, we'll be sure to add 'monetary' to our use of the word inflation, so that we have clear communication. 99/100 times you see 'inflation' used on this forum, it is in reference to increasing money and credit supply, not rising prices.
Check my blog, if you're a loser
Definitions identify the widest cause in a context and are based on the observation of similarities and differences in a context. Definitions can be too narrow or too wide. See Ayn Rand's _Intro. to. Objectivist Epistemology_ for the theory of definition.
Production is the application of reason to the problem of survival. AYN RAND
I can't tell if hoffmanjohn is attempting to provoke on purpose, or if he is truly ill informed in regards to the Austrian School.
I like the post. Great job. I wanted to add one more piece of information.
The "malinvestment" occurs when resources are taken away from one sector to be used in the sector that has the artificially high demand. Once the demand for a consumer good is revealed to have been artificial due monetary inflation and credit expansion, the malinvestment of capital goods is revealed.
e.g. Low interest rates and money injections into the real estate sector caused demand for real estate to rise. This signaled to construction companies to hire more workers, invest in new machinery that otherwise might not have been purchased until a future date, etc. to meet the increased demand. More construction workers got into the industry developing their construction skills, etc. as well. The increased demand of construction capital goods such as machinery and materials signaled to the producers of those capital goods to expand their appropriate businesses as well to meet that demand and so on. One of the problems is that in order to meet the demand for producing capital goods (typically long term investments), resources must be taken away from the production of other consumer goods or capital goods in other sectors - not real estate. There were a lot of people who could not afford real estate in the long term scheme of things except with artificially lower interest rates and when this realization came about, the malinvestment of all other higher order goods was realized and we are left with millions too many homes and other such related goods.
In order to correct the problem of oversupply - which just means prices are too high - prices must be lowered. I believe this is a correct summation based on the reasoning that who in their right mind wouldn't buy a home for $2 (assuming you weren't taxed out the wazzoo for doing so)? Also historically when prices have been kept artificially low on goods, there is almost always the problem of a shortage. e.g. Gas, food, housing, etc. I do realize that as an Austrian Economist, one isn't supposed to use historical examples like this due to the problem of not being able to prove the relation of cause and effect without pure theoretical reasoning as explained by Mises in his Treatise on Human Action. i.e. I can't say that the price fixing caused the shortage without already having prior knowledge of what causes shortages. We can't say based on this example that an increase in demand not related to low prices did not just cause the shortage. e.g. One might argue without apriori knowledge that the price fixing was put in place simply because there was an increase in demand which current supply could not meet and that the shortage was inevitable.
I am not 100% sure of my reasoning and would like to hear your thoughts.
david_z: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.
That's not really true, is it? Isn't the whole point that the new money is directed away from the stages of production closest to consumption to stages further. Which, without the decrease in interested rates would not have been profitable to invest in.
The decrease in interest rate makes the production of new capital, especially that furthest away from consumption profitable and provides entreprenuers with new and easy credit, hence the lengthening and widening of the capital structure. In fact, it is only when the money reaches the consumers and they begin to reestablish their preferences that problems begin.
"You don't need a weatherman to know which way the wind blows"
Bob Dylan
this is confusing to me as well. if.....
1000 ounces of gold existed and circulated as money in an economy for one year.
six months later several people have invested a total of 500 ounces of that gold into a large strand of timber to process lumber for dwellings.
six months later 1000 ounces of additional gold ( a doubling of the previous money supply in one year) enters the economy from a mining operation and additional timber and timber processing begins and doubles timber production in the same amount of time as previously done.
the 1000 new ounces of gold have all gone into timber processing yet the existing economy, the roughly 500 uninvested ounces of gold is consumer income to buy a portion of the new timber products....all the new processed timber goods are now sitting and not making anyone any money//
is this the jist of the malinvestment??
sthomper:is this the jist of the malinvestment??
No, the source of malinvestment proper is an unbacked expansion of the money supply.
A lot of the premises in the scenario you describe are so extreme that it's kind of impossible to evaluate, for instance, the total above ground stock of gold has never increased by more than 4 or 5% in any given year - and rarely grows by more than about 2% (we have about 5 centuries worth of reasonably reliable data on this).
you yourself say....."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".....
"New money, especially fiat money,..."
i know that gold has generally been pulled out of the ground at less than a double digit rate....at least that is what i have read at the mises.org site.
but gold could be fiat money.
i was using 'gold' as a general word for money proper.
i dont see how money backing is an issue if what ever the money happens to be is monopoly or govt imposed.
is there something else in my post that mistates the process of inflationary malinvestment?
sthomper:is there something else in my post that mistates the process of inflationary malinvestment?
What you're missing is that the amount of money in an economy and the rate of interest are not related. The purchasing power of money is determined by individuals demand for liquidity, the amount of money in the economy and the amount of goods in the economy. When an increase in gold occurs that new money filters through the economy and changes the general level of prices, it increases prices and drives down the purchasing power of money, real income and the ratio of prices stays the same. On the other hand, the rate of interest is determined by the time preferences of individuals in the economy, the extent to which individuals are willing to forego current consumption to increase the consumption of future goods.
However, due to FRB, money enters the economy through the loan market. When banks expand credit they push the rate of interest below what it would have otherwise been in order to loan out the expanded credit. It is this reduction of the interest rate that sets the boom bust cycle in motion, as opposed to new money entering the economy which merely distorts the intratemporal price structure. FRB distorts the intertemporal structure of prices, and as such sets in motion the ABCT. The other differences is that when new gold enters the economy it does so through voluntary exchanges, whereas credit expansion is the result of government priveledge and fraud.
ok..i will have to look at that more closely.
one issue that confuses me however...when the original poster speaks of injecting money into the economy. can injecting also just be an increase of the money not based on interest rates.
does new money entering the economy via interest rate manipulation only stay there temporarily where as newly created money finds a more permanant existence.
thanks
If everyone's money savings suddenly doubled overnight, there would be no effect on real interest rates, and likely little effect on relative prices, which is all that is important. However, rising prices might drive up nominal interest rates.
The original poster committed a fallacy. The increased demand arising from new money should not simply signal to businesses to produce more stuff. Profit margins do this. If everything has increased demand, all prices, including producer prices, will increase. Profit margins should stay about the same, and few will be persuaded into changing their business.
One thing it would do is reduce the difficulty of pre-existing debtors to repay, while diminishing the real gains their creditors make on their loans. Interest rates will change to reflect this in real terms; however, if inflation is continuously surprisingly pursued to creditor's dismay, this will have the effect of reducing time preference, reducing savings.
New money in real life has two important characteristics. One, it is not equally distributed relative to money savings. This means that new money creates specific winners and losers. It's best to be closest to the source of the money. This alters the structure of production.
Two, most new money originates in the banking system, which drives down interest rates. Thus, while time preference is actually reduced, interest rates also go down, a fundamental mismatch in the market's signals to determine production. This is the root of the business cycle. Interest rates and savings rates do not coincide, creating an unsustainable foundation for new investments.
Once the new money is loaned out, it can no longer effect interest rates, and they will rise to reflect time preference again, even if the new money is never removed from circulation. If new money is continuously produced and put into circulation through the credit market, it will continuously keep interest rates lower than they should be.
meambobbo: If everyone's money savings suddenly doubled overnight, there would be no effect on real interest rates, ... The original poster committed a fallacy. The increased demand arising from new money should not simply signal to businesses to produce more stuff. Profit margins do this.
If everyone's money savings suddenly doubled overnight, there would be no effect on real interest rates, ...
The original poster committed a fallacy. The increased demand arising from new money should not simply signal to businesses to produce more stuff. Profit margins do this.
I think you're misreading what I said, unless you're referring to some other OP. I'm not talking about an overnight increase in everyone's deposits, I'm takling about very specific increases in the money supply, the benefits of which are concentrated within a relatively small part of the economy.
sthomper:does new money entering the economy via interest rate manipulation only stay there temporarily where as newly created money finds a more permanant existence.
That's correct. In fact, this is partly what sets the business cycle in motion, FRB increases the amount of credit in circulation to the extent that the reserve ratio will allow. When entrepreneurs are forced to liquidate their investments due to malinvestment and return their loans to the bank, the amount of credit in the economy begins to decrease, moreover, since entrepreneurs are not as willing to take out loans, the banks have a much harder time increasing credit and this sets in motion a chain reaction, with more banks failing.
Stephen Grossman: But isnt the Austrian distinction between short- and long-run demand more important than aggregate?
But isnt the Austrian distinction between short- and long-run demand more important than aggregate?
The concept of AD is not used in AE. It doesn't make sense to add demands to each other for any purpose.