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.
Lee Kelly: So if monetary expansion via credit markets is offset by a reduction in present consumption, systemic malinvestment will not be the consequence? That's basically the position of free bankers.
So if monetary expansion via credit markets is offset by a reduction in present consumption, systemic malinvestment will not be the consequence?
That's basically the position of free bankers.
I'm not at all sold on the "free banking" argument. I tolerate it because I don't think it will work, and will result in something like 100% reserve banking, but that's not a topic I wish to discuss in this forum :)
But in a nutshell, yes, if you give up some consumption now and rather than consume, invest in productive assets, your patience will be rewarded. Sure, some investments will turn out to be unprofitable, but these are micro phenomena, not macro/systemic phenomena.
Lee Kelly:I suggest that since the bust, spending on present consumption has declined significantly. Do you think the Fed's recent monetary policy since then has been appropriate?
Hmmm. The fed is like inflating by the trillions. But it isn't making its way into the economy yet, instead being used basically to prop up the balance sheets of banks which are in distress/default. The fed is doing everything it can to keep rates between 0-25 bp which is simply not sustainable. But the Fed is buying trillions in commercial paper and treasuries and junk mortgage securities, they're urging us to reduce the national debt. These policies/goals basically contradict one another...
Meanwhile, people are doing everything they can to pay off debt. We're not really saving, per se, but we're trying very hard to get out of the debt burden as a precautionary measure. With that in mind, I think it's true that spending on consumption has been greatly reduced - we know that people are paying off debt, and we also know that one in five of us is unemployed or chronically underemployed. That adds up to less consumption. But I don't think the tradeoff towards the future/investment is occurring, either.
In the past, we borrowed from the future to finance the present. Presently, we're paying for the past. It's a tough pill to swallow.
Presumably yes, there is a "least bad" monetary policy, but I couldn't tell you what that is. I suspect that any measure they take will have some substantial (and unanticipated) negative consequences.
David Z: How do others in the economy respond? Higher relative prices signal "shortage" which may cause businesses to increase production when it's not really justified (per Say's Law). 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). 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... If the interest rate decreases, individuals contribute less to savings (investment in productivity) and more to consumption which exacerbates the problem. The productive capital necessary to sustain this level of consumption needs to have been put in motion ex ante. It's too late, now.
Suppose that the total amount of money in the economy is $100. And let me put myself into the picture. I am a pauper who has no money. Now the Fed prints a fresh $100 note and gives it to me(lets say under some welfare scheme). Roughly speaking, now I basically have 50% of the purchasing power in the economy. I have the 'power' to redistribute resources according to my preferences. So,lets say I spend my money on buying honey. And this gives a great boost to the honey industry. Honey producers start employing more people(bid away from other sectors of the economy) and make honey for my demand.
All this seems perfectly fine, no? Where is the boom happening here?
Prashanth Perumal:I have the 'power' to redistribute resources according to my preferences.
Prashanth Perumal: And this gives a great boost to the honey industry.
Prashanth Perumal:All this seems perfectly fine, no? Where is the boom happening here?
Snowflake:But you haven't produced anything. In this example, the market shifts from serving productive consumers to unproductive consumers.
Well, yes, I've used the money to consume.
Snowflake:At the expense of other industries built upon a productive consumer base.
You call it 'at the expense of other industries', because I've spent counterfeit money to bid those resources towards me?
Snowflake:People will see a "boom" because consumption has temporarily gone up. This boom is unsustainable because you can not keep borrowing money forever and then the honey industry will collapse. Though, If you could keep borrowing money forever, this is just a form of wealth redistribution and obviously the economy will be permanently weakened if you continue to buy honey by leaching other people's value with your printed money.
Okay, now, in the real world interest rates are lowered and new money created to fund investment projects. So low interest rates actually increase the per capita capital of the economy, isn't it?
Prashanth Perumal:Well, yes, I've used the money to consume.
Prashanth Perumal:You call it 'at the expense of other industries', because I've spent counterfeit money to bid those resources towards me?
Prashanth Perumal:Okay, now, in the real world interest rates are lowered and new money created to fund investment projects. So low interest rates actually increase the per capita capital of the economy, isn't it?
Prashanth Perumal:So low interest rates actually increase the per capita capital of the economy, isn't it?
Snowflake:Sure, if you pump an extra hundred dollars into the economy the GDP will be boosted, but only because of inflation. You having money you didn't earn sends a false signal to everyone that they need to produce your honey. When they find out you can't actually generate the wealth to keep paying for the honey, they will have to scale back their investments.
You ain't getting this. Ignore the case where I use the new money to consume honey. Just think that I am a entrepreneur who is interested in making business. So I am being given 50% of the purchasing power of the economy to do business. I take the money and build Capital equipments. So the economy has more Capital resources now, right?
My point is, society is made to forcefully save.
Prashanth Perumal:Ignore the case where I use the new money to consume honey.
Prashanth Perumal: So I am being given 50% of the purchasing power of the economy to do business. I take the money and build Capital equipments. So the economy has more Capital resources now, right?
Prashanth Perumal:My point is, society is made to forcefully save.
Snowflake:Yes... but the capital resources do not come out of nowhere. You've shifted economic resources from whatever they were doing before into capital resources.
Right.
Snowflake:But the economy has already proven that it doesn't need capital resources because they weren't being built before --> i.e. there is already a more profitable alternative in the market.
You must understand what makes these new roundabout projects appear unprofitable. It's the higher interest rates that show up once savers reassert their consumption-savings ratio. I will try to tell you whole story in a moment.
Snowflake:What? No. Low interest rates discourage saving....
It doesn't matter. There is fiat money to make people do what they really don't want to. When the central bank doubles money supply(from $100 to $200) and gives half(that is $100) the new amount of money supply to me, so that I can invest it in my business, society is made to forcefully save. I can use the extra purchasing power I now have to bid resources to my wishes.
Let me now try explaining what I think is the real problem with credit expansion. I would like to have your opinion.
Lets get to the same example. Initially the economy has a money supply of $100. Lets say people save 20% of their incomes, and the rest they spend on buying consumer goods. So right now the society's savings is $20. The central bank now prints $80 and loans it out along with the $20. Now remember, the total money supply is $80(money consumers decide to spend on present goods) + $20(money that people voluntarily save) + $80(newly created bank money) = $180(total money supply).
So prior to the bank creating new money, 20% of purchasing power went into investment purposes. After bank creating new money, 55% of purchasing power went into investment purposes. In short, people are forced to save more than they wish.
Assuming that investment prospects for businessmen are constant, now lets look at the loan market. Prior to new money being created, the loan market(with loans worth $20) clears at the interest rate of 10%. At this moment, businesses that promise a return over 10% will be undertaken.
After credit expansion, the loan market(with loans worth $100) clears at a lower interest rate of 5%. So now the business environment is simply superb. Businesses undertake any project that promises them a return over 5% itself.
Okay, and now businessmen take out loans and invest it in business projects that promise anything just over 5%. The lent money($100) percolates into the economy(like when businessmen pay their workers etc.); and this is when people reassert their original consumption-savings ratio, which is 80 for present consumption and 20 for savings. So in real terms, of the total money supply which is $180, $144 goes into present consumption and $36 into savings.
Contrast this with the previous ratio between consumption and savings: $80 into consumption and $100 into savings(Remember, of the $100 that has gone into savings only $20 was voluntary savings, $80 was forced saving as new bank money).
How does this affect the loan market? Assuming constant investment prospects in the business world, interest rates will be higher now, because of lower amount of available savings.(Note: savings have decreased from $100 in the previous round of bidding in the loan market to $36 in the present round)
Now do you see the problem? Interest rates rise, and many projects which looked profitable under low interest rates now turn into mailinvestments. They are no longer profitable in the present high interest rate regime. The bust arrives!
Your comments are welcome!
Prashanth Perumal:You ain't getting this. Ignore the case where I use the new money to consume honey. Just think that I am a entrepreneur who is interested in making business. So I am being given 50% of the purchasing power of the economy to do business. I take the money and build Capital equipments. So the economy has more Capital resources now, right?
No! No! No!
The problem is that the economy doesn't have "more capital resources now", they'll eventually have "more capital resources" in the future, but the only way this comes to pass is because you stole from the present
Now, people are generally willing to forgo the present in favor of the future, if they receive a return (interest) for the risk and time. Your counterfeit money offers neither.
David Z: The problem is that the economy doesn't have "more capital resources now", they'll eventually have "more capital resources" in the future, but the only way this comes to pass is because you stole from the present
Yes, right. When credit is expanded and businessmen invest this money, the economy's capital capacity increases.
David Z:Now, people are generally willing to forgo the present in favor of the future, if they receive a return (interest) for the risk and time. Your counterfeit money offers neither.
I do not by any means support counterfeiting of money, and the resultant credit-fed boom which is unsustainable, for reasons I've explained.
Prashanth Perumal:I can use the extra purchasing power I now have to bid resources to my wishes.
Why "you" and why "your wishes"? Don't other people matter? Don't other people deserve equity and fairness? Your purchasing power is de facto theft. Deal with it.
Prashanth Perumal:In short, people are forced to save more than they wish.
Charming. I still say it's not saving, it's the illusion of saving. Those who receive the money first benefit the most, and so on. But many people don't receive the money ever, or are injured when the new money steals resources away from them, etc. You've got to understand this, don't you?
Prashanth Perumal:when people reassert their original consumption-savings ratio
You are neglecting the other half of the equation: people save less when rates are lower. Which means they demand more now. And this demand can't be met without existing capital and productive factors (which don't yet exist), which means prices rise so that the consumer markets clear.
Prashanth Perumal:Yes, right. When credit is expanded and businessmen invest this money, the economy's capital capacity increases.
Capital is a factor of production. It is not money, nor is it credit.
David Z:Capital is a factor of production. It is not money, nor is it credit.
When people are forced to save more(through credit expansion), businessmen get more funds and are able to bid away factors of production from stages closer to consumption and use it in stages farther from consumption. In simple words, the per capita capital of the economy increases.
Whether these more round about projects are sustainable beyond a period of time is another story. The basic thing I want to say is, credit expansion does cause society to save more, forcefully.
Prashanth Perumal:Whether these more round about projects are sustainable beyond a period of time is another story. The basic thing I want to say is, credit expansion does cause society to save more, forcefully.
David Z:Why "you" and why "your wishes"? Don't other people matter? Don't other people deserve equity and fairness? Your purchasing power is de facto theft. Deal with it.
Dude, I am NOT justifying credit expansion. I am just looking at what happens when credit is expanded.
David Z:Charming. I still say it's not saving, it's the illusion of saving.
Right. Because interest rates will rise again when savers reassert their consumption-savings ratio. This will expose malinvestments.
David Z:You are neglecting the other half of the equation: people save less when rates are lower.
Yes, right.
David Z:Which means they demand more now. And this demand can't be met without existing capital and productive factors (which don't yet exist), which means prices rise so that the consumer markets clear.
It doesn't matter. Consumers have lesser purchasing power now. So they really can't bid against businessmen who now have more purchasing power.