On Malinvestment, How? and Why?

Economics Economics Questions
1

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.

2

What were the misconceptions you were getting about malinvestment?

3

Great post… I’m going to send this thread to a few friends.

4

I thought that new money primarily (solely?) enters the economy through the banking sector, in the form of new loans. Based on this, I would think that demand for consumption goods would be near the bottom of the list as to prices which are first affected by the new money.

Please clarify. Thanks.

5

Great job by the original poster; you explained mailinvestment clearly in a brief writing. The way I understand it is that when this money comes in, as you noted, primarily through the banking system and thus loans, it is usually directed towards high order goods because these goods require loans far more often than consumer products. The production process becomes extended in these sectors where the new money is directed to and more workers are obviously needed and these workers wages are pushed up by the inflation as well. These workers are consumers as well and they begin to spend their money on consumer goods like any other person which will push prices up. Eventually you have the consumer good price increases reaching a parity with high order goods in a sense. Although the “high prices” of the high order goods seemed high at first because relatively speaking consumer goods were still down, now that the inflation has caused rising prices in consumer goods and the playing field starts to become leveled, people realize those high order goods aren’t so high priced anymore and therefore are not as profitable as they previously thought. If something is not profitable people will of course not invest in it which will force these sectors to liquidate and the available capital is decreased causing a contraction. Hope that helps!

In liberty,

Chris

6

I figured that out. Higher prices for consumption goods arises relatively quickly. For now, I’ll take Murray Rothbard at his word when he says, “Soon the new
money percolates downward from the business borrowers to the factors of production: in wages, rents, interest.” (America’s Great Depression, p. 11)

Good enough.

Now, onto this statement:

I think this is wrong. Yes, consumption destroys products/services which have value. But consumption is of necessity the enjoyment or realization of value as well. You cannot ignore individual time preferences. By foregoing saving in favor of present consumption, the individual who consumes now is actualizing his time preference. Seems to me, therefore, that this would mean that, in this particular case, consumption (i.e. private consumption, strictly speaking, as opposed to government consumption), not saving, MAXIMIZES “value” by maximizing utility.

Agree or disagree?

7

Excellent primer. I might sticky it for the benefit of newbies.

Austroglide raised a similar objection as to what I’d have, but I think it’s a matter of phraseology more so than any problems in your analysis. Would it not be more correct to say any industries sensitive to interest rates (by definition the higher order goods, but also durable consumer goods like housing) are the ones prone to bubble activities, though, in light of the recent crisis?

8

I’m confused as to what “investment in higher-order industries” means.

I haven’t seen many explanations of this (i.e. I haven’t read a lot of Austrian stuff yet). One explanation says that the higher-order industries produce capital goods which are, in turn, used to produce yet other capital goods, etc., until finally a consumer good is produced.

Why, then, would high consumer prices be the catalyst for a shifting of resources away from the higher-order industries, when exactly these higher order industries are necessary in order to produce consumer goods (i.e. they’re the first link in the production chain)?

Do you know what I mean?

9

Nothing specific, it just seems to be a sticking point for many people who are new to Austrian theory. You know how like most mainstream writers use the “overinvestment” theory of the business cycle, for instance. People have a hard time grasping the concept in full…

10

Yes, I think that is more correct. I posted this here for comments & critique, so it’s much appreciated.

11

This is easy. A malinvestment is one dependent on artifically low interest rates or one predicated on inferring artifically low interest rates in the long term from artifically low interest rates in the short term. In our recent bubble we had short term rates as low as 1%. With a bunch of stupid laws and an insane system of motgage guarantees from the Government, underwriters would create adjustable rate and/or balloon rate mortgages. Lendees would agree to this based on the stupid concept that the interest rates would never go up. They were wrong.

As an example: A home builder builds homes for 100K each with an interest rate of 5% gives buyers a 30year fixed payment of 900. The builder purchases the materials and labor and begins construction give this data. If the interest rate rises to 6% then the payments rise to 1000. So now the builder has lots of problems. The builder has fewer potiential customers or must reduce the price and profit on each home. Furthermore, materials and labor if purchased on loan will be more expensive as well. What if the builder deferred purchases until the builder needed the materials? This is a perfect example of a bubble activity that is affect by even the smallest of interest rates.

12

(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.

13

Consumption can be both the realization of value, and the destruction of value.

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.

14

It is not simply inflation that drives up consumer demand. The artificially low interest rate reduces the amount of earned money supplied to the credit market, which is instead supplied in exchange for consumer goods.

I don’t believe increased demand for consumer goods would justify investments in higher order capital. Rather, businesses would demand more of their lower-order capital and more nature-given resources such as labor, and higher-order capital investments would be liquidated to free up such resources for more lucrative opportunities in the existing production structure.

15

Excellent point! C/P, a higher interest rate encourages people to “save” or “invest”, if the rate is forced lower by credit expansion, then marginal lenders/savers are crowded out of the market.

16

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.

17

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.

18

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.

19

“completely” might’ve been a poor choice of words.

20

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.