On Malinvestment, How? and Why?

Economics Economics Questions
21

More precisely, for any given level of real income (i.e. whether that level exists in an unfettered money market, whether that level exists in a 2% inflationary money market, or whether that level exists in a 10% inflationary money market, etc.) we can say that society has a distinct time preference.

More precisely still, for any given level of PERCEIVED real income, we can say that society has a distinct time preference. It is NECESSARY for consumers to MISPERCEIVE the inflationary income as new wealth in order for the Austrian analysis to hold: In other words, the Austrian analysis depends CENTRALLY on an increase in the prices for consumption goods RELATIVE to the prices of capital goods*. Without such a change in relative prices, the structure of production will remain unchanged.

I think it is MOST reasonable to make clear that society has a time preference, and a concomitant structure of production, for EVERY possible level of PERCEIVED REAL INCOME and, thus, for every possible level of UNEXPECTED inflation.

So , to again put the finest point possible on things, it is most accurate to draw the distinction NOT between “an inflated money market” and “a non-inflated money market”, but INSTEAD between “a non-inflated money market” and “an X% inflationary money market”; or between “an X% inflationary money market” and “an (X +/- N)% inflationary money market”.

END: I’m not trying to state this argument as an undeniable fact. I posit it because I think it’s quite reasonable and potentially helps to clarify things quite a bit. And we should be as conceptually clear and concise as possible in these matters. Any and all criticisms, clarifications, or denials are welcome.

EDIT: It goes without saying that, at each level removed from stasis (I don’t think this needs to be a 0% inflation money market, if enough time has passed for the structure of production to reach full fruition for the given level of real income in question), changes in the inflation rate actuate the deleterious processes of malinvestment, which in turn manifest themselves in changes to the “X real income” structure of production.

EDIT 2: * Were the inflation CORRECTLY pereived by wage, rent, and interest earners for what it was, no change in the RELATIVE price structure should occur.

22

I think this is appropriate.

23

Such a change in relative prices is a necessary consequence of inflation. Some economic actor, somewhere in the economy receives the new money before anyone else, and before the increase in M is known. This actor then has at his disposal more money than he would otherwise have. He competes for scarce resources with others, who do not have the benefit of this new money. He bids up the prices of these scarce resources, and takes them from where, in an unfettered market, they would be optimally allocated.

Prices just rose. Everyone else plays catch-up.

If a person knew, or could accurately predict now what the effects of inflation would be in a given period of time, he would arbitrage the opportunity, and prices would rise instantly as a result. This is the problem theoretically with prediction: if you can do it accurately, it’s self-invalidating.

If inflation didn’t cause an imbalance in the price structure, there would be no reason to pursue it as a policy. It is pursued precisely because it is known (or assumed) to affect the price structure.

24

Agreed.

25

Yes, thanks. I’m having to think a lot about this - it’s really messing me up at the moment.

26

What does Austrian theory tell us about where this new money is spent? Is it assumed to always be spent on final goods (i.e. consumer goods), for instance. Can it just as easily be spent on, say, higher-order capital goods?

27

I think this was a point I overlooked (or flubbed) in the intial post. It is assumed that new money is typically spent on higher-order capital goods, the money enteres the system through the banks, and is loaned to businesses. Even individuals who benefit from this new money typically aren’t taking out a $100 loan to buy new jeans at Macy’s, they’re taking out $190,000 to buy a house, or $22,000 to buy a car, etc. At the same time, however, real investment (deferred consumption) declines because of an artificially low interest rate, and real, immediate consumption rises..

28

Most investment costs are for original factors of production - wages, rent, and interest. For the recipients to invest that income into more capital goods rather than use it for consumption is highly unlikely, especially if interest rates are artificially low.

Edit - actually i meant supply credit, not make an investment. This may actually be a good point and be a reason for speculative asset bubbles - they appear to be low-risk means of earning a greater return than supplying credit. As far as investments in higher order capital goods, I don’t think most laborers, landlords, or creditors would have the nerve to either take such unknown risks or feel there is greater opportunity cost in learning the risk as opposed to their current income sources.

29

Here’s what Rothbard says in American’s Great Depression:

“Businessmen take their newly acquired funds and bid up the prices of capital and other producers’ goods, and this stimulates a shift of investment from the “lower” (near the consumer) to the “higher” orders of production (furthest from the consumer)—from consumer goods to capital goods industries. (p. 11)”

It makes sense that the new money - which enters the economy largely as bank credit - should finds its way first into markets for “capital and other producers’ goods”, as Rothbard indicates. For some reason, I was thinking incorrectly that the inflation first manifests itself in CONSUMER goods prices. Actually, the inflation first manifests itself in PRODUCER goods prices.

30

for sure. I definitely overlooked that in my analysis, I’m almost embarassed to admit having been so focused on the consumer-end, which doesn’t really result from the inflation per se, rather from the fact that the inflation has depressed interest rates, thus encouraging consumption. This is existing money, not new money, however, both the existing money diverted from investment and the new money are spent into the economy.

31

Great Post! It explains it really well, in brief.

32

I’ve posted a revised version, Malinvestment: A Primer.

Thanks everyone.

33

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?

34

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.

35

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.

36

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.

37

Govt does not change interest rates. It only mimics a change. The rates, as you say above, remain as they were.

38

  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.

39

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.

40

I demand somebody answer Ixtellor (because I lack the knowledge to).