On Malinvestment, How? and Why?

Economics Economics Questions
141

I am new to this forum although I’ve been reading mises.org for years.

I think the challenge for us is to make these issues more palatable to the average person with a short attention span. I just created a blog with this goal in mind http://austrianeconomicsinastory.blogspot.com/ There are only 2 posts up there so far but I hope to add to it as time permits. I think if we can get these issues into an interesting short story, summary, or antecdote we have a real shot of having a receptive audience. While it’s certainly essential to have scholars doing the heavy lifting I think its important to find different ways to get these ideas to the masses.

The post below seemed relevent to this threads discussion and yes i know its not a short story, but most of the other posts will be.

Business cycles are caused by the Federal Reverve

The business cycle under the Federal Reserve:

  1. The Fed lowers interest rates below what they would be on a free market.
  2. Businesses borrow money for long term projects that previously hadn’t seemed profitable.
  3. People and money flow into the sectors most influenced by the apparent boom.
  4. The Fed begins a process of incrementally increasing interest rates at regular intervals.
  5. Prices rise, often ending in a mania phase (examples: dot-com bubble, housing bubble)
  6. A realization occurs that there is not sufficient actual savings to make all the projects profitable in those sectors affected by the boom.
  7. Prices fall, unemployment rises, as the market tries to reallocate resources in ways that matches workers and capital into more useful projects.

Free market scenario:
8) The malinvestments are cleared from the system as those who made bad bets lose money. Those who risked the most money on ill-fated projects go bankrupt.
9) The assets of bankrupt firms are sold based on bankruptcy laws. Viable businesses reopen under new management.
10) Wage rates normalize across industrys based on market conditions. Workers realign themselves into healthy industries.
11) People make business decisions, especially those concerning long-term projects, based on the correct market interest rate.
12) When the amount of savings increases, interest rates fall. When the amount of savings decreases, interest rates rise.
13) The free market interest rate allows businesses to correctly judge the viability of long-term projects by matching up cheap money with situations where projects will be profitable upon completion. The savings exists to purchase the products.

Alternate scenario: our present day reality.
8) The Fed again lowers interest rates below what they would be on a free market.
9) Money losing businesses are kept alive by borrowing to finance their day-to-day expenses. They hope for a return to higher prices in an attempt to unload inventory and return to profitability.
10) Resources and workers are encouraged to remain in the unprofitable post boom industries.
11) Servicing large debt loads becomes widespread.
12) New long-term business projects are evaluated based on the artificially low rates.
13) Return to #2 above and repeat the cycle, now with larger debts loads.

142

the higher prices being merely reflections of the increased money supply, and not of any fundamental change in consumer preferences. - This is an error. Not all prices will rise simultaneously, especially if the new funds are being ‘targeted’ to specific sectors of the economy. Thus you can create a ‘housing boom’ or a ‘stock market bubble’ etc, while many other prices remain fairly stable. It is the early receivers of the new money (often government) who direct the funds into specific sectors.

If you had a counterfeiting machine and used it to quadruple your income, would you necessarily use 4 times as much food, gas, water, electricity, etc. Or might the extra money ALL be funneled to other uses that you weren’t already satisfying?

143

DavidZ,

the theory you have just described is very reasonable, but I believe it is not the Austrian Business Cycle Theory. (note it does not require the money to enter the system via the loan market, and does not mention interest rates; it works with ordinary prices).

it is really a mainstream theory called the “monetary misperception theory”, illustrated e.g. in Landsburg’s macro text. (where he says that for a few years in the seventies mainstream economists found it promising, then rejected because of some evidence I don’t recall. Also Mankiw discussed it in a paper I don’t recall.)

144

I have a question about Austrian business cycle theory. The main disagreement with it seems to be that low interest rates are not to be blamed for malinvestment. I was thinking about the criteria of a business failing the other day. A business does not fail when it makes a loss, but when it’s rate of return is less than what investors could get by putting their money on the bank. But what you can get for putting your money in the bank is directly affected by interest rates, obviously. That means that when a central bank artificially lowers interest rates, a lot of businesses appear to be profitable, because their return is higher than just putting your money on the bank. Lowering interest rates also lowers the bar for when a business is to be considered profitable. It seems that lower interest rates per definition leads to malinvestment.

145

There are two important questions about business cycles that need to be answered. 1 - Why are there clusters of business errors occurring at the same time? 2 - Why do such events occur repetitively?

Lowering interest rates by expanding the money supply will lead to price inflation and push up interest rates. So the change in the rate is an unexpected occurrence. Long-term investments, like a skyscraper, cannot start earning revenue until they are completed, which has to divert resources from other sectors. At a high rate of interest, such projects are simply unattractive. Something that takes 10 years to complete might turn a profit after paying back debt in 5 years at one interest rate and 50 years at another. Once such investments are abandoned, they are difficult to liquidate. A half-finished coal mine isn’t going to make a nice Starbucks. So then the banks that made the loans have to be more conservative in lending to absorb the loss, or go bankrupt. So basically these projects have to be stopped and the laborers and raw materials diverted back to maintaining and using the existing capital goods to produce consumer goods. This will lower input and consumer prices.

If interest rates are lowered via increased savings, this comes from lowered consumption purchases - so the profit rate is lowered for consumption good businesses. The rates for long-term capital goods projects’ profit rates are raised, as they are designed to reduce production costs in the future, raising profit rates for consumer good businesses. Sure there are failures, and they might be greater in a low interest rate environment, but there is no cyclical nature in the macro-sense.

146

Doesn’t Austrian Economics reject the idea of an indifference curve? Which is one of the things I actually disagree with the school about.

147

Yes, that sounds right, I’d specifically say the price that is distorted, relative to all other prices, is the interest rate, which is affected immediately upon money creation. It takes time before other prices in the economy rise therefore giving the immediate illusion to the borrower that a project he thinks he can afford will not be affordable as soon as prices realign to their former relationship to the price of money (the interest rate).

Another way of thinking about it is there are a certain amount of resources (don’t think in money terms - think in terms of labor, machines, natural resources) that can be used for the production of present goods (gas in the car, food on the table) or can be used for future goods (investment in an agriculture company that creates 5x the yield of corn/rice) that eventually leads to more present goods sometime in the future - but in the present, there is a sacrifice of those resouces for greater future benefit.

Printing money does not change the amount of resources society has set aside for present v future use. It merely deludes the businessman into thinking there are more resources available for future use then there actually are.

For a fuller explanation see my blog post here: http://www.acceptancetake.com/the-unnoticed-evil-of-fractional-reserve-banking/.

I’d really appreciate feedback, critical and praiseworthy commentary is much appreciated.

148

I don’t know about the Austrian school’s position on indifference curves, but I’d guess that you’d be correct because indifference curves are cardinal instead of ordinal. In other words, a slight curved line is drawn out with specfic points 3.2 goods of A and 3.6 goods of B vs 4 goods of A 3.2 of B. If you could measure this indifference curve, that is you test every point for a single individual, then you could have, essentially, a cardinal curve, but barring some testing, all you could do is use is ordinal measurements. If I know, for example, that I’m perfectly satisfied with either 3.2 of A and 3.6 of B vs 4 of A and 3.2 of B, then all I can have is two dots on a graph - no line being connected - and say there two points bring me equal satisfaction.

149

That’s still cardinal. Ordinal values cannot be equal.

150

((No. When you spend less on present consumption and save more for the future (capital investment) what you are doing is this: deferring some fraction of your consumption immediately, in favor of more consumption in the future.))

Here you assume that all savings is real and not nominal. Am I correct?

((On the contrary, when you have all the factors running at or very near full capacity (during an inflationary boom), and people start spending more and investing less, what happens is that not enough is saved to sustain the same level of consumption.))

Here you talk about economy running at full capacity. You did talk about fiat injections and how they are inflationary. I guess not when economy is not at full capacity. Is this your opinion?

May be we can say that what is really causing monetary inflation is overspending, not money supply. If demand doesn’t match real supply then that is inflationary. Am I correct?

You seem to build on Say’s law. Do you think market always clears? The money that was paid for the investment will consume the production of that investment? What if some of the workers who build the factory just hoard the money? (in this case money can be pieces of gold)

151

Say’s Law…The money that was paid for the investment will consume the production of that investment…

Say’s Law does not claim that “the money that was paid for the investment will consume the production of that investment”.

Have you been taught that that is Say’s Law? Or is it your considered summary of the law, having read Say’s work?

152

David Z: 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.

But demand for higher order goods is determined by the expected profits of consumer goods. The expected profits of consumer goods is determined by the demand for consumer goods. How then can new money be spent on higher order goods if new money isn’t also spent on consumer goods?

Let’s create an order of production list:

  1. A lumber company grows and chop down trees

  2. A separate company cuts and refines the wood

  3. Another company assembles cabinets with the wood

  4. Yet another company installs the cabinets in new houses

I gather that this list presents goods from higher to lower order. Is the claim that artificially low interest rates cause investors to invest disproportionately in #1? Why would they invest in #1 as opposed to the others? I would think the lumber company would only attract additional investment if they expected additional demand from the refining company, who in turn would only demand more wood if the assembling company increased their demand.

153

David Z: If the interest rate decreases, individuals contribute less to savings (investment in productivity) and more to consumption which exacerbates the problem.

So savings includes all types of investment? Why would someone invest less in the stock market because interest rates were lower? Don’t people invest in the stock market due to the rate of profit and not the rate of interest?

154

people will loan less than they otherwise would. they may speculate more (or hold cash which can be considered a very risk-free method of speculation), or buy more consumer goods.

155

OK, as I see it there are four things to do with your money: consume it, invest it (e.g., buy stock, start a small business), lend it (or put it in the bank who then lends it out), or hoard it.

So if interest rates were low, you would be less likely to put your money in the bank. So then you have to do one of the other three things. Somehow, in a way that is entirely unclear to me, this leads to malinvestment. So what is the Austrian solution? Require the banks to have 100% reserves. If banks had 100% reserves, then the interest you’d receive from having your money in the bank would be zero, or probably even less than zero. So why would this not have the same (or worse) deleterious effects as a low interest rate? Wouldn’t this drive up consumption as well?

156

It leads to malinvestment by taking resources to be used for future consumption and putting them in projects the require too many resources than actually exist. Try not to think about money - it can get confusing - just imagine a pool of scare resources society has set aside that can be used for longer term objectives - like building some widget that will increase food yields by 300%.

The interest rate is the market’s regulator as to whether people should invest their resouces for future consumption or just use them in the present.

When the Fed injects new money into the banking system, the rate of interest is lower than it would be on the free market. That signals to entrepreneurs, in the form of interest rates, that there are enough societal resoruces to take on longer projects - when, if enough time passed, interest rates would adjust back to the true free market level. It also signals to consumers that their investments aren’t as needed - they will get less of a return on their money on average.

Think of it this way - if entrepreneurs/businessmen can get money more cheaply from borrowing, why would they bother to sell equity? Yes, invidividual investors might shuffle stocks around - but that doesn’t mean more investor money is actually being used on a long term project.

Even if investors decided to invest more with lower interest rates, as long as the Federal Reserve is adding money into the system, the interest rate will still send a false signal as to how many resources are available. Even if the amount of societal resources available for future consumption increases, the added amount of money will make it seem like their are still more resources available than there actually are.

The Austrian solution, well there is some disagreement from within, but I agree with the Austrians that yes, we should have 100% reserves. The problem isn’t low interest rates - the problem is a not free market interest rate. And, if we had a 100% system, some people would choose to pay for safeguarding some of there money, while the rest of their money could be invested in safe bonds or time deposits with the bank.

If the rate is just the free market - the 0% interest rate would be a signal that the market has plenty of investment, and yes, it would encourage consumers to consume - but that would not be an unsustainble form of consumption.

157

also, keep in mind the only time money is “injected” into the stock market is during an IPO. none of the money traded daily between a seller of stock and a buyer goes directly into increasing the length of the production process. This is where corporate bonds are much more important, and they rely on interest rates.

as far as 100% reserves and the interest on a bank deposit, yes and no. yes, banks would have to charge you to safekeep your money and provide you with money substitutes. but no, there would still be time deposits, which are small loans to the bank, which would pay you interest. so it would simply divide the different functions of banks (demand deposit or warehousing and borrowing at interest). Currently they are conflated, which leads to greater banking instability, which leads to centralized banking, gov’t provided deposit insurance, and fiat currency…which leads to violent business cycles. if banks gathered their funds primarily from time deposits, they could easily match the maturity of their loans to their borrowed funds - something impossible with today’s conflated system.

here’s a good small-scale example of how the business cycle can work. http://mises.org/daily/3155

prices are used for economic calculability. the interest rate is one of them. An investment that won’t generate income for 10 years might take 20 years to be profitable at one interest rate but 100 years at a higher rate. The thing about the business cycle is that the more entrepreneurs are misled by the current interest rate created by means of credit expansion, the more upward pressure is put on consumer price inflation and interest rates.

So if entrepreneurs know the rate is artificial and will not last, they could plan accordingly. BUT they have no idea what the natural rate should be, and they do not know if or when rates will rise or how long gov’t and banks will try to keep rates low, etc. Simply put, there is much more uncertainty.

158

Andrew: It leads to malinvestment by taking resources to be used for future consumption and putting them in projects the require too many resources than actually exist. Try not to think about money - it can get confusing - just imagine a pool of scare resources society has set aside that can be used for longer term objectives - like building some widget that will increase food yields by 300%.

OK, can we flesh one example out? Maybe we can limit the resources to labor, for simplicity. So this widget for increasing food yields requires a certain amount of constant labor. Let’s say it takes five years to make. So that’s five years these laborers have to work on this widget when they could be producing something else, like a smaller yield of current food.

The first proposition seems to be that low interest rates cause businesses to take on these longer projects. This is because it tells them that there are more resources–i.e. that there are more laborers. But why does the belief that there are more laborers induce them to invest in a five year project instead of a one year project?

The second proposition is that there aren’t actually enough resources for this project. So what does that mean in practice? That there aren’t enough laborers for the project? Wouldn’t the business know this as soon as it goes to hire the laborers? Do the laborers drop off after a couple years for some reason I’m not aware of? Or does it mean that there aren’t enough consumers for the product once its finally finished?

159

also, keep in mind the only time money is “injected” into the stock market is during an IPO. none of the money traded daily between a seller of stock and a buyer goes directly into increasing the length of the production process. This is where corporate bonds are much more important, and they rely on interest rates.

Interesting. I think I heard something about that once before. I’ll have to research it.

as far as 100% reserves and the interest on a bank deposit, yes and no. yes, banks would have to charge you to safekeep your money and provide you with money substitutes. but no, there would still be time deposits, which are small loans to the bank, which would pay you interest. so it would simply divide the different functions of banks (demand deposit or warehousing and borrowing at interest). Currently they are conflated, which leads to greater banking instability, which leads to centralized banking, gov’t provided deposit insurance, and fiat currency…which leads to violent business cycles. if banks gathered their funds primarily from time deposits, they could easily match the maturity of their loans to their borrowed funds - something impossible with today’s conflated system.

I see. Time deposits would be lent out and you couldn’t get your money back until a certain time. In a sense, the banks would simultaneously be 100% reserve and 0% reserve.

160

Because the five year project has a higher ROI than the one year project - otherwise they wouldn’t do it. Investments are often like that - projects that take a long time to produce yield more than doing something you can do immediately - think of starting a business for example.

If we lived in a simple economy where there was one lender and one industry and only a few people it would be obvious like you say.

In the real world, all the businesses start off just fine. Eventually, though, yes - some of them will realize that they actually don’t have enough money (labor) to finish their project. The reason for this is that the new cost of labor (when interest rates finally go back to free market rates) is too high for some business - which then close.

It doesn’t mean the individual project is unsustainable - only certains parts of long term investments found somewhere in the entire economy. There were literally not enough laborers to begin with. Had the laborers demanded their free market wage (i.e. the interest rate had adjusted upwards or the real interest rate stayed the same) then the business cycle wouldn’t have begun in the first place. Of course, in the real world, it’s not just labor - it’s a whole convoluted, extremely complex system of prices that not even the great rational expectator Bryan Caplan could adjust for.

The price being paid for the workers is unsustaniable from the beginning - but it’s just about impossible to know that from an individual entrepreneur’s perspective.