Malinvestment

Malinvestment is an investment in wrong lines of production which lead to capital losses. "Wrong" in this sense means "incorrect" or "mistaken" from the point of view of the real long-term needs and demands of the economy, if those needs and demands were expressed with the correct price signals in the free market. Austrians believe systemic malinvestments occur because of unnecessary and counterproductive intervention in the free market, distorting price signals and misleading investors and entrepeneurs. For Austrians, prices are an essential information channel through which market participants communicate their demands and cause resources to be allocated to satisfy these demands appropriately. If the government or banks distort, confuse or mislead investors and market participants by not permitting the price mechanism to work, malinvestment will be the inevitable result.

Malinvestment results from the inability of investors to foresee correctly, at the time of investment, either the future pattern of consumer demand, or the future availability of more efficient means for satisfying consumer demand. Malinvestment is always the result of the inability of human beings to foresee future conditions correctly. However, such errors are most frequently compounded by the illusions created by undetected inflation.

The concept dates back at least to John Mills (not to be confused with John Stuart Mill) in An Article read before the Manchester Statistical Society in December 11, 1867, on Credit Cycles and the Origin of Commercial Panics:

Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.

Ludwig von Mises developed the concept in the context of the Austrian School's perspective on the deleterious effects of bank-created "fiduciary media":

The popularity of inflation and credit expansion, the ultimate source of the repeated attempts to render people prosperous by credit expansion, and thus the cause of the cyclical fluctuations of business, manifests itself clearly in the customary terminology. The boom is called good business, prosperity, and upswing. Its unavoidable aftermath, the readjustment of conditions to the real data of the market, is called crisis, slump, bad business, depression. People rebel against the insight that the disturbing element is to be seen in the malinvestment and the overconsumption of the boom period and that such an artificially induced boom is doomed. They are looking for the philosophers' stone to make it last.

More recently, Austrian School economist and libertarian Murray Rothbard used the concept of malinvesment to study the Great Depression is his revisionist work, America's Great Depression:

A credit expansion may appear to render submarginal capital profitable once more, but this too will be malinvestment, and the now greater error will be exposed when this boom is over. Thus, credit expansion generates the business cycle regardless of the existence of unemployed factors. Credit expansion in the midst of unemployment will create more distortions and malinvestments, delay recovery from the preceding boom, and make a more grueling recovery necessary in the future. While it is true that the unemployed factors are not now diverted from more valuable uses as employed factors would be (since they were speculatively idle or malinvested instead of employed), the other complementary factors will be diverted into working with them, and these factors will be malinvested and wasted. Moreover, all the other distorting effects of credit expansion will still follow, and a depression will be necessary to correct the new distortion.

Austrian Business Cycle Theory and Malinvestment

Main article: Austrian Business Cycle Theory

The complicated and somewhat fragile production structure requires that complementary inputs be available not only in the right magnitudes but also at the right moments in time. If they are not, then projects that appeared profitable are soon revealed to be unprofitable. In other words, what appeared to be capital creation is seen in fact to be capital consumption.

In a monetary expansion, monetary growth cannot produce economic growth. The economy is being pulled in two directions. Entrepreneurs want more capital goods, at the same time that consumers want more consumer goods.

The decline in interest rates means it pays less to save, so consumption is raised beyond levels that would have otherwise taken place. At the same time, more real funding seems to be available for businesses. More resources are used for the production of consumer goods and less for the maintenance and improvement of the wealth-producing infrastructure. This lowers the economy's capacity to produce final consumer goods and so it weakens the pool of funding - contrary to the popular idea that a central bank can grow the economy by keeping interest rates as low as possible. The needed correction comes in the form of a recession, during which many projects are liquidated and unemployment rises.

Austrian Business Cycle Theory focuses on the "medium run", because that is where problems arise. In the short run, the capital structure cannot be changed significantly, and in the long run all errors have been rectified. In the medium run there is time enough for capital projects to be initiated and the direction of production to change, but not enough time for malinvestments to be corrected - at least not without serious repercussions.

The inability to smoothly liquidate or redirect projects stems largely from the heterogeneity of most capital goods. Capital goods cannot immediately be converted into final consumer goods - or other capital goods. Changes in the structure of production cannot easily be reversed. There is a significant degree of "path-dependence" involved with the capital restructuring that occurs in the medium run. The economy cannot simply "erase" the errors and start over.

Malinvestment occurs due to misleading relative price signals, and it necessitates a corrective contraction - a bust following the boom.

At the same time, there is also the phenomenon of overinvestment, because entrepreneurs are led to believe that the subsistence fund is larger than it actually is.

Government intervention

Government interference can also distort market information signals. For example, if the government creates a false expectation of greater trust (e.g. by declaring its backing of one of the parties), it can cause the second party to invest too much in this relation (and thus create "overinvestment"). In the opposite case, it can create distrust, causing people to invest too little and making them lose potential benefits from unconsummated transactions. By generating such fluctuations, the government can "add" or "remove" trust from various private activities or individuals, or it can interfere with them by its own activity and crowd them out. In financial markets, the government in most cases obtains more favorable loan conditions than any other potential borrower. The most common explanation attributes this advantage to the government’s power to tax. As a result, it crowds out private investments that cannot compete.

Similarly, some studies of crowding-out in the area of private philanthropy explain it with reference to private charities’ reduced effort to raise funds from individuals after they receive a government grant.

Rothbard stated the following in relation to the "pointlessness" of government intervention in the economy:

Government is deprived of a free price system and profit and-loss criteria, and can only blunder along, blindly 'investing' without being able to invest properly in the right fields, the right products, or the right places. A beautiful sub­way will be built, but no wheels will be available for the trains; a giant dam, but no copper for transmission lines, etc. These sud­den surpluses and shortages, so characteristic of government plan­ning, are the result of massive malinvestment by the govern­ment.

External links

• Malinvestment on Wikipedia
• Is "Malinvestment" enough to go bust? (pdf) by Enrico Colombatto, summer 2005
• Explaining Malinvestment and Overinvestment (pdf) by Larry J. Sechrest, winter 2006
• Capital, Credit Expansions, and the Subsistence Fund (pdf) by Larry J. Sechrest, November 2002
• Malinvestment, Not Overinvestment, Causes Booms by Ludwig von Mises
• Aerial Footage: Portrait of a Housing Bust by Barry Ritholtz, October 2010