What is malinvestment? It seems like no one in the media really knows. Most economists probably don’t understand what malinvestment is either because of their Keynesian heritage.
First, let’s look at government investment in general. To Keynes all investment was equal. Keynes believed that the government building a pyramid was just as economically valuable as building roads or cars or anything else for that matter. This may seem absurd, building pyramids does not increase the wealth of society, it destroys wealth by taking valuable resources and labor and putting them to use that is not needed. The thousands of people building the pyramids could have instead added value to society by building stuff that was actually needed like roads. Unfortunately, roads were not easy for a government to build either. Though the pyramid contributes no economic value to society, roads do because they provide transportation. The problem is that government planers are not very good at building roads to meet the needs of society. How many roads should a community build? Should a government build five roads for a small town or twenty five? Should it be on this side of town or that side? When government gets into building roads absurd things happen like the “Bridge to Nowhere”, a three hundred million dollar investment for a town of fifty people. This is not wise but for a government bureaucrat there is no cost benefit analysis. Would a one million dollar bridge be worth it? Or would a fifty thousand dollar ferry be more cost efficient? There is really no way for a bureaucrat to know, because there is no market pricing system that signals demand for such things. It is only when a totally ridiculous “investment” like the Bridge to Nowhere is proposed that people take notice but most bad investments do not go noticed because there is truly no way to know if it is a bad investment until it reaches the realm of absurdity. It should be apparent through these examples that some investments are better than others but ultimately it is still a guessing game because there is no price system. Governments waste a huge amount of capital on bad investments because they are basically guessing at what the public needs. It is like throwing a dart at a dart board in the dark. You hope it hits in the right place but you don’t really know where it will go. Government spending is the same way, its usefulness will never be known until it is built. Even then, we still don’t know if the funds could have been used more productively in a different area. Ultimately, bridges to nowhere, pyramids, and roads built where nobody drives might be bad investments but they are not considered malinvestment.
If these are bad investments what are malinvestments?
Malinvestment, a term used by the Austrian economists, have very unique set of characteristics. To put it simply, malinvestments are created in the private sector during an inflationary boom. They are investments that were made even though there was no or very little market demand for them. Just like the government infrastructure that served no real purpose because there is no public demand for huge pyramids or bridges to nowhere, the private market can potentially create goods that are not demanded by the public either. The housing boom that ended in 2008 was a perfect example of this. The housing sector in the United States created millions of more homes than were not needed by the public. Keynes never really understood why booms and busts happen and blamed irrational human behavior or “animal spirits” for this. The Austrians economists were unsatisfied with this reason and wanted to look deeper into the boom/bust phenomenon in the “free-market”. As the Austrians started studying boom and busts they started to observe unique market characteristics of booms and busts that would later lead to an explanation about their nature. While the Keynesians simply considered booms and busts a natural element of the unbridled free-market without any analysis, the Austrians actually looked at the phenomena in a penetrating way. The Austrians noticed that booms were characterized by a large amount of investment errors in a small period of time across the economy as a whole. This is very unusual because the market naturally sifts out entrepreneurs who make poor predictions through the profit and loss system. Poorly run firms incur economic losses and factors in a free-market naturally shift capital to economic actors who make more accurate economic forecasts about future demand. For entrepreneurs across the economy as a whole to make a series or errors at once in a very small time frame in very odd to say the least and goes against common sense economic understanding of how national economy should function.
The other characteristic that Austrian Economists noticed about booms and busts was that errors seemed to be much larger in long term investment projects that take many years to complete like mines, power plants, and other complex industries. Short term consumer goods were affected much less by the bust part of the cycle and did not suffer from as large of losses on their balance sheets. These two observed phenomena that characterized booms and busts lead the Austrians to believe that there was more “going on” than the simple Keynesian explanation of “animal spirits” or today’s term “irrational market exuberance”
If markets naturally move toward equilibrium and market actors in general make good market predictions, what was going on? Why were booms and busts happening if the free-market should naturally become more stabilized over time? The Austrians correctly believed that there was another unseen actor on the scene. Something had to be influencing the system that had been previously neglected by mainstream economists.
This unseen force creating the boom bust cycle was central banking.
The Austrians knew that there had to be something that was influencing how entrepreneurs were making investments. Entrepreneurs, by their nature, take risk in the hope of gaining profit down the road. Entrepreneurs also take out loans from banks to finance their projects. Banks charge an interest rate and this interest rate is very important key to whether a investment project will be profitable or not. Even small change in the interest rate can mean the difference from a profitable investment or an investment that will incur losses. One way to think about this is to think about the housing market. When interest rates are very low, a home becomes much more affordable. A one or two point drop in the interest rate can save a home buyer hundreds of dollars a month. A home buyer that could originally afford a $150,000 house could potentially own a $180,000 or a $200,000 house. This drop in the interest rate literally changes human behavior because now people can afford a much more expensive house than they could before. Human beings, being what they are, want the biggest house they can afford and will buy the bigger house. Entrepreneurs make similar decisions as well. They make investments that are similarly more expensive than they otherwise would have if the national interest rate was higher. Higher interest rates would have signaled that the investment would not be profitable. If I can build a property or a factory the can produce a certain amount of income per year, I would need the cost of building the property to be less than the income generated by the developed property to make a profit. For example, if I built a car factory for ten million dollars because of low interest rates and the cars that were finally produced by the factory produced an income of one million dollars a year then the company would be profitable in ten years. If interest rates were high, the factory could cost twenty million dollars or more to build and this would not yield a profit for twenty years or longer. Such a long time frame to reach profitability means much more risk because there is no guarantee that the model of cars produced or any product for that matter will still be in demand twenty years down the road. This could mean the difference from a potentially profitable business and a business that will go totally bankrupt. A small tinkering with interest rates can potentially have wide range impact that is hard to precisely predict.
As you can see, interest rates can have a profound impact on business and the economy but what are interest rates? Well, let’s take a closer look. When central banks lower interest rates, money is “cheap”. When a person takes out a loan the interest rate is the “price” of money. This can be easily understood with a little critical thinking. Human beings naturally prefer to have their money in the present. This should be obvious if someone asked you if you wanted a million dollars now or a million dollars fifty years from now, which would you choose? People obviously prefer money in the present not to mention that a person could make their fortune much larger if they had fifty years to be more productive with it. People naturally want to have money in the present and want to consume goods in the moment. Investors have to give people an incentive for people to part with their money. This incentive is interest; people defer present consumption by giving money to an investor in hopes that he will get more money back in the future. Banks are the intermediary between investors and savers. Both sides of this transaction gain from it. The investor gains because he is able to start his project with the capital he received from the saver and the saver gains because he will be able to consume more goods in the future with the extra capital he receives in interest from the investor. This transaction happens millions of times in an advance economy and is responsible for most modern economic growth. The lower the interest rate is a signal that there is a large amount of savings in the economy. Just like any market, the larger the supply of a good, the lower the price. The more savings there is in the economy as a whole, the lower the cost to borrow savings. The interest rate is a critical price signal in the economy. Just like all prices, it creates incentives. When interest rates are high because there is little savings in banks or because of high demand for capital investment, people are more likely to save because they will get larger returns on their savings. When interest rates are low because of a glut in savings or little investment demand, people (entrepreneurs included) are more likely to take out loans. When banks and interest are left unfettered, the market tends towards equilibrium and money is allocated efficiently. The problems start when central banks artificially lower the interest rate through open market functions (the details of which are not important to this article.)
When central banks artificially lower interest rates across a whole economy it creates false price signals. Entrepreneurs take huge loans for projects that they would have never done otherwise because money is “cheap.” Your average person will also often take out very large loans that they use for consumption like buying a car or a large house because they can now afford it. Even worse, people are much less likely to save money because they will receive less return on their capital. This creates a two fold problem where people are taking out very large loans even though there is very little capital in banks and capital is reduced even more than it would have otherwise because less people are saving because of low interest rates. This creates an unsustainable boom that will eventually result in a bust. Simply put, the money simply is not there. People do not consciously think about how much money is in an economy but instead act upon what the given interest rate is. It is a price, and like any good, the lower the price, the more people will want it. When the cost of money (interest) is low, people will demand more of it but as discussed above the money is simply not there. This is where malinvestment comes in.
The distortions created in the interest rates lead entrepreneurs to invest in unsustainable projects. Consumer goods are produced when there is not enough demand. These are the malinvestments. The houses that were over built in the housing boom where the most obvious types of malinvestments during the last boom but the houses themselves were by no means the only part of the economy that was over built. Anything associated with housing, like home improvement stores, where built in overabundance. Also, millions of jobs went into the housing market that otherwise would not have if there was no central bank fueled bubble. Potentially millions of people are in career fields where there was never the level of demand that they thought. Construction workers, home loan bankers, real-estate agents and the dozens if not hundreds of other jobs associated with the housing market will have to be reduced. As you can see, the central bank driven boom and bust cycle not only wastes a tremendous amount of physical capital but it also wastes a huge amount of human capital as well. The time spent training workers, the energy used to build building/goods and the materials used to build the capital and goods are all lost. This is malinvestment, mostly unrecoverable investment made in the wrong areas of the economy. Trillions were lost during the housing boom. Not only were these trillions lost, but if they were invested in the right areas of the economy trillions more of capital could have been produced on top of it. So not only was there an immediate loss of capital but there was future capital lost as well. It is kind of like taking away a foundation of a house. If the foundation was built correctly, the rest of the house could have been easily been built on top of it but if it is not built correctly than the builder also loses the future house as well. This is what was happening millions of times over during the housing boom, the economy as a whole not only lost present wealth but future wealth as well because foundations were built in the wrong places. Multiply this process over and over again since the creation of central banking and the losses are incalculable. Maybe without a hundred years of the boom bust cycle the average American citizen would be able to buy a new car for $5,000 or maybe we would be colonizing the moon, we simply don’t know. As much as central bank inflation steals money from the people, the distortions caused central banking likely steals much more. The only solution is sound money and free banking.