SummerSimo Travel Troubles Notes and The Purring Page

With the ongoing monetary tightening by many central banks, a term that we have not heard in a long time, but which has its own economic rationale, is becoming interesting again: malinvestment, that is, distorted investment that leads to the destruction of invested capital.

Malinvestment is a term used by the Austrian school of economics to refer to the wrong or inefficient investments that occur due to a distortion of price signals caused by an artificial monetary expansion. Malinvestment mainly occurs during the boom phase of the business cycle, when banks reduce interest rates and increase credit, inducing entrepreneurs to undertake projects that later turn out to be unprofitable.

Hayek’s business cycle theory, explains that malinvestment is due to the combination of two factors: fractional reserve and artificially low interest rate. Fractional reserve is the practice of banks lending out a portion of customers’ deposits, keeping only a fraction as reserve. This allows banks to create money out of thin air and expand credit beyond the amount of real savings available. The artificially low interest rate is the result of monetary expansion, which decreases the cost of money and makes long-term investment more attractive.

Hayek argues that the interest rate has a key function in coordinating the decisions of economic agents, particularly among consumers and investors. The interest rate reflects consumers’ time preference, that is, their degree of patience or impatience to give up present consumption in exchange for greater future consumption. A high interest rate indicates a strong preference for the present, while a low interest rate indicates a weak preference for the present. The interest rate also affects the choices of investors, who must compare the expected return on their projects with the cost of capital.

We could explain this differently: interest is the price of time. If the price of time, i.e., interest, is high, people will tend to buy less with the loan, so they will tend to make investments that have returns over shorter periods of time. If the price is high, then more will be bought If the price is kept artificially low, then it will distort consumer and business choices by pushing them toward longer-term investments. What are these investments? In classic case is real estate, but they could also be investments of no profitability except in the long run, such as unproven technologies with long development time.

When the interest rate is determined by the market, it tends to balance the supply and demand for savings and to ensure proper allocation of resources among different stages of production. In fact, production has a time structure, ranging from goods furthest from final consumption (such as raw materials) to goods closest to final consumption (such as consumer goods). The stages farthest from consumption are longer and require more capital, but they also offer higher returns in the long run. Stages closer to consumption are shorter and require less capital, but also offer a lower return in the short run.

When the interest rate is manipulated by central banks or authorities through monetary expansion, it no longer reflects consumers’ time preference and creates a discrepancy between investors’ and consumers’ plans. Investors are led to believe that there is more savings available and that consumers are willing to postpone their consumption in exchange for more future consumption. As a result, investors stretch the structure of production and initiate projects that require more time and capital but promise high returns in the long run. This phase is the boom phase, characterized by increased economic activity, employment and profits.

However, this situation is not sustainable because consumers have not changed their time preference and continue to desire a high level of present consumption. Real savings are not sufficient to finance all projects initiated by investors, and the interest rate must inevitably rise to restore the balance between supply and demand for savings. At this point, many projects prove unprofitable and must be abandoned or restructured. This phase is the crash phase, characterized by reduced economic activity, unemployment and losses.

Let’s take a practical example: at a time of forced low interest investors are driven to believe that there is strong demand for assets with long-term returns and requiring high investment, typically houses. This increases economic activity because it comes on top of the normal demand for short-term goods, consumer goods, so we have a boom time. Gradually, though, the excess demand generates inflation and thus also generates an increase in interest rates, due to the maintenance of real yields, net of inflation. At this point, the capital on offer is both too expensive and scarce, and this excessive cost causes long-term real estate investment to fail. We will have a plethora of unfinished projects, therefore of virtually zero value that are sold off in the market, and we will see the destruction of invested capital. The boom is followed by the crash, and its intensity comes to be dependent on the previous excess of consumption.

Malinvestment, therefore, is the main cause of the business cycle according to Hayek’s theory. Malinvestment implies a waste of resources and a loss of social welfare because investment is not coordinated with consumer preferences and does not meet consumer needs. Malinvestment also requires a process of correction, which involves liquidating or reconverting the wrong investments and bringing the structure of production back in line with actual demand. This process is painful and takes time, but it is necessary to restore the health of the economy.

To avoid malinvestment and the business cycle, Hayek proposes abolishing the fractional reserve and adopting a currency based on gold or another scarce and stable asset. In this way, the interest rate would be determined by the market and not by banks, and would reflect the time preference of consumers. Investors would be guided by true price signals and coordinate their plans with those of consumers. The structure of production would be adjusted to actual demand, and there would be no artificial fluctuations in economic activity.

The point Hayek makes was correct in the era in which he operated, when most currencies were still pegged to gold in some form. Recall that, for example, in the very 1930s of the Great Crisis, it was Lord Keynes, Hayek’s personal friend and ideological opponent, who detached the Pound Sterling from gold convertibility, thus overcoming the Austrian’s view that saw private banks as the moment of excess money generation. Nowadays, it is the monetary policies of central banks that decide the money supply, which is now completely detached from gold.

This development, however, has not eliminated the possibility of generating malinvestment, if anything it has changed its direction: if before it was the credit system that was the possible culprit, today it is the central banks, acting with political motives, in an attempt to support the business cycle and growth. A positive function, but one that should be accompanied by fiscal and demographic policy, not be something separate and autonomous, almost detached from factual reality. Instead, demographic policy was destroyed, fiscal policy was congealed and depowered, with budget constraints and draconian regulations controlling the private and public sectors, and it was claimed that only monetary policy could guarantee stability and growth. The results are there for all to see: a succession of booms and crashes that do not bring, but destroy, prosperity.