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Explaining Malinvestment and Overinvestment
Original Article By: Larry J. Sechrest
The Quarterly Journal of Austrian Economics Winter 2006 vol 9 no 4
Major Topic: Economics
Minor Topic: Politics

Précis:

         Austrian Business Cycle Theory explains the business cycle by calling attention to the bad effects on business decisions of a central bank's monetary policy. It is a theory of unsustainable economic growth which leads to a corrective decrease in business activity – a recession. The theory includes two fundamental concepts: malinvestment and overinvestment.

         Production takes time and it costs money. Factor inputs in the production process must become available at a specific time and in a specific amount. Even small failures in planning will result in increased costs of production; and if large enough, these failures may make the project unprofitable.

         Why are businesses failing to plan properly and generating unprofitable production all at about the same time (that is during an economic slowdown or contraction)? The short answer: market interest rates (that is those determined by the central bank's rate) below the natural rate of interest (the rate at which net output equals the money supply increase; the rate needed for stable prices) create an unsustainable demand that cannot be supplied.

         In such a scenario the central bank makes credit expansion cheaper by lowering the interest rate (this makes loanable funds available appear greater than they really are). These low interest rates persuade businesses to invest more into longer term projects. This increases the demand for capital goods. However, if the interest rate is below the natural rate then consumers have not deferred any of their consumption spending. So this new demand for capital goods does not offset a drop in consumer consumption rather it adds to the demand from consumer consumption. The result is an increase in the prices of all inputs and finished products. Consumers, being a larger class, will always out bid businesses in the competition for factors of production. Businesses in consumption related enterprises will be able to out bid businesses in longer term projects. Many factors of production will be more profitable if they are devoted to consumption goods rather than capital goods since the return on investment is over a shorter period of time. The result of this competition is business failures of planning in longer term projects; inputs show up late and/or in less quantities than needed but always at higher prices. These extra and unplanned expenses have a more detrimental effect on longer projects and will result in an increase in bankruptcies, lost jobs and lower consumer sentiment – in other words all those who expanded and lengthened their production process will be the first to feel the pain of a recession.

         Only too much credit in the hands of businesses creates the conditions for a business cycle. Credit to other classes will not result in a direct need to liquidate assets due to the unavailability of some factors of production. Two criteria must be met for credit expansion to generate the business cycle: (1) credit expansion must be artificial – that is not due to an increase in the savings of the people. (2) credit available to businesses must be greater than the savings available to businesses.

         The savings available to businesses determine the sustainable amount of investment; the credit available determines the actual amount of investment. It is when credit exceeds savings that unsustainable investment is made. However savings is not a precise enough term.

         Wages, rents and other costs associated with the production process must be advanced to the owners of the factors of production before the capitalists can finish and sell their production. The subsistence fund is that part of a capitalist's saved profit that is re-invested in productive projects. It is the fund that pays for the factors of production before the final product is sold. Or in other words: the subsistence fund is what the factors of production need in order to maintain themselves – ultimately what they need are consumption goods.

         Savings is distinguished from the subsistence fund in that savings represents the maximum possible demand – the theoretical upper limit of the subsistence fund. In the real world the subsistence fund is always smaller than savings because capitalists are also consumers and need to eat too.

         This distinction between savings and the subsistence fund demonstrates how it could be possible to have unsustainable investment that is still below total savings.

         The author then raises the question as to why recessions last so long. Why is it that the correction process in the general economy is so time consuming when corrections in the stock market, for example, are so quick? Malinvestment – businesses investment decisions based on corrupted relative price signals – makes a correction necessary; overinvestment – the belief that the subsistence fund is larger than it is – prolongs the contraction. The author believes that the modern abandonment of the idea of a subsistence fund has made it possible to justify inflation, deficits and expanded government spending.

         Complementarity is the notion that input factors must arrive at the needed time in the required amounts. Further, that proper planning, under normal circumstances, can insure their timely and proportional arrival. A longer production process, resulting from longer range planning and facilitated by lower market interest rates, means that all factors of production need more consumption goods to sustain them before the capitalist, who advances their maintenance, can earn his profit. However, enough of such consumption goods, the author claims, will not exist unless: (1) consumers have chosen to reduce consumption, (2) capitalist have chosen to reduce consumption and (3) the saved consumption furnishes the credit of businesses (or in other words: the subsistence fund is enlarged).

         This artificial demand for capital goods at the same time as a normal demand for consumption goods is the proximate cause of both overinvestment and malinvestment. The increase in demand is not offset by a decrease in consumption; therefore the prices of all goods jumps unexpectedly; whereupon the increase in costs to secure factors of production makes it harder and more expensive to stay with pre-planned projects; some of these, the ones that are not profitable, will need to be liquidated or will be completed at a loss. If there is not any loss in the liquidation, or even if there is a loss, the real problem would still not be solved. The real problem is that the consumption goods needed to sustain the factors of production are nonexistent. The problems will continue until the subsistence fund is large enough to advance the needs of the factors of production. If investment never exceeds the subsistence fund there would not be any business cycle.

         In other words, lower market rates of interest encourage businesses to invest in more costly and longer run projects. As long as businesses believe that factors of production will be available businesses have an incentive to lengthen the production process. However, if the market interest rate falls below the natural rate, the demand for capital goods will compete with the demand for consumption goods for input factors of production. If committed investment is higher than the subsistence fund, factors of production will disappear when the investment spent equals or exceeds the subsistence fund (this is the point where there are not enough consumption goods to maintain the factors of production – and they, or their owners, will look for greater returns in a different project). This point is the beginning of the economic crash.

Added on: 2009-05-18 23:04:00
Précis by: James Jeff McLaren
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