Malinvestment
Malinvestment is a mistaken
investment in wrong lines of production, which inevitably lead to wasted
capital
and economic losses, subsequently requiring the reallocation of
resources to more productive uses. "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. Random, isolated
entrepreneurial miscalculations and mistaken investments occur in any
market (resulting in standard bankruptcies and business failures) but
systematic, simultaneous and widespread investment mistakes can only
occur through systematically distorted price signals, and these result
in depressions or recessions.
Austrians
believe systemic malinvestments occur because of unnecessary and
counterproductive intervention in the free market, distorting price
signals and misleading investors and entrepreneurs. For Austrians,
prices are an essential information channel through which market
participants communicate their demands and cause resources to be
allocated to satisfy those demands appropriately. If the government or
banks distort, confuse or mislead investors and market participants by
not permitting the price mechanism to work appropriately, unsustainable
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 market conditions correctly.
However, such errors are most frequently compounded by distorted price
signals (the essential information channel through which entrepreneurs
can identify investment opportunities) and these distortions in turn are
most often caused by government intervention or
inflation misleading market participants.
[1]
It should be noted that it is often only in retrospect that
malinvestments can be identified, as price distortions and financial
bubbles can confuse investors and market participants for extended
periods of time.
[citation needed]
History
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:
[2]
Panics do not destroy capital;
they merely reveal the extent to which it has been destroyed by its
betrayal into hopelessly unproductive works.
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.
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
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. The price
mechanism co-ordinates production by "signalling" excesses and shortages
in the market, allowing stocks to clear and markets to function
efficiently.
In a monetary expansion caused by
fractional reserve banking, price signals are confused. Monetary growth reallocates resources but cannot in itself 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 by a central price fixing authority
such as the central bank 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.
[5]
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.
[6]
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.
[7]
Rothbard stated the following in relation to the "blindness" of government intervention in the economy:
[8]
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.
Analogies
As Mises wrote: "The whole entrepreneurial class is, as it were, in
the position of a master-builder whose task it is to erect a building
out of a limited supply of building materials. If this man overestimates
the quantity of the available supply, he drafts a plan for the
execution of which the means at his disposal are not sufficient. He
oversizes the groundwork and the foundations and only discovers later in
the progress of the construction that he lacks the material needed for
the completion of the structure. It is obvious that our master-builder's
fault was not overinvestment, but an inappropriate employment of the
means at his disposal."
[9]
Some may think that the "capital consumption" during the
unsustainable boom period must show up in things like reduced spending
on building maintenance, or perhaps in the owner of a fleet of trucks
neglecting to have the tires rotated.
In reality, it's more accurate to say that during the boom
period, entrepreneurs (led by false signals) invest in projects that are
individually rational and "efficient," but that don't mesh with each
other. In other words, it's not so much that a farmer forgets to plant
some of the seed corn in order to have a future crop. Rather, it's that a
farmer plans on expanding his output, and so he plants much more than
he did in the past, but unbeknownst to him, the owners of the silos and
railroads (needed to bring the harvest to market) aren't expanding their
own operations at the same pace.
In summary, it's not that an inspection of an individual
enterprise would reveal a technological deficiency. Rather, it's that
all of the entrepreneurs are "getting ahead of themselves," trying to
develop too quickly. There aren't enough real savings to allow all of
the new processes to be completed.
[10]
Examples
U.S. housing bubble
In May, 2010,
Detroit
started to tear down vacant and abandoned structures, planning to knock
down 10.000 to "reconfigure the city to reflect its shrinking
population."
[11]
The city of Dayton,
Ohio,
plans to demolish 500 of the 1,732 properties on the city’s nuisance
list in 2011. The process to demolish a property can take a year or more
and costs an average of $13,800. The city doesn’t have the capital to
demolish these structures and has to rely on federal funding.
The federal
Neighborhood Stabilization Program
funds the demolition of houses in neighborhoods hit hardest by
foreclosure. City leaders say the $28 million Dayton has received will
only make a small dent in the growing list of vacant and deteriorating
properties, estimated to be as high as 10,000. The program money amounts
to the demolition of only about 1,500 structures. Housing officials
estimate they will need an additional $20 million to $30 million in
funds — money the city does not have — to deal with the remaining vacant
housing stock.
[12] As of July, 2011, the
Bank of America and other mortgage holders were donating foreclosed and abandoned houses they couldn’t sell for demolition.
[13]
Ironically this is occurring in the midst of a crisis of homelessness
in America, indicating the extent of the bizarre malinvestment and
economic dislocation.
[14][15][16]
Meanwhile, the rash of foreclosures and mothballed construction
projects has launched a boom in the business of shrink-wrapping.
Plastic-covered foreclosed homes, half-finished hotels, a canceled
casino project in Las Vegas, new terminal expansion projects at the San
Jose or Sacramento airports and even a church stand as silent indicators
of a global recession.
[17]
Irish housing bubble
In the
Irish property bubble,
around 2006, more than a fifth of the Irish workforce was employed
building houses. The Irish construction industry had swollen to become
nearly a quarter of the country’s G.D.P.—compared with less than 10
percent in a normal economy—and
Ireland
was building half as many new houses a year as the United Kingdom,
which had almost 15 times as many people to house. Since 1994 the
average price for a Dublin home had risen more than 500 percent. By
2007, Irish banks were lending 40 percent more to property developers
than they had to the entire Irish population seven years earlier.
Morgan Kelly,
a professor of economics at University College Dublin, predicted the
Irish real-estate prices could fall relative to income—by 40 to 50 per
cent, and they did.
Many of housing developments are called "ghost estates" because
they’re empty. According to the audit of Ireland’s Department of the
Environment published in October, 2010, of the nearly 180,000 units that
had been granted planning permission, only 78,195 were completed and
occupied. Others are occupied but remain unfinished. Virtually all
construction has ceased. There were never enough people in Ireland to
fill the new houses.
[18]
Spanish housing bubble
In
Spain,
2006 was a milestone as regards the number of houses constructed:
760,000; more than the 650,000 started that year in France and the
United Kingdom, whose combined populations almost triple that of Spain.
Between 2001 and 2008 around four million new houses have been built and
the average number of housing units completed per year was 565,000,
more than double the figure of 250,000 for the previous decade. This is
equivalent to the construction of twelve dwellings per thousand
inhabitants, far in excess of the European average of five per thousand.
In 2009, after the collapse of the construction sector caused by
the bursting of the housing bubble and the effects of the global
economic crisis, the number of housing units started fell to 160,000,
and there were almost 700,000 housing units in stock (that is, completed
but unsold).
[19] This has created ghost towns all across Spain.
[20]
Other countries
The shipping industry has been heavily affected by the
Great Recession, about 12 per cent of the world's container ships were estimated to be 'doing nothing' in 2009.
[21][22]
Dubai
was a land full of grandiose, landmark projects, only to see the bubble
burst. The office-space vacancy rate in prime locations was in 2009
according to some estimates at around 40%, other estimates arrived at a
total 74% occupancy rate in residential and commercial space.
[23]
Burj Dubai, the tallest building in the world (about 2,600 feet high
with 160 stories) has been at its opening in January, 2010, described as
mostly empty.
[24] 90% of its 900 apartments were still empty a year later.
[25] (The construction of the world's tallest buildings seem to correlate with the business cycle - see the
Skyscraper Index.
[26])
China's
economy is continuing to grow despite the global recession, helped by
massive government spending. For years, regional governments across
China have been building massive real estate projects that have
attracted both private and corporate buyers. As prices have continued to
rise (residential values in 70 large and medium-size cities across
China soared in 2009, according to real estate consultancy Colliers
International), more investors have become speculators, buying brand-new
properties with the sole intention of flipping them.
A notable example is the city Ordos in Inner Mongolia, a whole
town built with government money that is standing empty. The district
was originally designed to house, support and entertain 1 million
people.
[27][28] Other examples abound. Some estimates put the number of empty homes at as many as 64 million.
[29][30][31]
Unfinished skyscrapers
There are also many buildings that, as proposed, would have become
the world's tallest (or close to it) but were never completed. The
Council on Tall Buildings and Urban Habitat has identified a number of
those:
- Nakheel Tower (Dubai) was a proposed 3,300-foot-tall skyscraper
with 156 planned elevators. Nakheel was designed to be the visual and
economic focal point of the man-made Palm Jumeirah, the fake series of
islands off of Dubai that is now experiencing extreme erosion and other
environmental problems.
- India Tower, the 2,356-foot tower planned for Mumbai in 2010, was halted the following year after construction had begun.
- The 2,008-foot Russia Tower (Moscow) was already under construction
when the downturn hit the following year, and the building's developer
announced he'd be unable to put up the $3 billion needed for the
building work. The construction site was turned into parking.
- At 1,808 feet, the Doha Convention Center Tower was destined to
become one of the world's tallest buildings. Because it was so tall,
officials worried it would make it tough for pilots landing and taking
off from the new airport. Construction was halted until Doha's new
airport was finished... Until the project was abruptly cancelled
anyways.
- Burj Al Alam (Dubai) was a flower-shaped tower proposed to rise
1,670-feet into the air. It was cancelled in 2013 after a long, slow,
much-denied decline.[32]
Criticisms
Tyler Cower, while leaning to the Austrian view, ponders that it "has
a hard time explaining how so many investors can be fooled into so much
malinvestment, especially given the traditional Austrian perspective
that markets are fairly effective in allocating resources."
[33]
As Robert Murphy explains, free individuals often make mistakes —
even systematic mistakes. But even perfectly rational entrepreneurs who
know a boom is underway cannot prevent their more reckless competitors
from taking cheap (or now free) government loans and bidding away scarce
resources. Workers don't care whether their paychecks come from genuine
saving or from the printing press, and every few years there is always a
fresh crop of naïve employers willing to borrow money and start new
projects.
Second, Austrians emphasize that interest rates
communicate information
to entrepreneurs. In some critiques it seems that "everybody knows"
that the true interest rate ought to be 5 percent, and so the central
bank's efforts to push it down to 3 percent should be easily corrected.
Yet nobody knows what the truly free-market
interest rate
is. That's why market prices are important in the first place, and why
government distortions of these prices lead to real imbalances in the
economy.
[34]
Entrepreneurs don't need to speculate about a change in consumers’ "rate of
time preference",
or about the "supply of capital goods". An individual entrepreneur is
concerned only with a very small set of market prices, namely, the
prices of the inputs she will need for her projects, and the prices for
which these products will sell. That’s the whole point of relying on the
market rates of interest and other prices — it eliminates the need for
individuals to speculate about aggregates that are far too complex for
any single mind to comprehend.
Also, some expositions of ABCT assume an initial free market state, and then analyze the impact of a one-shot
intervention.
But in reality the government of each major country intervene
permanently in the credit market by the creation of a central bank (or a
centralized system of banks). Actors in these economies have no idea
what the free market rate of interest would be in the absence of such
interference; even if the rates were raised, the new rate could still be
below the "natural rate".
[35]
More generally, Reinhart and Rogoff speak about the "this time is different syndrome" while analyzing centuries of
financial crises.
Financial professionals and, all too often, government leaders explain
that we are doing things better than before, we are smarter, and we have
learned from past mistakes. Each time, society convinces itself that
the current boom, unlike the many booms that preceded catastrophic
collapses in the past, is built on solid fundamentals, structural
reforms, technological innovation, and good policy.
[36]
References
- Jump up ↑ Percy L. Greaves Jr. "Mises Made Easier", "Glossary, Malinvestment - Mutatis mutandis", referenced 2010-05-11.
- Jump up ↑ As quoted in Financial crises and periods of industrial and commercial depression, Burton, T. E. (1931, first published 1902); see online version, New York and London: D. Appleton & Co.
- Jump up ↑ Ludwig von Mises, Human Action: A Treatise on Economics, 1966.
- Jump up ↑ Murray Rothbard, America's Great Depression, 2005, 5th Edition, Ludwig von Mises Institute, Chapter 1, The Cluster of Error.
- Jump up ↑ Frank Shostak. "The Subsistence Fund", Mises Daily, August 2004, referenced 2010-05-11.
- Jump up ↑ Larry J. Sechrest. "Explaining Malinvestment and Overinvestment" (pdf), October 2005, referenced 2010-05-11.
- Jump up ↑ Pavel Chalupnicek and Lukas Dvorak. "Health Insurance before the Welfare State The Destruction of Self-Help by State Intervention (pdf), The Independent Review, v. 13, n. 3, Winter 2009, referenced 2010-05-11.
- Jump up ↑ Murray N. Rothbard. "Chapter 12—The Economics of Violent Intervention in the Market", Man, Economy and State, 10. Growth, Affluence, and Government, referenced 2010-05-11.
- Jump up ↑ Ludwig von Mises. Human Action, p.557, referenced 2010-05-11.
- Jump up ↑ Robert P. Murphy. "My Reply to Krugman on Austrian Business-Cycle Theory", Mises Daily, January 24, 2011. Referenced 2010-05-11.
- Jump up ↑ Alex P. Kellogg. "Detroit Shrinks Itself, Historic Homes and All", The Wall Street Journal, May 14, 2010.Referenced 2011-02-15.
- Jump up ↑ Katie Wedell. "City needs millions more to raze nuisance housing", Dayton Daily News, February 8, 2011. Referenced 2011-02-15.
- Jump up ↑ Lindsey Rupp. "BofA Donates Then Demolishes Houses to Cut Glut", Bloomberg, July 27, 2011, referenced 2011-07-28.
- Jump up ↑ Homeless Kids Crisis
- Jump up ↑ Homeless Problem
- Jump up ↑ Squatters and Foreclosed Homes
- Jump up ↑ Bill Fink. "Web Exclusive: Wrapping Up a Recession", American Way Magazine, August 1, 2010. Referenced 2011-02-15.
- Jump up ↑ Michael Lewis. "When Irish Eyes Are Crying", Vanity Fair, March 2011 issue. Referenced 2011-02-15.
- Jump up ↑ Isabel Concheiro. "Spain Interrupted: On the form of the financial bubble", DAP - Digital Architectural Papers, Issue 1, 16.2.2011. Referenced 2011-02-15.
- Jump up ↑ Harold Heckle. "Spain Ghost Towns Develop From Real Estate Crash (PHOTOS)", Huffingon Post, posted: 02/16/2012. Referred from here with more resources and comments. Referenced 2012-02-18.
- Jump up ↑ Simon Parry. "Revealed: The ghost fleet of the recession anchored just east of Singapore", Daily Mail, 28th September 2009. Referenced 2011-02-15.
- Jump up ↑ Tyler Durden. "Thousands Of Rusting Ship Hulls Are A Fitting Tribute To The Speculative Market Bubble", Zero Hedge, 09/16/2009. Referenced 2011-02-15.
- Jump up ↑ Fernando Ulrich. "Rise and Fall in Dubai: An Austrian Perspective", Mises Daily, December 16, 2009. Referenced 2011-02-15.
- Jump up ↑ Christopher Hawthorne. "The Burj Dubai and architecture's vacant stare", Los Angeles Times, January 1, 2010. Referenced 2011-02-15.
- Jump up ↑ Simon White. "The ghost town that is Dubai's property market", 14 February 2011. Referenced 2011-02-15.
- Jump up ↑ Mark Thornton. "Skyscrapers and Business Cycles", Mises Daily, August 23, 2008. Referenced 2011-02-15.
- Jump up ↑ Bill Powell. "Inside China's Runaway Building Boom", see also the slideshow "Ordos, China: A Modern Ghost Town". TIME, April 05, 2010. Referenced 2011-04-06.
- Jump up ↑ AlJazeeraEnglish. "China's empty city" (video), Al Jazeera, November 9, 2009; original video. Referenced 2011-04-06.
- Jump up ↑ Adrian Brown. "China's Ghost Cities" (video, YouTube), dateline, a show of SBS TV (Australia), on air: 20th March 2011. Referenced 2011-04-06.
- Jump up ↑ Michael Bristow. "Work stops on Chinese ghost town", BBC News', 26 May 2010. Referenced 2011-04-06.
- Jump up ↑ Daily Mail Reporter. "The ghost towns of China: Amazing satellite images show cities meant to be home to millions lying deserted", Mail Online, 18th December 2010. Referenced 2011-04-06.
- Jump up ↑ Kelsey Campbell-Dollaghan. "The Sad Fates of the World's Six Tallest Unfinished Buildings", Gizmodo, 2014-11-17. Based on ""Dream Deferred: Unfi nished Tall Buildings" (pdf), The Council on Tall Buildings and Urban Habitat, CTBUH Journal, 2014 Issue IV. Referenced 2014-11-18.
- Jump up ↑ Tyler Cowen. "Two Prisms for Looking at China’s Problems", The New York Times. Published: August 11, 2012. Referenced 2013-01-17.
- Jump up ↑ Robert P. Murphy. "Correcting Quiggin on Austrian Business-Cycle Theory", Mises Daily: Monday, May 25, 2009, referenced 2009-11-11.
- Jump up ↑ Robert P. Murphy. "The Rational Expectations Objection to Austrian Business Cycle Theory: Prisoner’s Dilemma or Noisy Signal?" (pdf), last updated May 25, 2005, referenced 2009-11-12.
- Jump up ↑ Carmen M. Reinhart & Kenneth S. Rogoff. This Time Is Different: Eight Centuries of Financial Folly (pdf), Preface, see also the summary page. Referenced 2013-01-18.
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