Understanding Mal-Investment

Hello all,

So, I've been listening to a lot of the lectures in the media section here, and several of the folks have discussed a phenomenon called "Mal Investment" which is said to occur whenever the fed expands credit, especially beyond the natural savings rate.  They say that this distorts the market by providing bad information to the market regarding the time-preferences of consumers.  Most of this I understand, but the nature of Mal Investment still has me scratching my head.

Since I've worked for several failed startups, my first impression of the term "Mal Investment" was that it referred to the stupid decisions of Venture Capitalists and Mortgage companies to fund bad things, e.g. the dot-coms I worked for, housing loans to those who couldn't afford them, etc. 

But then another lecturer actually attempted to explain the phenomenon of Mal Investment (finally!) by comparing it to a Brick Maker mis-informing a House Builder about his availability of bricks.  The house builder begins too many house projects for the actual available bricks, and as a result, none get completed.

So, my first impression was that Mal Investment is "Poor Choice in the Quality of Investment", whereas the later lecturer seemed to be saying it was really "Wrong Amount of Investment in Good Things".

Can someone set me straight?

Thanks,

Bo Zimmerman

As I understand it (I'm still pretty new to Austrian economics, but learning rapidly), malinvestment is closer to the second option you stated.  It's basically misinvestment in the wrong line of things.

It comes about because banks flood credit into capital markets, making it seem like people's consumption-investment ratio has changed to favor investment and that there's more funds to invest in capital than there truly exists.  The new bank credit is invested in capital for which there's actually not enough demand for from entrepreneurs.  The new credit trickles down and spreads itself out over the whole mass of the people who keep reasserting the correct consumption-investment ratio, and so lower orders of production (closer to the consumer) keep bidding resources away from higher orders of production until the banks can't keep up the credit expansion any longer (for risk of hyperinflation or gold drain to foreign countries [if under a gold standard]).  Once the bank credit expansion is forced to a halt, the free market consumption-investment ratios reassert themselves again and expose all the excess investment in the higher orders as having been malinvestment, putting the wrong amount of investment into capital (which is a good thing) rather than consumer goods.

If I'm off-base on this explanation, someone else please correct me.

Thanks for your response Freiheit, it was entirely helpful.

I must continue to wonder, has anyone ever studied whether the amount of Stupid Investment is also in any way higher during artificial booms?  Although entirely anecdotal, I am thinking about the dot-com boom, which involved not only over-investment in internet stocks and companies that did not survive long enough to do well, but investment (period) in BAD internet stocks and companies that had a poor chance of ever surviving.  Granted that hindsight is always 20-20, but it seems that, viewing returns from investment as espected goods, investors with less money to play might be more conscientious about their next investment than those with too much money to play with.  Has anyone stumbled upon any considerations of this at mises.org?

 

If I'm correctly understanding your question, artificial booms ARE that stupid investment.  If you haven't read Chapter 1 of Murray Rothbard's "America's Great Depression" (free pdf on Mises.org), it talks a lot about what you're getting at, I think.

Bo Zimmerman:

Granted that hindsight is always 20-20, but it seems that, viewing returns from investment as espected goods, investors with less money to play might be more conscientious about their next investment than those with too much money to play with.  Has anyone stumbled upon any considerations of this at mises.org?

 

Very good! And who has more money than banks? As credit gets easier and reserve requirements drop, they must lower credit-worthiness and credibility requirements to expand their lending. Add the cushion of bailouts, and they are ready to invest in the Moon. Now they have the moon falling on their heads.

But then another lecturer actually attempted to explain the phenomenon of Mal Investment (finally!) by comparing it to a Brick Maker mis-informing a House Builder about his availability of bricks. The house builder begins too many house projects for the actual available bricks, and as a result, none get completed.

But the real cause of the problem is not mere 'mis-information'. The reason why the the house can't be completed is that the needed bricks don't exist. That is, the 'credit' that the banks extend is not credit based on real savings.

Juan:

But the real cause of the problem is not mere 'mis-information'. The reason why the the house can't be completed is that the needed bricks don't exist. That is, the 'credit' that the banks extend is not credit based on real savings.

Right. What happened was interest rates are driven to artificial lows, which spurs investment in goods that take longer to produce (since they are by definition, more sensitive to changes in interest rates). No similar signal was given to the stone-cutters, and hence there are not enough bricks. 

Long term investments, especially those on the margins, appear artificially profitable and in many instances compete for capital with short- and medium-term investmenets. More goods of this sort (goods w/longer time horizons) can only be produced if the necessary short- and medium-term inputs (e.g., bricks) have already been produced, but the capital required to produce these inputs has been bid away by the longer-term investments and/or there was no signal given to these producers that said "start firing more bricks."

Production can only be completed at considerable extra cost in terms of time and/or expenses in procuring sufficient quantity of bricks. This eats into, or destroys profitability.

Malinvestment is characterized as the allocation of capital towards longer-term processes than those which could be sustained by the existing capital stock of short- and medium-term factors of production.

Great explanation.  Of course, there is also a euphoric effect to cheap and easy credit, not unlike playing with "house money" if the rates are cheap enough.  As credit eases, lending standards also appear to relax, allowing not only malinvestment by otherwise prudent investors, but malinvestment by malinvestors. 

Absolutely. At some point, creditors run out of "worthy" loan applicants. In order to keep earning interest on money that they create out of thin air, they have to start loaning to poorer credit prospects.  If the "smart" or "prudent" investors couldn't manage the malinvestment phase, there is no reason to believe that the average Joe, or hell, not even the average Joe but the bandwagon investor (think about how popular "house flipping" became in the past decade...)

The fundamental problem is that the (artificially) low interest rate is sending a signal to the marketplace that does not accurately describe the structure of production necessary to bring all the desired goods to completion.