GDP and Inflation

Money Matters, Monumentally - Part six: Malinvestment

Tuesday July 10, 2018 Konrad Hurren

In our last article we covered how an increase in the money supply (inflation) through Fractional Reserve Banking (FRB) leads to capital consumption. The present article covers a similar phenomenon – malinvestment. It is similar because it has the same underlying driver: the inflation falsifies economic calculation which introduces systematic errors. It does so by tricking entrepreneurs into thinking production inputs are adequate at the specific times and places they are needed, when they are in fact inadequate.

This concept is incredibly esoteric but is absolutely crucial to understanding the events that will unfold over the next 6 – 18 months. Let’s dive in, using a bit of introspection and some concrete concepts to try to match every day terms.

 

You may have heard the term “easy money” or “cheap debt” being bandied around (particularly in the wake of 2008). The price of debt here referring to the interest rate. The concept of “cheap debt” basically means exactly as it suggests, the interest rate is low.

Where does an interest rate come from? Ruminate on a simple question: would you like to give me $50 now in exchange for $80 in 3 months? Put another way: would you prefer a basket of goods worth $50 today, or do you like the basket of goods $80 will buy in 3 months better? This ratio between the two money amounts is the interest rate I am offering you.

 

Avid readers of our money series will remember that the central bank in our society acts to influence this. It does so by dictating what rate it will charge on overnight loans to the other banks in order for them to clear (our) transactions between each other. The central bank knows that by setting this rate low, the banks will create more money “out of thin air” and so the money supply will rise and the interest rate will fall.[1]

 

Something might immediately strike you as odd. If a central bank is pushing one way on this rate, but the rate they push for is different from that which reflects time preferences, shouldn’t there be something amiss?

And you’d be right, that “something amiss” is what falsifies economic calculation and leads to the structural errors we call “malinvestment”. Let’s keep digging.

 

The key is recognizing that resources (including capital) are scarce. And that investments are made always with an eye on the supply of inputs in an economy (wheat, labour, computing power …). When you invest in capital goods you make an assessment that the supply of other inputs in the economy will be adequate at the specific time and place you need them to be. If the resources are adequate great, you will make a profit. If not, bad luck, you’ve made an error and your punishment is a loss.

 

The information you use to make this decision is the interest rate. A low interest rate is a signal to you that there are sufficient saved resources at the time and place you need them for your investment to be profitable.

 

In a world where this interest rate is pushed and pulled every which way by actors outside the market you can see how entrepreneurs might systematically make errors in their investment plans. After all, the investments look profitable before the fact.

 

And those systematic errors are what we refer to as malinvestment.

 

 

Part six and a half – the bust and the reaction

 

Let’s come up with a more relatable story:

 

In a time of “cheap money” you might be enticed to take out a loan. What might you seek to buy? Presumably you might buy some goods for immediate consumption, maybe you rent a house to live in. After satisfying your demand for immediately consumable goods maybe you think that you’d enjoy more consumption in future years. And so you purchase “higher order goods” or goods that produce consumption goods at some later time. You might purchase a house. You might purchase any number of other higher order goods.

 

Note that a share in a company is essentially a claim on higher order goods. The current value of the NZX50, an index of the 50 largest publicly traded companies, is around 9,000. Compared to 10 years ago it was around 3,000.

 

So the prices of these “higher order goods” have shot up, now we need to consider those goods which produce the “higher order goods”. Clearly, if the higher order goods are selling for such high prices there must be opportunities for savvy entrepreneurs to jump in and produce these higher order goods.

 

And that is exactly what savvy entrepreneurs do. They invest in assets to create things that create other things. Let’s call these “stage 3 goods” Maybe they build a plant that produces lumber (to make houses which then produce the consumption good of shelter), or a factory which produces the driers used in milk powder production.[2]

 

To produce these “stage 3 goods” these entrepreneurs hire workers (awesome!), they also borrow savings from people with savings (capitalists). [3] Savings and labour are both scarce, whatever is used in the production of “stage 3” goods cannot also be used in the production of lower order goods. To attract these factors of production to this use the entrepreneur must offer them higher remuneration than they are currently receiving.

 

Production happens, some time passes. It comes time to remunerate the workers with wages, and the capitalists with interest.

 

These people collect their remuneration, and happily go to market for consumption goods. What would you buy, if you found yourself with a higher income than previously? You’d be able to afford some things you couldn’t before, but there’s no reason those all-important time-preferences would change.

 

And so demand for the consumption goods begins to increase. Since resources were diverted into producing the “stage 3 goods” they were not also available to produce the consumption goods. As we know, greater demand in the face of stagnant supply means the prices of the consumption goods will rise.

 

The savvy entrepreneurs see this too, they know they can profit from making consumption goods again. They liquidate their investments in the “stage 3” goods. Laying off workers and liquidating assets. An economy-wide sell-off occurs. Unemployment spikes. The economy enters into a depression.

 

Really astute readers might notice that this depression seems to be more like a correction of things that shouldn’t have been in the first place. And they’d be right. The depression is a necessary correction. Indeed the longer the “boom” goes the more malinvestments will accumulate, once the bust comes this implies there are more liquidations to be made, so the bust must be worse.[4]

 

On Thursday 28/06/2018 the Reserve Bank of New Zealand announced it would maintain the Official Cash Rate at 1.75 percent. In other words, it would maintain this “cheap debt” policy, and continue to postpone the depression. And on 4/07/2018 the Reserve Bank of Australia followed suit: holding their rate at 1.5%.

The justification was that maintaining this inflation was necessary for that economy. In other words, postponing the inevitable is the play.

 

Question is, how long until the readjustment cannot be postponed any further.

 

 



[1] Despite the near infinite number of possible higher order goods it’s very difficult to name them on the spot.
 
[2] These are probably the same people in the modern world where almost everyone who is employed owns index funds and shares. Either through schemes like Kiwisaver or otherwise.
 
[3] Some readers might remember Nobel laureate Frederic Hayek saying “fear the boom not the bust”. This is why.
 
[4] A bit of a leap of faith, we’re really talking about an interest rate structure, or a list of rates available from different lenders. But keep it simple just assume there is one rate to rule them all. The argument isn’t invalidated by this assumption.