On Malinvestment, Austrian Economics, and Prices

In an interesting piece for Bloomberg, Noah Smith tries to apply Austrian economic theory to the current economic slowdown in China.  The article comes off as a bit confused, partly because Mr. Smith doesn’t fully understand what exactly Austrian economic theory is. (His description of it is rather unflattering, and mostly incorrect).  I’d like to address one question he raises:

One of these [items that are appearing in China] is “malinvestment.” Austrian thinkers such as Mises contend that recessions happen because too many resources are funneled into assets that won’t actually be productive in the future. By the time businesses realize that they have made a mistake, they are locked into bad lines of business, or bad business locations.

It has never been very clear exactly why malinvestment causes an economic hangover. Why don’t businesses just cut their losses and immediately start investing in something more useful, as soon as they realize that they’re doing the wrong thing? Austrian theory has never been particularly clear on that (and its notorious refusal to use precise mathematical models certainly doesn’t help).

Let’s ignore the childish quip about “refusal to use precise mathematical models,” (if Mr. Smith has come up with a way to predict randomness, free will, and black-swan events, I’d love to see it).  Malinvestment, he correctly notes, is the idea that resources are funneled into unproductive causes.  It’s a head-scratcher to me that his next question is “why do unproductive resources cause recessions?”  The reason seems pretty obvious to me: unproductive resources cause recessions because they are unproductive.  Given that the ultimate goal of all production is to promote more and better consumption, when production produces something that cannot or will not be consumed, it will ultimately lead to recession.

The next question is a good one: “Why don’t businesses just cut their losses and immediately start investing in something more useful, as soon as they realize that they’re doing the wrong thing?”  Some do.  They reallocate their resources as necessary, sometimes resulting in layoffs or, in extreme cases, bankruptcy.

But sometimes, the incentive system is messed up and it continues to reward malinvestment.  This is usually when the price system is tampered with.  For example, the very evidence Mr. Smith cites: China.  The Chinese government, through diktat and subsidies, had firms create massive Potemkin villages; ghost cities with no one living in them.  These are classic examples of malinvestment caused by government.  These buildings were funded by artificially induced debt, and now that the time has come to pay the piper, the Chinese government finds itself short of resources.  Another example is the 2008 Housing Crisis: the Federal Reserve kept interest rates (and thus borrowing costs) too low, the government prompted banks to give out sub-prime mortgages (both through diktat and the promise it would back/buy said mortgages via Fannie Mae and Freddie Mac), and subsidized new borrowers who had little to no credit.  These activities lead directly to a housing bubble and the subsequent and inevitable bust.  A third example is price controls in Venezuela: by keeping prices artificially low, firms invest too little toward consumer goods, and this creates shortages.

The answer to Mr. Smith’s question is that yes, we have been clear on what causes malinvestment.  We fight so much to keep government from creating price distortions simply because those distortions create the malinvestment!  And, because it takes time for resources (including labor) to move from malinvested uses to more productive uses, time inevitable will be marked by recessions.

Update: My good friend and colleague Jim reminded me of something so important I am ashamed I skipped over it.

Regarding why malinvestment causes a hangover, it is also important to remember that real capital goods are not homogeneous; they are not lumps of k that can be quickly reassigned.  A dump truck is a dump truck and cannot easily be turned into a computer.  A dump truck factory cannot be effortlessly retooled overnight to make computer parts.  These things take time, and that time period is called a “recession.”

Quoted, with his kind permission:

“Capital heterogeneity is really core to Austrian Capital Theory and the Austrian Business Cycle Theory.” -Jim Chappelow, The Barbarian Economist.

8 thoughts on “On Malinvestment, Austrian Economics, and Prices

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  2. “Capital heterogeneity is really core to Austrian Capital Theory and the Austrian Business Cycle Theory.”

    As is labor heterogeneity. Some folks seem to believe that unemployed labor is homogenous like play-doh. Those high skilled dump truck workers might be terrible at making computers.

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  3. One other aspect Smith hints at is where did the inflation from QE go?

    Leftists such as Noah Smith are very flat thinkers, and if they can’t see it in front of their face, they dismiss it out of hand.

    A large part of the answer to this question is excess reserves, held at the Fed:

    https://research.stlouisfed.org/fred2/series/EXCSRESNS

    And here is some additional Austrian commentary on the “missing” inflation:

    https://mises.org/library/where-inflation

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  4. One other aspect Smith hints at is where did the inflation from QE go?

    Leftists such as Noah Smith are very flat thinkers, and if they can’t see it in front of their face, they dismiss it out of hand.

    A large part of the answer to this question is excess reserves, held at the Fed:

    https://research.stlouisfed.org/fred2/series/EXCSRESNS

    And here is some additional Austrian commentary on the “missing” inflation:

    https://mises.org/library/where-inflation

    Smith gets an awful lot wrong in his scattershot quasi Austrian hit-piece.

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  5. The Austrian Business Cycle Theory makes a ton of sense to me, but I’ve never understood why it seems to get so little mainstream recognition. I vaguely recall Milton Friedman once saying that investigated it and found the evidence did not confirm it, but is anyone aware of serious, published research on the topic?

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  6. “Why don’t businesses . . . immediately start investing in something more useful, as soon as they realize that they’re doing the wrong thing?”

    This question is as dumb as Bernie Sanders statement “that if we can afford to spend $38 billion more on the military we can afford to spend more on education.”

    Spending resources does not cause other resources to magically materialize. It is because we might spend the $38 billion on the military that there will be that much less to spend on other thing, like education. Because resources are spent in one way means they will not be available to invest in anything else. Malinvestment destroys wealth. Destroyed wealth cannot be invested in something more useful.

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  7. The problem is lack of diversification and poor risk management in the hands of a few mega banks. Lowered interest rates are not as evil as the Austrian economists make them out to be. In fact they completely ignore other possibilities.

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