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.

Can’t Have Profit Without Productivity

Over at EconLog, David Henderson has a great post on markets and worker safety where he tries to answer the question “Does the market under-provide safety for the poor?”  The blog post is a good one and I’d like to add my two cents:

From a purely productivity viewpoint, disregard for safety is disregard for profits. If workers are constantly getting hurt on the job, it hinders their productivity. Given that profit is tied to productivity, lower productivity means lower profit. Workers can’t increase their productivity if they are being hurt or killed. Any firm would tell you constant turnover is bad.  You lose intelligence and skill. 

Accidents happen in the workplace, not due to some careless disregard for safety (although I am willing to bet that may be the case in some minority of instances), but because they are indeed accidents.  Any firm looks to protect its investment, whether that be a worker, piece of machinery, or building.  An employer does not subject his investments to unnecessary risk.  or, if he does, he doesn’t stay in business long.  

Making Eden out of the Wasteland

I was driving on the highway this evening and was greeted by an amazing sight: a tiger sky lit my way; the orange of the setting sun was overlayed by black clouds from a nearby thunderstorm.  Against this backdrop, the green of the trees was even more vibrant.  It hadn’t started raining yet, but the air held that electric anticipation that comes before a storm.  I thought to myself “God hath made wondrous things.”

But then it occurred to me: it’s wondrous because of the wealth we have in this nation.  I am well protected from these storms thanks to 4 sturdy walls and a roof.  I can enjoy the pageantry of the storm (lightening and hail) from the comfort of my air-conditioned living room.  In fact, the biggest inconvenience was when I lost satellite reception for my TV.  The interconnections of humans, as coordinated by markets, made this possible.  200 years ago, such a storm would have been terrifying.  Markets have helped us tame Nature and create our very own Eden.

The Problem With Efficiency Standards

As economists, one of our chief focuses is on effeciency.  Economics is, after all, the study of allocation of scarce resources.  Why, then, do so many free market economists like myself oppose effeciency standards like C.A.F.E?  It’s not out of some dogmatic mantra that government can only harm but rather out of objection to a poor definition of effeciency.

The political definition of effeciency is “to use fewer resources.”  This is partly correct, but there is another part. The economic definition is “to maintain or improve output using fewer resources.”  Therein lies the rub.  To use fewer resources is easy. A firm could use less labor if it fires half its workforce. A dishwasher could use less resources by spraying plates with a trickle of water. I car could use fewer resources by cutting back on features.  But all of these methods represent a decrease in standards of living. 

True effeciency gains lie when output is increased or maintained. Cars today can run a/c, radio, and GPS while releasing less carbon emissions. LED lights cast more light while using less electricity. Computers have greatly increased labor capabilities.

The problem with government mandated effeciency standards is that they do not take into account increased standard of living. Low flow toilets, for example, use less water but are more prone to back ups or require multiple flushes. Diswasher energy standards and soap regulations have reduced the ability of washers to clean.  These represent a decrease in living standards.  By focusing on only half the issue, government standards will continue to only half achieve its goals.