When is an investment not an investment?

On Tuesday we talked about the loose monetary policy of theFederal Reserve and how it was propping up stock prices. This process falls under the term mal-investment in its simplest form. Mal- investment is a term developed in the Austrian school of economic thought. It simply refers to poor economic decisions being made by firms, and resources being allocated inefficiently to areas of the economy where prices would otherwise not send them. The Austrian business cycle predicts that the artificially low interests rates (the price of money) and government intervention give misleading price signals and result in money pouring into the wrong places, ultimately causing asset bubbles. It is a competing economic theory with the more mainstream neoclassic economics, which tends to believe that you can smoothly adjust monetary (central bank) and fiscal (government spending) policy to adjust the level of investment in the economy. With the booms and busts in the business cycle, you can’t help but wonder if they’re wrong.

The Austrian Business Cycle Theory predicts that when interest rates are lowered by a monetary authority for an extended period, businesses will borrow and overspend on capital goods in order to ramp up production (the credit expansion phase). The eventual end is that businesses have large loans which were used to purchase equipment which is not needed. The resulting default on these loans causes the contraction in credit and the ensuing chaos. The big problem with the Austrian Business Cycle Theory is that it doesn’t provide a very convincing reason why people would make these bad economic decisions. The sophistication of forecasting techniques and relative transparency of central banks lead me to believe that a recurring and erroneous overspend on capital goods by the whole business sector is unlikely. I believe booms and busts are more to do with the short term outlook of business, moral hazard, and an inability to comprehend a system as complex as a national, let alone global economy (although we do our best to make some sense of it here). However, whatever the reason for it, you can’t deny that “mal” or “bad” investment occurs. Did the economy really need 2 million houses in 2005? Did it really need a company called webvan.com so bad that it was worth 1.2 billion dollars? History suggests it didn’t. And yet these investments continue to go ahead, cycle after cycle.

The green shoots of the next cycle of mal-investment in its simplest form are occurring as investors are pushed out of bonds and into riskier investments like stocks as described in Economy doing too well. Stocks Slump. This is how bubbles begin. Initially, long term capital investments are too illiquid for businesses to be convinced to invest; a fund manager will invest in shares knowing that he can sell them at the push of a button, whereas a factory cannot be quickly sold before it drops in value when Bernanke announces a withdrawal of stimulus. However hold interest rates down long enough, and mal-investment eventually sprouts into more complex forms of investment as the boom cycle gains momentum, but with one thing in common: being inefficiently allocated, they are unlikely to make a sufficient return. The reserve bank can lower interest rates to make borrowing less expensive, but it can’t engineer profitable investment opportunities.

Mal-investment doesn’t just come from the private sector. Governments around the world have been “allocating” (blowing) cheap money to “inefficient projects” (cash for clunkers) like it’s going out of fashion. It is private sector mal-investment that is the primary concern though, as it has the ability to grow to epic proportions. Eventually enough printed money runs out of profitable avenues  for investment, and so it starts chasing bad ones. These bad investments are profitable when it costs 3% per year to borrow, but when rates inevitably rise the investments tank. Next article I plan to show exactly why reserve bank stimulus won’t help the economy.