Malinvestment

Malinvestment is a mistaken investment in wrong lines of production, which inevitably lead to wasted capital and economic losses, subsequently requiring the reallocation of resources to more productive uses. "Wrong" in this sense means incorrect or mistaken from the point of view of the real long-term needs and demands of the economy, if those needs and demands were expressed with the correct price signals in the free market. Random, isolated entrepreneurial miscalculations and mistaken investments occur in any market (resulting in standard bankruptcies and business failures) but systematic, simultaneous and widespread investment mistakes can only occur through systematically distorted price signals, and these result in depressions or recessions. Austrians believe systemic malinvestments occur because of unnecessary and counterproductive intervention in the free market, distorting price signals and misleading investors and entrepreneurs. For Austrians, prices are an essential information channel through which market participants communicate their demands and cause resources to be allocated to satisfy those demands appropriately. If the government or banks distort, confuse or mislead investors and market participants by not permitting the price mechanism to work appropriately, unsustainable malinvestment will be the inevitable result.

Malinvestment results from the inability of investors to foresee correctly, at the time of investment, either the future pattern of consumer demand, or the future availability of more efficient means for satisfying consumer demand. Malinvestment is always the result of the inability of human beings to foresee future market conditions correctly. However, such errors are most frequently compounded by distorted price signals (the essential information channel through which entrepreneurs can identify investment opportunities) and these distortions in turn are most often caused by government intervention or inflation misleading market participants. It should be noted that it is often only in retrospect that malinvestments can be identified, as price distortions and financial bubbles can confuse investors and market participants for extended periods of time.

History
The concept dates back at least to John Mills (not to be confused with John Stuart Mill) in An Article read before the Manchester Statistical Society in December 11, 1867, on Credit Cycles and the Origin of Commercial Panics: "Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works."

Ludwig von Mises developed the concept in the context of the Austrian School's perspective on the deleterious effects of bank-created "fiduciary media":

"The popularity of inflation and credit expansion, the ultimate source of the repeated attempts to render people prosperous by credit expansion, and thus the cause of the cyclical fluctuations of business, manifests itself clearly in the customary terminology. The boom is called good business, prosperity, and upswing. Its unavoidable aftermath, the readjustment of conditions to the real data of the market, is called crisis, slump, bad business, depression. People rebel against the insight that the disturbing element is to be seen in the malinvestment and the overconsumption of the boom period and that such an artificially induced boom is doomed. They are looking for the philosophers' stone to make it last."

More recently, Austrian School economist and libertarian Murray Rothbard used the concept of malinvestment to study the Great Depression in his revisionist work, America's Great Depression:

"A credit expansion may appear to render submarginal capital profitable once more, but this too will be malinvestment, and the now greater error will be exposed when this boom is over. Thus, credit expansion generates the business cycle regardless of the existence of unemployed factors. Credit expansion in the midst of unemployment will create more distortions and malinvestments, delay recovery from the preceding boom, and make a more grueling recovery necessary in the future. While it is true that the unemployed factors are not now diverted from more valuable uses as employed factors would be (since they were speculatively idle or malinvested instead of employed), the other complementary factors will be diverted into working with them, and these factors will be malinvested and wasted. Moreover, all the other distorting effects of credit expansion will still follow, and a depression will be necessary to correct the new distortion."

Austrian Business Cycle Theory and Malinvestment
The complicated and somewhat fragile production structure requires that complementary inputs be available not only in the right magnitudes but also at the right moments in time. If they are not, then projects that appeared profitable are soon revealed to be unprofitable. In other words, what appeared to be capital creation is seen in fact to be capital consumption. The price mechanism co-ordinates production by "signalling" excesses and shortages in the market, allowing stocks to clear and markets to function efficiently.

In a monetary expansion caused by fractional reserve banking, price signals are confused. Monetary growth reallocates resources but cannot in itself produce economic growth. The economy is being pulled in two directions. Entrepreneurs want more capital goods, at the same time that consumers want more consumer goods.

The decline in interest rates by a central price fixing authority such as the central bank means it pays less to save, so consumption is raised beyond levels that would have otherwise taken place. At the same time, more real funding seems to be available for businesses. More resources are used for the production of consumer goods and less for the maintenance and improvement of the wealth-producing infrastructure. This lowers the economy's capacity to produce final consumer goods and so it weakens the pool of funding - contrary to the popular idea that a central bank can grow the economy by keeping interest rates as low as possible. The needed correction comes in the form of a recession, during which many projects are liquidated and unemployment rises.

Austrian Business Cycle Theory focuses on the "medium run", because that is where problems arise. In the short run, the capital structure cannot be changed significantly, and in the long run all errors have been rectified. In the medium run there is time enough for capital projects to be initiated and the direction of production to change, but not enough time for malinvestments to be corrected - at least not without serious repercussions.

The inability to smoothly liquidate or redirect projects stems largely from the heterogeneity of most capital goods. Capital goods cannot immediately be converted into final consumer goods - or other capital goods. Changes in the structure of production cannot easily be reversed. There is a significant degree of "path-dependence" involved with the capital restructuring that occurs in the medium run. The economy cannot simply "erase" the errors and start over.

Malinvestment occurs due to misleading relative price signals, and it necessitates a corrective contraction - a bust following the boom.

At the same time, there is also the phenomenon of overinvestment, because entrepreneurs are led to believe that the subsistence fund is larger than it actually is.

Government intervention
Government interference can also distort market information signals. For example, if the government creates a false expectation of greater trust (e.g. by declaring its backing of one of the parties), it can cause the second party to invest too much in this relation (and thus create "overinvestment"). In the opposite case, it can create distrust, causing people to invest too little and making them lose potential benefits from unconsummated transactions. By generating such fluctuations, the government can "add" or "remove" trust from various private activities or individuals, or it can interfere with them by its own activity and crowd them out. In financial markets, the government in most cases obtains more favorable loan conditions than any other potential borrower. The most common explanation attributes this advantage to the government’s power to tax. As a result, it crowds out private investments that cannot compete.

Similarly, some studies of crowding-out in the area of private philanthropy explain it with reference to private charities’ reduced effort to raise funds from individuals after they receive a government grant.

Rothbard stated the following in relation to the "blindness" of government intervention in the economy:

"Government is deprived of a free price system and profit and-loss criteria, and can only blunder along, blindly "investing" without being able to invest properly in the right fields, the right products, or the right places. A beautiful sub­way will be built, but no wheels will be available for the trains; a giant dam, but no copper for transmission lines, etc. These sud­den surpluses and shortages, so characteristic of government plan­ning, are the result of massive malinvestment by the govern­ment."

Analogies
As Mises wrote: "The whole entrepreneurial class is, as it were, in the position of a master-builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master-builder's fault was not overinvestment, but an inappropriate employment of the means at his disposal."

Some may think that the "capital consumption" during the unsustainable boom period must show up in things like reduced spending on building maintenance, or perhaps in the owner of a fleet of trucks neglecting to have the tires rotated.

In reality, it's more accurate to say that during the boom period, entrepreneurs (led by false signals) invest in projects that are individually rational and "efficient," but that don't mesh with each other. In other words, it's not so much that a farmer forgets to plant some of the seed corn in order to have a future crop. Rather, it's that a farmer plans on expanding his output, and so he plants much more than he did in the past, but unbeknownst to him, the owners of the silos and railroads (needed to bring the harvest to market) aren't expanding their own operations at the same pace.

In summary, it's not that an inspection of an individual enterprise would reveal a technological deficiency. Rather, it's that all of the entrepreneurs are "getting ahead of themselves," trying to develop too quickly. There aren't enough real savings to allow all of the new processes to be completed.

U.S. housing bubble
In May, 2010, Detroit started to tear down vacant and abandoned structures, planning to knock down 10.000 to "reconfigure the city to reflect its shrinking population." The city of Dayton, Ohio, plans to demolish 500 of the 1,732 properties on the city’s nuisance list in 2011. The process to demolish a property can take a year or more and costs an average of $13,800. The city doesn’t have the capital to demolish these structures and has to rely on federal funding.

The federal Neighborhood Stabilization Program funds the demolition of houses in neighborhoods hit hardest by foreclosure. City leaders say the $28 million Dayton has received will only make a small dent in the growing list of vacant and deteriorating properties, estimated to be as high as 10,000. The program money amounts to the demolition of only about 1,500 structures. Housing officials estimate they will need an additional $20 million to $30 million in funds — money the city does not have — to deal with the remaining vacant housing stock. As of July, 2011, the Bank of America and other mortgage holders were donating foreclosed and abandoned houses they couldn’t sell for demolition. Ironically this is occurring in the midst of a crisis of homelessness in America, indicating the extent of the bizarre malinvestment and economic dislocation.

Meanwhile, the rash of foreclosures and mothballed construction projects has launched a boom in the business of shrink-wrapping. Plastic-covered foreclosed homes, half-finished hotels, a canceled casino project in Las Vegas, new terminal expansion projects at the San Jose or Sacramento airports and even a church stand as silent indicators of a global recession.

Irish housing bubble
In the Irish property bubble, around 2006, more than a fifth of the Irish workforce was employed building houses. The Irish construction industry had swollen to become nearly a quarter of the country’s G.D.P.—compared with less than 10 percent in a normal economy—and Ireland was building half as many new houses a year as the United Kingdom, which had almost 15 times as many people to house. Since 1994 the average price for a Dublin home had risen more than 500 percent. By 2007, Irish banks were lending 40 percent more to property developers than they had to the entire Irish population seven years earlier. Morgan Kelly, a professor of economics at University College Dublin, predicted the Irish real-estate prices could fall relative to income—by 40 to 50 per cent, and they did.

Many of housing developments are called "ghost estates" because they’re empty. According to the audit of Ireland’s Department of the Environment published in October, 2010, of the nearly 180,000 units that had been granted planning permission, only 78,195 were completed and occupied. Others are occupied but remain unfinished. Virtually all construction has ceased. There were never enough people in Ireland to fill the new houses.

Spanish housing bubble
In Spain, 2006 was a milestone as regards the number of houses constructed: 760,000; more than the 650,000 started that year in France and the United Kingdom, whose combined populations almost triple that of Spain. Between 2001 and 2008 around four million new houses have been built and the average number of housing units completed per year was 565,000, more than double the figure of 250,000 for the previous decade. This is equivalent to the construction of twelve dwellings per thousand inhabitants, far in excess of the European average of five per thousand.

In 2009, after the collapse of the construction sector caused by the bursting of the housing bubble and the effects of the global economic crisis, the number of housing units started fell to 160,000, and there were almost 700,000 housing units in stock (that is, completed but unsold). This has created ghost towns all across Spain.

Other countries
The shipping industry has been heavily affected by the Great Recession, about 12 per cent of the world's container ships were estimated to be 'doing nothing' in 2009.

Dubai was a land full of grandiose, landmark projects, only to see the bubble burst. The office-space vacancy rate in prime locations was in 2009 according to some estimates at around 40%, other estimates arrived at a total 74% occupancy rate in residential and commercial space. Burj Dubai, the tallest building in the world (about 2,600 feet high with 160 stories) has been at its opening in January, 2010, described as mostly empty. 90% of its 900 apartments were still empty a year later. (The construction of the world's tallest buildings seem to correlate with the business cycle - see the Skyscraper Index. )

China's economy is continuing to grow despite the global recession, helped by massive government spending. For years, regional governments across China have been building massive real estate projects that have attracted both private and corporate buyers. As prices have continued to rise (residential values in 70 large and medium-size cities across China soared in 2009, according to real estate consultancy Colliers International), more investors have become speculators, buying brand-new properties with the sole intention of flipping them.

A notable example is the city Ordos in Inner Mongolia, a whole town built with government money that is standing empty. The district was originally designed to house, support and entertain 1 million people. Other examples abound. Some estimates put the number of empty homes at as many as 64 million.

Unfinished skyscrapers
There are also many buildings that, as proposed, would have become the world's tallest (or close to it) but were never completed. The Council on Tall Buildings and Urban Habitat has identified a number of those:
 * Nakheel Tower (Dubai) was a proposed 3,300-foot-tall skyscraper with 156 planned elevators. Nakheel was designed to be the visual and economic focal point of the man-made Palm Jumeirah, the fake series of islands off of Dubai that is now experiencing extreme erosion and other environmental problems.
 * India Tower, the 2,356-foot tower planned for Mumbai in 2010, was halted the following year after construction had begun.
 * The 2,008-foot Russia Tower (Moscow) was already under construction when the downturn hit the following year, and the building's developer announced he'd be unable to put up the $3 billion needed for the building work. The construction site was turned into parking.
 * At 1,808 feet, the Doha Convention Center Tower was destined to become one of the world's tallest buildings. Because it was so tall, officials worried it would make it tough for pilots landing and taking off from the new airport. Construction was halted until Doha's new airport was finished... Until the project was abruptly cancelled anyways.
 * Burj Al Alam (Dubai) was a flower-shaped tower proposed to rise 1,670-feet into the air. It was cancelled in 2013 after a long, slow, much-denied decline.

Criticisms
Tyler Cowen, while leaning to the Austrian view, ponders that it "has a hard time explaining how so many investors can be fooled into so much malinvestment, especially given the traditional Austrian perspective that markets are fairly effective in allocating resources."

As Robert Murphy explains, free individuals often make mistakes — even systematic mistakes. But even perfectly rational entrepreneurs who know a boom is underway cannot prevent their more reckless competitors from taking cheap (or now free) government loans and bidding away scarce resources. Workers don't care whether their paychecks come from genuine saving or from the printing press, and every few years there is always a fresh crop of naïve employers willing to borrow money and start new projects.

Second, Austrians emphasize that interest rates communicate information to entrepreneurs. In some critiques it seems that "everybody knows" that the true interest rate ought to be 5 percent, and so the central bank's efforts to push it down to 3 percent should be easily corrected. Yet nobody knows what the truly free-market interest rate is. That's why market prices are important in the first place, and why government distortions of these prices lead to real imbalances in the economy.

Entrepreneurs don't need to speculate about a change in consumers’ "rate of time preference", or about the "supply of capital goods". An individual entrepreneur is concerned only with a very small set of market prices, namely, the prices of the inputs she will need for her projects, and the prices for which these products will sell. That’s the whole point of relying on the market rates of interest and other prices — it eliminates the need for individuals to speculate about aggregates that are far too complex for any single mind to comprehend.

Also, some expositions of ABCT assume an initial free market state, and then analyze the impact of a one-shot intervention. But in reality the government of each major country intervene permanently in the credit market by the creation of a central bank (or a centralized system of banks). Actors in these economies have no idea what the free market rate of interest would be in the absence of such interference; even if the rates were raised, the new rate could still be below the "natural rate".

More generally, Reinhart and Rogoff speak about the "this time is different syndrome" while analyzing centuries of financial crises. Financial professionals and, all too often, government leaders explain that we are doing things better than before, we are smarter, and we have learned from past mistakes. Each time, society convinces itself that the current boom, unlike the many booms that preceded catastrophic collapses in the past, is built on solid fundamentals, structural reforms, technological innovation, and good policy.

Links

 * Is "Malinvestment" enough to go bust? (pdf) by Enrico Colombatto, summer 2005
 * Explaining Malinvestment and Overinvestment (pdf) by Larry J. Sechrest, winter 2006
 * Capital, Credit Expansions, and the Subsistence Fund (pdf) by Larry J. Sechrest, November 2002
 * Malinvestment, Not Overinvestment, Causes Booms by Ludwig von Mises
 * Aerial Footage: Portrait of a Housing Bust by Barry Ritholtz, October 2010
 * This '60 Minutes' Video Of China's Ghost Cities Is More Surreal Than Anything We've Ever Seen (video) by Mamta Badkar, March 2013