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Introduction to Austrian Economics
Podcast surveying the basic concepts of Austrian Economics.
Does Malinvestment Matter?
Only if we care about freedom and prosperity.
Two years into the Obama administration we have seen an unprecedented rise in government spending and unprecedented federal budget deficits, all in the name of “stimulating” the economy. Nor is Barack Obama the only president to engage in economic “stimulus”; his predecessor George W. Bush also spent recklessly for the same reason.
Yet with literally trillions of dollars spent, the rate of unemployment hovers around 10 percent, many banks remain in a precarious state, and a meaningful economic recovery is as elusive as ever. On one side the Keynesians claim that had the government not spent these huge sums, the economy would have collapsed even more.
On the other side, however, are the members of the Austrian school of economics, who say that the very rush of government spending, along with the expansionary monetary policy of the Federal Reserve, has made the economy weaker not stronger. Obviously, the differences between the Austrian and the Keynesian views are fundamental, so if I am to point out why Austrians do not support government “stimulus” efforts, I need to supply something other than the usual political rhetoric.
Of the two economic viewpoints, the Keynesian one is easier to explain and appeals to the sentiments of ordinary people. As long as individuals spend all their income on consumption goods and do it quickly, the economy will hum along. However, if people get nervous and save some of their money, the economy will slip into the doldrums and only can be rescued by government spending.
In the Keynesian viewpoint, an economy is a circular-flowing mechanism that simply needs enough money to keep the wheels greased. Nothing else matters, just as long as the money keeps flowing.
The Austrian View
Austrians hold to a much different viewpoint. Here I wish to deal with what Austrians call malinvestments and explain what they are and why they lead to recessions. While Keynesians believe that the only thing which matters is spending on consumer goods (with all factors of production, including labor and capital, simply following whatever spending patterns arise), Austrians understand that the structure of production matters.
The production structure is the mix of factors that are used to produce goods over time, and in a market economy the value that consumers place on the final, or consumption, goods will be imputed to the various factors. For example, during the housing boom, a number of factors went into that line of production, from building materials to real estate agents. While the government directed new credit into the housing market, the economy boomed as owners of the factors gained new income.
However, the market could not sustain the housing boom as home prices increased at much faster rates than individual incomes and home sales fell. Furthermore, the financial instruments created to help finance the boom also lost value as it became obvious the boom could not continue.
In the Keynesian view the housing boom did not need to end; all that was needed was for the government to throw even more money into it and have the Federal Reserve purchase at face value the financial paper that had lost real value.
Austrians, however, hold that there were massive malinvestments in housing, and that the malinvested factors needed either to be liquidated or transferred to other uses that would reflect the directions of consumer choices.
Austrians believe that once an unsustainable boom begins, a bust is inevitable, and further attempts to sustain the boom only pull the structure of production into more distorted and unwieldy shapes. Thus the “stimulus” spending, according to Austrians, has not sustained the economy, but rather has further disfigured it, guaranteeing more disruptions in the future.
There is no way to reconcile these two viewpoints. To Keynesians an economy is a homogeneous mix of goods that needs only more money to be sustained. Austrians, however, know better. They understand an economy is complex and full of heterogeneous factors. Government stimulus, they realize, only makes things worse.
Comment by Larry Ruane on 26 May 2010:
The Keynesian idea (have the government spend money; it doesn’t matter on what) also enables vast corruption. If it doesn’t matter what the money is spent on, then why not throw it in the direction of Obama’s friends and others connected to the government? The way the Keynesians look at it, it’s all going to a good cause, so it doesn’t matter.
Comment by Kent Lalley on 26 May 2010:
“Keynes did not teach us how to perform the miracle . . . of turning a stone into bread, but the not at all miraculous procedure of eating the seed corn.” — Ludwig von Mises, Greatest Economist of the Twentieth Century
Comment by David on 26 May 2010:
Blowing air in a bubble will always cause it to pop…aka: malinvestment.
However, economists often deal with markets in the abstract; not that there is really another way to deal with them. But in dealing with most any economic theory on free markets, the resoution of issues relys upon taking some type of correct actions (and doing nothing is an option) and the passage of a certain period of time.
For example, the “let the banks all fail” idea proposed that new banks would enter into the void left behind. I suspect there is validity in the logic. But the problem is when you move from the macro to the micro: what about the hundreds of thousands of people who no longer have jobs, money, food, housing, etc.? What do they do while the time is passing? Do we include allowing them to suffer part of the price of market resolution?
Thus, this becomes the point at which some type of economic intervention becomes necessary…perhaps not economically necessary, but socially and morally.
The question is what is the right type of intervention. Which is why I generally approve of the idea of bridge loans to get businesses from point A to B. I also agree is setting up stop gaps to keep us from falling back to point A.
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Comment by Steve on 27 May 2010:
To comment on what David said:
On the idea of Bridge loans. Which businesses would receive the loans? Wouldn’t it be subjective to say who deserves a loan and who doesn’t? Also with loans you have to assume that the market wants the business at point B. What if the market has no desire for this business to be at pt B?
On the idea of stop gaps. Having a stop gap doesn’t allow individuals to bear the full cost of their actions, which often leads to too much risk and malinvestment.
While I do not wish unemployment upon any one I do not think it is the governments place to intervene if someone becomes unemployed. Often times people forget about private charity and look to much to the government for help.
Comment by Peter Namtvedt on 28 May 2010:
Malinvestment can come in the form of investing in the wrong product, or investing too much in already successful products. It can be putting money into a business that one should know would fail if one did proper market and technological research. It can be due to momentum trading, which Investors Business Daily touts all the time, counting on the latest hot stock or commodity as being the “bottle rocket” that cannot fail but to continue upward at the already known rate.
When my family got interested in moving to another city in 2004, the home prices of our favorite city seemed unbelievably high did discourage us to a degree. However, when we made our own comparison of our home with existing properties for sale, we were positively surprised to find that what we paid $44,000 in 1992 was now worth at least $140,000.
We had the equity in that property plus savings to face the housing market in our new city: reconciled with the fact that a house there would cost twice as much. Furthermore, we had an income that would finance a large mortgage.
When we put our old house on the market the appraisal said it was worth $180,000! We then bid aggressively on a house in the new city, and had to counter-offer twice, ending on a price of $285,000. Our mission was successful, and knew that we could not lose with a 40% down payment, but we knew the whole situation was irrational.
When Zillow.com reported over the next three years that our house there was appreciating at a rate of over 5% per year, we were even more sure that the whole market was going crazy. Our house value topped out at $430,000 and began depreciating. The proof was there, the housing market was a bubble. We watched our house fall until recently touching $328,000. Even that seems high by established historical rates of appreciation.
In the meantime, those who were involved with mortgage banking, home building and thousands who were pushed by government encouragement were starting to lose big-time. That was inevitable.
It was like Tulip Mania.
Keynes must have been smoking some good stuff.
Comment by Ralph Musgrave on 26 September 2010:
Larry Ruane: Keynes did not advocate having “government spend money; it doesn’t matter on what”. The idea that government SHOULD spend money “it doesn’t matter on what” is patently ridiculous, as the average mentally retarded ten year old probably appreciates.
Keynes DID once (as a joke) suggest having some unemployed dig holes and fill them up all day. His point here (a perfectly valid one) is that if government finances any activity with new money (rather than money withdrawn from the economy via tax), those employed on the activity will in turn spend their wages, which in turn gives the economy an overall boost.
Comment by Will King on 2 February 2012:
@Ralph Muxgrave
But using that new money causes inflation, so it is the same as taxing people because suddenly they have less money.
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