no third solution

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On “Over-Investment”

January 10th, 2008

The Financial Times had a piece yesterday morning about the role developing countries may play in stabilising the global economy throughout the coming economic downturn.

“Developing countries are playing a very positive role in stabilising the global economy.”

Perhaps.  If by “stabilising” you really mean “importing most of the developed world’s inflation.”

Stop with the crackpot theories, you ask? The FT continues with a caution:

Excessive monetary easing “would be particularly dangerous for developing countries if the bulk of the resulting liquidity were to move into rapidly growing developing regions, provoking the same kind of over-investment conditions that arose in the US housing market”.

I hate the phrase “over-investment,” because it’s not really very accurate. An economy isn’t made up of homogeneous capital, and while “under-investment” may appear in one arena, “over-investment” may appear in another, resulting in the classical Hayekian malinvestment, which according to the Austrian theorists, is proximately caused by central banks meddling with the interest rates.

Meddling with interest rates, a proxy for time preference (being the price of future goods in terms of present goods), sends bad signals to investors and entrepreneurs about how and where to invest. When the interest rate is kept artificially low, it appears as though time preference has changed to favor longer-term investments. In an unhampered market, this is precisely what a low interest rate indicates: plentiful capital brought about by longer time preference and less emphasis on immediate wants and needs. According to the Hayekian framework, an artificial lowering of the interest rates encourages investments like those that would occur had time preference actually changed. But time preference hasn’t changed, and consumers reassert their real consumption/savings ratio.

When credit expansion comes to a halt and interest rates rise, these errors are revealed: Entrepreneurs have invested in projects with too long a horizon to be profitably justified in light of people’s actual time preference. Many of these projects will need to scrapped altogether, or put to secondary (suboptimal) uses, all of which is really the destruction of wealth, appearing to the lay person (or the lay economist) as “over-investment.”

Whenever you hear the phrase “over-investment,” ask yourself what (if anything) could bring about such systematic error in a free market. Remember the real destruction of wealth.

Then remind yourself that the market isn’t free.


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no third solution

Blogging about liberty, anarchy, economics and politics