Sunday, 26 August 2012

What is "Malinvestment"?

Whether you are an investor, money manager, economist, CFO or something completely different, chances are that malinvestments, either done by yourself or on a grand scale by others, will negatively affect your life in some ways. Malinvestments by others are also something you can profit from or at least protect yourself from. Given the current huge economic problems in the U.S. and the EU, understanding the concept of malinvestment and some of its underlying causes is an absolute necessity. Below follows therefore information on this subject with links should you want to become more advanced.

Malinvestment is very simply stated a bad investment. Wikipedia defines it as follows,
Malinvestment is a concept developed by the Austrian School of economic thought, that refers to investments of firms being badly allocated due to what they assert to be an artificially low cost of credit and an unsustainable increase in money supply, often blamed on a central bank. This concept is central to the Austrian business cycle theory. Austrian economists such as Nobel laureate F. A. Hayek largely advocate the idea that malinvestment occurs due to the combination of fractional reserve banking and artificially low interest rates misleading relative price signals which eventually necessitate a corrective contraction—a boom followed by a bust.
The concept dates back to at least 1867. In 1940, Ludwig von Mises wrote, "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."
Malinvestment is hence an important concept in the Austrian School of Economics. The Ludwig von Mises Institute explains,
Malinvestment is an 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. 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 these demands appropriately. If the government or banks distort, confuse or mislead investors and market participants by not permitting the price mechanism to work, 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 conditions correctly. However, such errors are most frequently compounded by inflation misleading market participants.
Malinvestments' importance in the Austrian Business Cycle Theory (ABCT) is described by the Ludwig von Mises Institute as follows,
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, 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 also leads to malinvestment as it distorts price signals. The Ludwig von Mises Institute explains it as follows,
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.
Some recent examples of malinvestment is the U.S. housing bubble, the Spanish housing bubble, and now, according to some (including myself), the U.S. government bond bubble (see for example here). And there are bound to be many more in due course as long as governments and central banks continue to intervene in the financial markets and the markets in general. I have found no better website on this subject and the related problems and how they come about than the Ludwig von Mises Institute so read more about that here.

Good luck.