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Wednesday, May 26, 2010

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.

  • Dr. William Anderson is Professor of Economics at Frostburg State University. He holds a Ph.D in Economics from Auburn University. He is a member of the FEE Faculty Network.