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Malinvestment

Abstract

In the Austrian business cycle theory, monetary expansion lowers the interest rate and sends misleading relative price signals to investors, who then make investments that turn out to be unprofitable. One criticism of the theory is that if malinvestment is predictable, investors should understand their businesses well enough to see and avoid the temptation to be lured into unprofitable investments. A broader understanding of the Austrian school's framework explains why malinvestment takes place. The economy is a complex order, and while the theory explains that malinvestment will rise during the expansionary phase, it cannot identify which investment projects will eventually become unprofitable, nor can investors themselves tell ahead of time. Furthermore, applying the fallacy of composition, it may be that one investor could profitably invest based on those price signals, but all investors cannot. Monetary expansion lowers the informational content of prices, making it more likely that unprofitable investments will take place. Even if investors become more cautious, the percentage of investment projects that eventually will prove unprofitable will rise.

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Notes

  1. O’Driscoll and Rasmussen (2012) question whether the Austrian business cycle model developed by Hayek is really a monetary theory, an issue that is beyond the scope of the present paper, which explicitly analyzes the effects of monetary fluctuations on investment.

  2. Not all of this investment will be malinvestment, because some inframarginal investment could be profitable, and because of other uncertainties assumed away here that affect the profitability of investment.

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Acknowledgments

The author gratefully acknowledges insightful comments from Larry White and two anonymous referees. While it is customary to thank referees, in this case I found their comments to be especially helpful. Any shortcomings of the paper remain the responsibility of the author.

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Correspondence to Randall G. Holcombe.

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Holcombe, R.G. Malinvestment. Rev Austrian Econ 30, 153–167 (2017). https://doi.org/10.1007/s11138-016-0343-2

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  • DOI: https://doi.org/10.1007/s11138-016-0343-2

Keywords

  • Business cycles
  • Investment
  • Monetary policy
  • Fractional reserve banking
  • Austrian school of economics

JEL Classification

  • E3
  • E5