The New Palgrave Dictionary of Economics

2018 Edition
| Editors: Macmillan Publishers Ltd

Over-Investment

  • Michael Bleaney
Reference work entry
DOI: https://doi.org/10.1057/978-1-349-95189-5_1447

Abstract

The term ‘over-investment’ is used principally in relation to a certain type of theory of the trade cycle in industrial capitalist economies. Such theories flowered into a brief prominence in the inter-war period, but disappeared virtually without trace after 1940, probably owing to the fact that they did not attach sufficient weight to the concept of effective demand. The key characteristic of these ‘over-investment’ theories was their stress on a disproportionate development of the producer goods industries not only as a feature of the boom but also as a cause of the subsequent relapse into depression. Since a similar pattern has been observed in some socialist economies since 1945 and has been held by many authors to be the major cause of fluctuations in the growth rates of real output, ‘over-investment’ theories of cycles in socialist economic systems will also be discussed.

The term ‘over-investment’ is used principally in relation to a certain type of theory of the trade cycle in industrial capitalist economies. Such theories flowered into a brief prominence in the inter-war period, but disappeared virtually without trace after 1940, probably owing to the fact that they did not attach sufficient weight to the concept of effective demand. The key characteristic of these ‘over-investment’ theories was their stress on a disproportionate development of the producer goods industries not only as a feature of the boom but also as a cause of the subsequent relapse into depression. Since a similar pattern has been observed in some socialist economies since 1945 and has been held by many authors to be the major cause of fluctuations in the growth rates of real output, ‘over-investment’ theories of cycles in socialist economic systems will also be discussed.

According to Haberler (1937), whose work constitutes the best survey of the trade cycle literature of this period, one may distinguish a monetary and a non-monetary strand of over-investment theory. Prominent amongst the former were L. Mises and F.A. Hayek; amongst the latter, A. Spiethoff and G. Cassel. The monetary strand followed up Wicksell’s idea that the monetary authorities could cause the money rate of interest to deviate from the equilibrium rate (or natural rate in Wicksell’s terminology) which brought planned savings and investment into equality, thus causing investment intentions to get out of balance with the savings plans of the community. Mises regarded ideological and political pressures on central banks to maintain low interest rates as the main initiating cause of trade cycles. Hayek (1933, p. 150) was sceptical about this, and preferred to stress changes in the economic environment (such as new inventions) which create new investment opportunities. These developments would raise the natural rate of interest, but the ability of the commercial banks to create money means that these new demands for credit are initially met at the existing rate of interest.

Either way, a disequilibrium is set up in which demand for investment goods is out of balance with the demand for consumer goods. In the boom the investment goods industries are over-developed, and the pressure on resources will pull up production costs. In the absence of a sufficient further monetary expansion many investment projects will begin to seem ill-judged, and will not be completed. Investment falls off dramatically, and a slump ensues. A distinctive feature of these theories was their tendency to see slumps as a necessary process of purging the economy of the maladjustments created in the course of the booms. This idea is articulated most clearly by Hayek (1933, pp. 19–22), who argues that an expansionary monetary policy, far from curing such slumps, merely prolongs them by delaying the necessary readjustments. Hayek interprets the slump of 1929–33 in this fashion, following the boom of 1927–9.

The non-monetary theorists laid greater stress on the real factors which might cause investment to rise at the start of a boom; they were generally willing to concede that a credit expansion was a necessary permissive factor in this, but they did not see monetary disturbances as the prime cause of the trade cycle. Since in Hayek’s theory (but less so in that of Mises) money is a permissive as much as an initiating factor (because of the elasticity of bank credit), the monetary/non-monetary distinction is ultimately of little importance. The distinctive feature of the over-investment theories is the presumption that the boom constitutes a misdirection of productive resources towards the investment goods industries as compared with the equilibrium situation, and that the deflationary aspects of depression are necessary to cure this. In the Hayekian theory it is perfectly possible to imagine a slump caused by under-investment, where the natural rate of interest falls below the money rate; this possibility is however very much down-played in the analysis.

A major difficulty with this theory was that it never achieved a really satisfactory explanation of the necessity of depression in purging the maladjustments of the boom. Why could equilibrium not be re-established without the ‘over-shooting’ effect of relapse into depression? A further set of questions was raised by the publication of Keynes’s General Theory, which implied that depressions were pre-eminently conditions of low effective demand and unused productive capacity. If this were so, then the slump would not cure a state of over-investment; it would exacerbate it. Finally, the over-investment theory was too restrictive even on its own terms. Suppose that the natural rate of interest rose, not as a result of the opening-up of new investment opportunities, but as a result of a fall in the community’s desire to save. The enhanced consumption demand would generate boom conditions in a manner similar to that analysed for increased investment. But (at least initially) this boom would not be characterized by over-expansion of the producer goods industries relative to consumer goods, but precisely the opposite. It would be an under-investment rather than an over-investment boom.

Theories of investment cycles in socialist economies have been based on experience in eastern Europe since 1950 (Bajt 1971). These theories could be termed ‘over-investment’ theories to the extent that they perceive these economies to be organized in such a way as to create a situation of persistent excess demand, and to give priority to investment over consumer demand in cases of shortage. This means that in periods when investment plans are unusually ambitious, the excess demand and shortage of consumer goods become exceptionally acute, resulting in delayed completion of investment projects, popular dissatisfaction etc. In reaction to this, the investment tempo is deliberately reduced; but once the problem has been solved, political pressures for more ambitious plans may build up once again.

The tendency towards over-investment results from the particular institutional circumstances rather than the mere fact that the means of production are mostly in public ownership. The important features are: the ‘softness’ of enterprise budget constraints, which enables them to win any competition for resources with consumers; insufficient penalties to the enterprise for unprofitable investments; deliberate understatement of the costs of investment projects in order to obtain scarce investment credits; and insufficient information in the hands of the central planners to enable them to counteract these tendencies effectively (Kornai 1980). Nevertheless there seems no reason why, by learning from experience, the planners should not be able at least to reduce the amplitude of such cycles.

See Also

Bibliography

  1. Bajt, A. 1971. Investment cycles in European socialist economies. Journal of Economic Literature 9: 53–63.Google Scholar
  2. Haberler, G. 1937. Prosperity and depression. Geneva: League of Nations.Google Scholar
  3. Hayek, F.A. 1933. Monetary theory and the trade cycle. London: Jonathan Cape.Google Scholar
  4. Kornai, J. 1980. The economics of shortage. Amsterdam: North-Holland.Google Scholar

Copyright information

© Macmillan Publishers Ltd. 2018

Authors and Affiliations

  • Michael Bleaney
    • 1
  1. 1.