Blogs > Liberty and Power > Most Investors, Economists, and Policy Makers Are Blind to the Mountain of Malinvestments

Jul 23, 2009 7:11 pm

Most Investors, Economists, and Policy Makers Are Blind to the Mountain of Malinvestments

Reading about the first Quarterly Bloomberg Global Poll of investors, which found that almost 75 percent of those surveyed give Ben Bernanke favorable marks for his actions as chairman of the Fed during the current financial and economic crisis, my first reaction was to wonder, What are these people thinking? The news article also notes that Martin Feldstein, a leading establishment economist, recently said in an interview with Bloomberg that Bernanke has “done a very good job and I think he should be reappointed.” Feldstein is a fairly reliable barometer of what mainstream economists think about macroeconomic policy.

In contrast, when I think of Bernanke’s actions as chairman of the Fed, I am appalled. During the past year, he has taken the lead in flooding the financial system with an unprecedented amount of newly created central-bank credit - more than a trillion dollars of new Fed credit has been advanced since mid-September 2008, more than doubling the total amount outstanding. Thus, Bernanke has shown himself to be the greatest inflationist of modern times in the advanced economies.

Because the commercial banks have added almost all of the newly created base money to their reserve accounts at the Fed, rather than using it to make new loans and investments, the effect on the money supply and hence on the price level has been muted so far. Bernanke clearly supposes that he has been heroically fending off the greatest threat to the world economy he can imagine - the dreaded deflation of the price level for currently produced goods and services, a phenomenon associated in his mind with the horrors of the Great Contraction of 1929-33.

He also believes that when the price level begins to accelerate as the banks put their vast, (legally) excess reserves to use, he will be able to take counter-measures, such as paying a higher rate of interest on commercial-bank reserves at the Fed or selling securities now held by the Fed in the open market, which will soak up just enough of the potential for the creation of new money that the Fed will be able to disengage gradually and smoothly from its recent, gigantic effusion of new credit, thus avoiding the hyperinflation that it might otherwise produce.

I have serious doubts about whether Bernanke will be able to pull off this Houdini escape from the ravages of the still-dormant monster he has created, but at the moment my concern is not so much with that issue as with the amazing fact that so many investors and economists have applauded his actions so far. The politicians are not so puzzling: in today’s world, they invariably demand resort to inflation of money and credit whenever a recession begins - they are inflationists to their very souls (that’s assuming they have souls). Putting aside the politicians, I am willing to conjecture as to why so many investors and economists are making what seems to me a huge mistake in evaluating Bernanke’s actions.

The root problem, I believe, lies in the aggregative character of contemporary thinking about macroeconomic fluctuations. In this view, rising aggregate real output is good, no matter what the composition of the newly produced goods and services. A recession, which most analysts understand as a sustained decline of aggregate real output, is bad, and, in their view, it should be combated by fiscal “stimulus” and by expansionary monetary policy in order to reverse the decline in aggregate demand. They do not worry about - indeed, they rarely even pay much attention to - the makeup of the aggregate output that is added during business expansions, lost during business recessions, or brought into being by the government’s compensating fiscal and monetary actions. Output is output; spending is spending. In fact, the whole idea of using government spending to offset reduced spending by investors or consumers turns on this assumption that a dollar spent is a dollar spent, regardless of what it is spent for.

In today’s vulgar Keynesian environment, investors and economists do not appreciate how the seeds of macroeconomic busts are sowed by artificially created credit that is employed to finance investments that would not be undertaken if they had to be financed by real savings - investments known in economic theory as malinvestments. When a large volume of malinvestments has been undertaken during a boom (e.g., much of the investment in residential housing and commercial real-estate development between 2002 and 2006), and when for whatever reason the pace of new credit creation slows, causing interest rates to rise, then the unsustainability of these malinvestments becomes increasingly apparent. More and more of them are terminated, often in unfinished condition, and many such projects go bankrupt for want of buyers willing and able to pay for them in the market.

If the government and the central bank use their fiscal and monetary policies to prop up these malinvestments, they do not solve the basic problem; they only paper it over for the time being. The vast assistance given recently to financial institutions embarrassed by investments in bad real-estate-related securities, for example, has allowed these institutions to delay the write-offs and other balance-sheet adjustments that would reflect the errors they have made. The bailouts have created a large number of zombie financial institutions, much like the ones that caused the Japanese economy to stagnate during the 1990s and later. Owners and managers of financial firms laden with rotten securities have been holding out for government rescues of various sorts, rather than carrying out the required restructuring, which in many cases must include bankruptcy proceedings.

Just as the malinvestments were made possible in the first place by effusions of artificially created credit and hence artificially depressed interest rates, so now the Treasury and the Fed are keeping the owners of these malinvestments afloat by further effusions of artificially created credit. But so long as these inherently unsustainable projects continue, they constitute a huge legion of the living dead. They may look viable, but their viability hinges entirely on de facto subsidies via the government’s various bailout schemes. Such projects will remain unsustainable unless continually propped up at the expense of the general public, who will suffer because of increased ordinary taxes or a mounting inflation tax on their dollar-denominated assets. If the government goes forward in this fashion, it will be sustaining an economy rife with malinvestments kept in operation only by constant transfusions of other people’s wealth channeled to the zombie projects by the Treasury and the Fed - a permanent policy of robbing prudent, responsible Peter to pay imprudent, irresponsible Paul. No sound, long-run economic development can be based on such productivity-sapping transfers of wealth into projects that are not worth the expense of keeping them going and which misallocate resources to the overall economy’s detriment so long as they continue.

Meanwhile, to return to the Bloomberg poll, “more than three-quarters of investors expect U.S. financial institutions will be in better shape a year from now,” and a majority believe “the world economy is stable or improving.” And why do they expect this progress will occur? Because, “almost three quarters say[,] central banks will hold rates near current levels to support growth.” Indeed, Bernanke promises that this policy is precisely the one he will continue to follow. “Monetary policy remains focused on fostering economic recovery,” he declares. The Fed will maintain a “highly accommodative” stance “for an extended period.” In short, if an immense amount of monetary-base inflation and other artificial credit expansion is good, then a great deal more of the same is even better. Après nous le déluge - oh, but I forget, Bernanke stands ever ready to sponge up that base money the minute the price indexes begin to rise at more than a slight, tolerable annual rate. Trust him.

Except for the Austrian School economists, hardly anyone is worried that the extensive restructuring necessary to put the economy back on a healthy, market-sustainable track is not being carried out - or, certainly not being carried out on the scale that the current situation requires. For the overwhelming majority of today’s investors, economists, and policy makers, output is output, and spending is spending. They are blind to the mountain of malinvestments staring them in the face. In the seventy years since John Maynard Keynes steered macroeconomic policy thinking into the dead-end street of misleading, highly aggregative thinking, tremendous damage has been done, but clearly a great deal of additional damage will have to be suffered before the people who bear the burdens of this kind of policy-making awaken to its operation as a mechanism for robbing the many for the benefit of the politically connected few.

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Bill Woolsey - 7/29/2009

I don't favor the reappointment of Bernanke. The policy of targetting funds to troubled sectors of the credit markets was a serious mistake. Paying interest on reserves was a mistake. Supporting TARP and the fiscal stimulus package were mistakes.

However, the increase in the monetary base (and the matching increase in Federal Reserve "credit") were not mistakes, or rather, the "mistake" has been that the incease should have been greater.

Cutting interest rates was not an error. They should have been cut sooner and more. My perspective, however, is that the Fed's error was propping up market interest rates by failing to expand base money to meet demand.

Nominal income in the economy for the first quarter of 2009 was below where it had been in the first quarter of 2008. Nominal income fell sharply in fourth quarter of 2008 and the first quarter of 2009.

In my view, this is only possible if the quantity of base money was less than the demand to hold it.

Maintaining growth in nominal income is not the same thing as preventing the liquidation of malinvestments. Malinvestment isn't simply the overproduction of certain goods, but rather the misalloaction of resources between the production of different goods. The other side of the coin of malinvestment is too little output of the products of industries that had been starved for resources.

If the problem really was that excessive credit creation (or anything) resulted in too much production of housing (and commercial real estate,) what that means is resources were shifted away from the production of other goods.

If the problem was really that there wasn't "real saving," then that means that it was consumer goods industries that were starved for resources.

(In reality, I don't think excessive credit creation was really the problem. It was rather that credit was misallocated, and that too much housing and commercial real estate and too few other capital goods were produced.)

During the last quarter of 2008 and the first quarter of 2009, there wasn't a shift of resources into the industries that had been underproducing. Instead, there was a decrease in demand, production, and employment in both consumer goods and other capital goods industries.

Rather than malinvestments being corrected by a reallocation of resources, there was just underproduction of just about everything.

The problem is that the quantity of base money, even though high by historical standards, was below the demand to hold it. The Fed has a monopoly on the production of base money. The price is fixed by definition. The Fed underproduced it. And the shortage of base money showed up as a surplus of everything else.

There is a market process that will correct this problem. And that is a drop in prices, including the prices of resources like labor. The lower prices increases the real quantity of base money until it matches the demand. As this happens, real aggregate demand expands. (Notice that aggregate demand does need to expand.) The pigou effect is that the higher real quantity of money increases real wealth, reduces saving, and raises consumption. Real interest rates can be reduced by the price level actually falling "too much" so that it is expected to rise, causing real interest rates to fall (perhaps to negative values) so that investment and consumption increase.

The notion that the pattern of real demands that is generated by the market recovery process is sustainable in the long run is just an illusion. Once production and employment begin to recover, expectations, nominal interest rates, the demand for base money, and the equilibrium price level will all adjust again. Anyone who uses the nominal or real interest rates that are generated as the economy runs though the deflationary wringer for long term planning would be setting themselves up for new malinvestments.

I think the best (least bad) macroeconomic environment for the liquidation of malinvestment is stable growth in nominal income. The quantity of any sort of money, including base money, should adjust in a way consistent with that background.

If the quantities of various sorts of money must adjust, that means both increase and decrease. When the demand for base money falls, the Fed must decrease it.

If banks choose to hold less reserves and begin to expand lending, and the Fed responds by selling government bonds, then what happens is that the increase in credit and money that could be created is smaller. There is never any contraction in credit--just a smaller expansion that otherwise would occur.

The Fed can contract credit, but that doesn't mean that credit contracts. The banks lend less to the Fed, and the Fed lends less to... well, "troubled sectors of the credit market." The banks lend more to other people. Perhaps some can borrow less (from the Fed) and others borrow more (from the banks who are now making loans rather than holding balances in reserve accounts.) It may even be that those who were borrowing from the Fed or from the banks that were borrowing from the Fed, will be the ones borrowing from the banks.

What is the problem? If the Fed was wrong, and when the economy recovers those sectors are still troubled (say, representing malinvestments) then the Federal Reserve will not have enough assets to sell. It will, as Bernanke said, need to raise the interest rates it pays on reserves or else, perhaps, sell its own bonds. That way it can conitnue to direct credit to troubled sectors. Or else, get a bailout from the Treasury.

Anyway, the solution was for the Fed to purchase safe assets. Sticking to government bonds would have probably been best, but if the Fed ran out of those, loans to sound banks, AAA commercial paper, and the like could be used.