The Myth Of Malinvestment

JVH wants me to respond to the “Austrian” critique of monetary stimulus:

How do you respond to libertarian critiques of stimulus through the central bank? I’m really very ignorant of this, but as far as I know, the standard libertarian argument is that central bank policy can set interest rates below what they should be in the free market. The end result is a supply of investment that overshoots demand, creating a bubble. When people realize that these investments aren’t working out, we get a crash and we’re in a worse mess than we started. I’ve heard this proffered as one explanation of the current crisis. What do you think of the argument?

So of course central banks can make money too lose. If you have a central bank with discretion, the central problem is that the discretion will sometimes be misused.

That said, as an explanation of recessions this makes very little sense. Paul Krugman called it the “hangover theory” and did a very comprehensive takedown over a decade ago. As a critique of counter-cyclical policy, though, the main question you have to ask yourself is how can malinvestment actually make a society worse off? It’s clear how malinvestment can make a society worse off than it otherwise could have been. China, for example, has a lot of distortionary policies in place that cause Chinese firms to over-invest in production for the US market and underinvest in production for the Chinese market. China would be better off with a somewhat different set of factories geared to make a somewhat different set of goods for a somewhat different set of customers. But it’s not like the malinvestment is so terrible that they’d be better off with no factories at all.

Similarly it’s clear that the housing boom of the early oughts left us over-supplied with houses in certain locations. In particular we overbuilt houses in the Inland Empire in Southern California, in the suburbs of Las Vegas, Phoenix, and Miami and in some parts of the Florida Gulf Coast. That misallocation of resources is unfortunate. It would have been better to expend that manpower and material on other things. But it’s not as if the existence of some houses that never should have been built is currently immiserating anyone. We’re not facing a national shortage of building material or something. It’s just waste. A sunk cost that you have to write off and move forward. The nature of a market economy is that at any given time a lot of entrepreneurs are going to be coming up with terrible ideas and suckering morons into backing their investment. The fact that a full employment economy will feature lemons and white elephants is just an inevitable fact of life, not a reason to fear full employment.