Sunday, January 09, 2011


A central concept in the Austrian school of economic thought is “malinvestment.” The Austrian school began in the Austro-Hungarian empire in 1871 with the publication of Principles of Economics by Carl Menger. Menger developed the concept of the time structure of capital goods, a classification of capital goods depending on their periods of production, or how it takes for the capital good to provide its full return to the investors. Goods of lower order, such as inventory, circulate rapidly. Goods of higher order, such as real estate construction, have a long period of production.
An economic investment is the production of capital goods and human capital. The amount of investment depends on the expected profit relative to the prevailing interest rate, since one could alternatively buy interest-paying bonds. One invests if the expected rate of return, relative to risk, is greater than that of safe bonds.
In the business-cycle theory of the Austrian school, a “malinvestment” is an investment in capital goods that ends up causing a loss. The prefix “mal” can mean “bad” or “wrongful.” The most important systemic malinvestments are those based on an unsustainably low rate of interest. The rate of interest gets pushed down by an excessive expansion of the money supply. We witnessed such expansion of money and credit after 2001, when the Federal Reserve lowered the inter-bank-loan interest rate (federal funds rate) to one percent, and then again after the Crash of 2008.
The higher-order capital goods are the most sensitive to interest rates, as the asset is held for a long time. The biggest malinvestment has been in buildings. The real estate boom of decade before the Crash of 2008 included the construction of housing and commercial buildings that later incurred losses as borrower defaulted, leaving a mess of vacancies. The investors thought that demand would continue up in a straight line, whereas the boom peaked and crashed.
But what really rises and falls in the real estate cycle is land value. Real estate investors are also buying land in the expectation that land values will keep rising. The conventional ABC (Austrian business cycle) theory overlooks the role of land value in the boom-bust sequence. Since economic investments are an increase in the stock of capital goods and human capital, land is not an economic investment. If one buys land expecting its price to rise, that is a speculation. The buyer speculates that an increase in demand will raise the price.
A speculation is the purchase or sale of an asset in order to gain from a favorable change in the price. A malspeculation is the purchase of an asset based on mistaken beliefs, which results in a loss. During the real estate boom, there is both systemic (economy-wide) malinvestment and malspeculation. Real estate developers expect to profit not just from the capital goods, the buildings, but also from a further rise in the site value.
The 19th-century economist and social philosopher Henry George developed the theory of the business or trade cycle based on malspeculation in land value, although he did not use that term. Such malspeculation would not occur in a pure free market, thus the “business” cycle should more accurately be called "the interventionist cycle" or "the economic distortion cycle."
There are two major interventions that cause malspeculation. First is an injection of money into the banking system, an increase in loanable funds not caused by higher savings but by money expansion. The resultant cheap credit fuels both malinvestment and malspeculation in real estate. When the money injections stop, interest rates rise back up, and such projects and purchases slow down and stop. When land values stop rising, speculators sell, and the fall in land values brings down the financial sector that provided the mortgages.
The second major intervention is government spending for public goods. Public works and civic services raise land values, and when these works are financed by taxing labor, goods, and enterprise, then in effect landowners get subsidized. Much of the gains from economic expansion go to higher land rent and land value, which attracts speculators who expect great profits from the leverage of using other people’s money. Malspeculation carries land values beyond that warranted by the rents. Henry George called this a lockout of labor and capital. With the use of real estate now unprofitable and unaffordable, land values crash.
The boom-bust real estate and economic distortion cycles have repeated for that past 200 years, yet the 2008 crash surprised not just malspeculators but also economists, financial analysts, and governmental officials. The reason the cycle recurs is that, as the philosopher Hegel observed, people do not learn from history. Or they learn the wrong lessons. They shun Georgist theory, and thus become mal-economists, mal-financiers, and mal-authorities. As one would say in Spanish, todo es muy malo.
Add “malspeculation” to your dictionary. Malspeculation is a vital concept that curiously has not had a name, because the role of land in the boom-bust cycle has not been appreciated. The Crash of 2008 was caused by malspeculation, and so the word will find the light of day.


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