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Source link: http://archive.mises.org/7608/credit-expansion-and-submarginal-investments/

Credit Expansion and Submarginal Investments

January 3, 2008 by

Markets are ruthlessly efficient, meaning in large part that people will not undertake investment projects with risk characteristics that are not aligned with savers’ preferences. All profitable opportunities will be exploited in equilibrium, and no potentially profitable projects will be left undone.

One of the unfortunate consequences of credit expansion is that many projects which were formerly passed over by investors will be undertaken because of the incorrect signal sent into capital markets by artificially reduced interest rates. These problems will be compounded by the fact that savers will pull real resources out of the capital market, meaning that previously profitable investment projects will now be unprofitable malinvestments. FULL ARTICLE


roman January 3, 2008 at 9:30 am

The broader implication of malinvestment in housing resulting from artificially low interest rates goes beyond the sub-prime. It seems there has been a pervasive over-investment in housing across all economic strata. Families now live in much larger houses than generations ago, and even sq.ft for sq.ft, the houses themselves have changed. Multiple bathrooms, multiple garages, walk-in closets, granite countertops, etc. etc. Imagine how much capital would have been available to invest in productive directions if the average family still lived in a 2 bedroom 1000 sq.ft bungalow!

Housing is NOT an investment, it a depreciating/high carry-cost consumption good!

Byzantine January 3, 2008 at 10:04 am


I’d temper that comment slightly. After all, those homeowners are simply exercising their own individual preferences and consequently, capital aligns itself to meet the demand.

But you are essentially correct. Some of the demand for multiple bathrooms, granite counters, etc. is undoubtedly fueled by the false signals of artificially cheap credit whereby a house is seen as an “investment” and such improvements are made when people would otherwise do with two bathrooms or formica.

I look out my car window every day and wonder who’s going to buy all these $700K townhomes and $1M single family dwellings.

Bob Kaercher January 3, 2008 at 11:44 am

“As Cowen correctly points out, this is not a moral issue as much as it is an issue of monetary policy; Cowen is not himself a believer in Austrian Business Cycle Theory, but he is correct in noting that the current problems plaguing housing markets are related to policy rather than moral failings.”

I somewhat take issue with this point. To some degree, the policy problem IS a result of moral (and ethical) failings:

1.) It is immoral and unethical for one group (government) to presume a monopoly over the supply of money and credit in the first place. As your article demonstrates, it massively defrauds milions of people.

2.) Willful ignorance, is, IMO, something of a moral failing, and I think that’s an accurate description of today’s Boobus Americanus. It’s perhaps one thing to not see the problems in the first years after the establishment of a central bank, but after nearly an entire century of booms and busts one would think that more people would at least investigate the causes. From where I’m sitting, too many people in this country don’t want to bother their little minds to even think about it, or for that matter any other problems resulting from government policy.

Please forgive my cynicism, but I just spent an entire week in a part of Middle America where it seems that everyone automatically blames economic problems on foreigners rather than trying to reason out the actual causes.

Moral failing and bad policy are mutually reinforcing. You can’t have one without the other.

roman January 3, 2008 at 1:17 pm

“I look out my car window every day and wonder who’s going to buy all these $700K townhomes and $1M single family dwellings.”

Byzantine, no-one is going to buy them. I can’t see prices reseting downwards during the coming depression; mortgage strapped owners and banks will simply be caught and left in a limbo – why sell something with negative equity? why foreclose on an asset that can only be resold at a huge loss? why walk if the alternative is living on the street? the pretence of book values will be maintained as long as possible.

And who would want to buy these monstrosities and take on ever escalating property taxes and bloated maintenance costs? A house isn’t a house anymore, esp. those slapped-up in the last decade using cheaper and cheaper materials. I know what I’m talking about, I built my own house 15 years ago, and back then we used real plywood and sold wood framing, not this engineered compressed-sawdust garbage. A few years without viligant maintenance and these faux mansions won’t be worth the cost of demolition.

Paul Marks January 3, 2008 at 2:51 pm

The United States government has not taken a monopoly of credit – it has added to the credit that would have been available from real savings.

As we all know this is the whole point of the Federal Reserve system (and other such schemes in other nations and times) the government stands behind the fractional reserve banking system trying (in various complex ways) to ensure “confidence” so that credit will be expanded via “lower interest rates”. Of course even before the existance of the Federal Reserve system the Federal government tried to do this via the National Banking Act (1861 if my old memory serves), which, of course, also lead to various booms and busts (just as other schemes did before it).

Of course in the housing market there are also the specific absurdities of Fannie Mae and Freddie Mac (with endless demands that they be expanded).

However, there is another point somewhat more specific than the general one about the Federal Reserve system credit-money bubble.

Someone who borrows money on a “flexible” interest rate to buy a house is a SPECULATOR.

Now there is nothing evil in being a speculator – but someone who jumps up and down saying “my mortgage interest rate has gone up” should blame no one but himself.

If you speculate (i.e. you borrow money in the hope that the interest rate will fall or at least stay at the artifically low level you borrowed the money at) and the interest rate goes up – well hard cheese.

If you want to avoid higher interest rates then borrow at a fixed rate – “but that rate is higher than I would like”, see above.

Alex January 3, 2008 at 5:20 pm

I agree with the article’s basic analysis, but, as always, when the discussion of investment comes up in such articles I shall ask my usual question: What determines the Austrian investment curve? Maybe someday someone will give me an answer.

fusgerm January 3, 2008 at 8:48 pm

There are some excellent points made in this article which (for me) throw a new light on the pitfalls of tampering with market rates.

Profitable firms have to try to estimate for themselves the real market rate in order to gauge “the intertemporal consumption preferences of savers”, since “projects that were unprofitable at a free-market interest rate of 5% will be unprofitable at a distorted-market interest rate of 4%, provided that the interest rate consistent with intertemporal consumption preferences is 5%.”

Thank you. Enlightening.

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