Lesson 4 of 8
Wrong, not too much
The tradition insists the boom misdirects capital rather than producing too much of it. Keynes thought the word over-investment was ambiguous. Both are here.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The claim is that a credit boom puts capital in the wrong places, not that it produces too much capital in general.
- The distinction matters because the remedies differ. Too much of the right thing is absorbed by waiting. The wrong thing has to be written down or redeployed.
- Keynes attacked the word from the other side, arguing that over-investment is ambiguous and that most of what a boom produces is investment destined to disappoint rather than genuinely surplus capital.
This is the distinction the tradition will not give up, and it is worth being exact about what it claims, because the looser version of it is easy to attack.
Two diagnoses of the same boom
Too much capital
- More of the right things were built than are wanted yet.
- Demand catches up, or depreciation removes the excess.
- Losses are timing losses.
- Nothing has to be redeployed.
Capital in the wrong place
- Things were built in the wrong stages for what people actually want.
- No amount of waiting makes a plant serve a demand that is not coming.
- Losses are permanent for the specific assets involved.
- The complementary goods those assets needed were bid away.
Time cures one of these. It does not cure the other.
Why the tradition insists on it
Because the mechanism it describes is a change in relative prices, not a change in the total. In Hayek's account the fall in the rate makes early stages more attractive relative to later ones, and non-specific factors move accordingly. There is no step in the sequence at which more capital in general becomes worthwhile.
Hayek's 1933 lecture uses the word directly. His argument is that the situation of the capital market in general, rather than the special position of a particular industry, can produce malinvestments not in one or a few industries but in all of them at once.
Why the distinction has teeth
Because of specificity. A general purpose asset that was built early is simply early. A purpose-built asset committed to a process that is no longer worth completing has no second buyer at anything like its cost, and the previous course showed why.
So the difference between the two columns in the figure is the difference between a loss that unwinds with time and a loss that is realised.
Keynes, attacking the same word
In chapter 22 of The General Theory of Employment, Interest and Money, published in 1936, Keynes considers the view that over-investment characterises the boom and that avoiding it is the only remedy. He says inferring that from his own analysis would be a serious error, and his first reason is that the term over-investment is ambiguous.
He separates two things it could mean. Investments destined to disappoint the expectations that prompted them, or which have no use in conditions of severe unemployment. And a state in which every kind of capital good is so abundant that no new investment would cover its replacement cost even at full employment. Only the second, he says, is over-investment strictly speaking.
He then says the boom is characterised by investment made in the expectation of a yield it will not earn, and that the disillusion replaces that with an error of pessimism. That is not the Austrian account and it is not far from it on this one point, which is worth noticing rather than hiding.
Where they part
Keynes concludes that the remedy for the boom is a lower rate of interest rather than a higher one, because that may let the boom last, and that the right course is to abolish slumps rather than booms. The Austrian conclusion runs the other way.
The point of putting them side by side here is that the disagreement is about what follows, not about whether some boom-era investment is mistaken. Both courses on the Depression in this track return to it.
Check yourself
What is the Austrian claim about a credit boom?
- That total investment exceeds total saving by a fixed ratio
- That capital is directed into the wrong stages of production, not that too much capital is produced in general
- That firms stop investing entirely
Show the answer
Answer: B.
The mechanism is a change in relative prices between stages, so there is no step at which more capital in general becomes worthwhile.Why does specificity give the distinction teeth?
- Because specific assets depreciate faster
- Because a purpose-built asset committed to an abandoned process has no second buyer near its cost, so the loss is realised rather than deferred
- Because general assets cannot be sold
Show the answer
Answer: B.
An asset that is merely early is absorbed by time. An asset in the wrong place is not.What was Keynes's objection to the word over-investment?
- That investment can never be excessive
- That it is ambiguous, covering both investment that will disappoint expectations and a genuine abundance of every kind of capital good
- That it applies only to housing
Show the answer
Answer: B.
He says only the second is over-investment strictly speaking, and describes the boom as investment made in expectation of a yield it will not earn.Sources
- Hayek, 'Price Expectations, Monetary Disturbances and Malinvestments', a lecture given in Copenhagen in December 1933 and reprinted as essay IV in Profits, Interest and Investment, 1939, section III, for the claim that the general situation of the capital market can produce malinvestments in all industries at once.
- Hayek, Prices and Production, first published 1931, second revised edition 1935, lecture III, for the change in relative prices between stages as the mechanism.
- Keynes, The General Theory of Employment, Interest and Money, 1936, book VI, chapter 22, section III, for the ambiguity of the term over-investment, the two senses he separates, the description of boom investment as made in expectation of a yield it will not earn, and his conclusion about the remedy.
- Lachmann, Capital and Its Structure, 1956, chapter 1, for why a broken combination is a realised loss.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The two firms and the 400m are invented figures chosen to separate a timing loss from a realised one. No company is described.
- Setting Keynes beside Hayek here is not a claim that their accounts agree. They differ on what follows, and the disagreement is treated properly in the course on the Great Depression.
- Whether misdirection rather than excess is what actually happens in any episode is an empirical question, and the measurement problems named in the previous course apply.