[murphy560]

Professor Herbener, in reading some critiques of ABCT I’ve come across the accusation that it is “simply another overinvestment theory” whereas Austrians reply that it is in fact a malinvestment theory. Can you explain exactly what the difference is between overinvestment and malinvestment in this context and explain how you can have overinvestment without having malinvestment? Thanks.

P.S. the course on textbook economics is absolutely great!

[jmherbener]

Over-investment theories claim that during the boom total spending in the economy shifts away from consumption and toward investment. The ABCT argues that monetary inflation and credit expansion suppress interest rates which leads to more consumption and a shift of investment into longer production processes, which eventually prove to be unprofitable.

Take a look at the article by Joe Salerno:

http://mises.org/journals/qjae/pdf/qjae15_1_1.pdf

[murphy560]

Thanks. If we imagine a production structure with five stages (each of equal duration) why is it that lower interest rates disproportionately favor expansion of the higher stages? If each stage takes the same amount of time, why would low rates favor stages more temporally removed from consumption? Wouldn’t investors just be concerned about their one year long production process instead of the five years to consumption? Also, when we say that these production processes prove unprofitable, how is this unprofitability ultimately revealed? Is it that when interest rates eventually rise future business loans are more expensive than anticipated or that the unexpected competition for factors of production between lower and higher stages lead to higher factor prices than originally expected?

[jmherbener]

The present value of future revenue is found be discounting the future revenue by the factor (1+i) raised to the exponent corresponding to the future time period. For example, revenue to be earned after two years at 5 percent is discounted by 1.05 squared or 1.1025. So, $1,000 to be received two years from today has a P.V. of $907.03. Revenue to be earned ten years from now at 5 percent is discounted by 1.05 raised to the 10th power or 1.629. So $1,000 to be earned in ten years has a P.V. of $613.87. If the interest rate falls from 5 percent to 4 percent, then the corresponding discount factors are now 1.0816 and 1.480. So the 2 year discount falls by 1.9 percent while the 10 year discount falls by 9.2 percent.

So, for two investment projects of different time horizons, when the interest rate falls the discount on shorter term projects falls less than the discount on longer term projects. The result is that longer term projects gain in P.V. compared to short term projects.

To see the effect of a lowering of the interest rate on the length of the entire capital structure, take a look at Murray Rothbard’s illustration in chapter 8 of his book, Man, Economy, and State:

http://mises.org/books/mespm.pdf

[murphy560]

Thank you. Also, when we say that these production processes prove unprofitable, how is this unprofitability ultimately revealed? Is it that when interest rates eventually rise future business loans are more expensive than anticipated or that the unexpected competition for factors of production between lower and higher stages lead to higher factor prices than originally expected?

[jmherbener]

When interest rates rise, the P.V. of longer term projects falls more than the P.V. of shorter term projects. The greater capital losses in longer term investments leads capitalist to shift toward shorter term projects. To see how this affects profitability, consider iron mining over the cycle. The build-up during the boom in mining production will prove to be profitable as business demand for iron is increasing in other stages of production. But when interest rates rise and the bust ensues, the demand for iron in the other stages declines, but the cost structure of the built-up mining production remains at boom-levels until the collapse of asset prices. Then the collapse of prices of assets used in mining will make their production less profitable and so on. As the liquidation and re-allocation process proceeds, the capital structure is shorten to once again satisfy people’s time preferences.

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