Ron Paul Explains Malinvestment, Inflation and Crashes

During my recent webinar for Birch Gold Group, I briefly mentioned the topic of malinvestment. Today I want to take a moment and explain what malinvestment is, and how it can disrupt the economy – and how you can protect yourself from the inevitable boom-and-bust economic cycle…

Ron Paul Explains Malinvestment, Inflation and Economic Crashes
Image (CC BY-SA 2.0 DEED) by Gage Skidmore

By Ron Paul, for Birch Gold Group

During my recent webinar for Birch Gold Group, I briefly mentioned the topic of malinvestment. Today I want to take a moment and explain what malinvestment is, and how it can disrupt and even destroy the economy.

Malinvestment explained

Let’s start with a simple definition: combine the prefix “mal-” (from the Latin malus, “bad”) and “investment” and it’s pretty straightforward! A bad investment. We’ve all made them.

However, malinvestment has a specific economic definition. In the Austrian school of economics, a malinvestment is a badly allocated business investment. But it’s not just a bad decision! Malinvestment results from artificially low interest rates for credit, which causes an unsustainable increase in money supply.

You have to understand that, in a free market, interest rates are the cost of credit. It’s the amount of return a lender demands from a borrower in exchange for the risk of making a loan. When I talk about “artificially low interest rates,” I mean the Federal Reserve’s intervention in the free market. The Fed can adjust the Effective Federal Funds Rate (EFFR) at its whim – regardless of the state of the economy.

Malinvestment is, ultimately, a misallocation of resources caused by interest rate manipulation. Courtesy of the Federal Reserve.

Here’s how the business cycle works:

1. “Stimulating” the economy: Interest rate repression by the central bank makes credit cheap. Taking on debt becomes more attractive.

2. Boom: Businesses use debt to finance investments. Over time, those investments tend to grow in scope and cost – but they think that’s okay, because credit is cheap right now. This excess credit leaks into the broad economy. Here’s a brief description, from Mark Thornton’s book The Skyscraper Curse:

For example, if the interest rate on inventory paid by an automobile dealership falls from 10 percent to 1 percent, the dealer will want to carry a much larger inventory to better approach maximal profits. This increased inventory, reflected across the economy, will cause higher levels of production, employment, and wages.

During these times, households take on debt to finance purchases – and all this demand, from businesses and households, drives prices up.

3. Bust: Rising prices make business costs (as well as household bills) increasingly unaffordable. That causes two problems: First, projects that looked like a good idea when prices were low look increasingly like bad ideas when costs rise.

Think of the car dealership in the example above. “Higher levels of production, employment and wages” raise the owner’s cost of doing business! Payroll goes up, along with renting space for increased inventory, and utilities rise along with prices…

Sometimes, busts happen when overextended businesses start defaulting on their loans because they just can’t afford rising prices. Bankruptcies and unpaid loans mean losses for banks, and lost jobs for employees.

Other times, busts are triggered when the Federal Reserve begins raising interest rates to fight the inflation that they caused. Pulling the rug out from under businesses and households who planned on interest rates staying low forever.

Defaults on loans and bankruptcies lead to less credit, higher unemployment and much less spending on speculative investments. Less credit means less spending, so prices fall – so life gets easier (for those who still have jobs).

But this is a cycle. The combination of rising unemployment and business distress leads back to step 1, where the Federal Reserve steps in to start stimulating the economy again…

The business cycle cartoon by Matt Wuerker

© Matt Wuerker, Politico's resident cartoonist and winner of the 2012 Pulitzer Prize for Editorial Cartooning (finalist in 2009 and 2010).

The boom is always followed by a bust.

Distorting the cost of credit has consequences! The longer a credit-fueled boom lasts, the more severe the following bust is.

The overhang hangover

Debt overhang is another useful bit of economist jargon. Here’s what it means:

a situation in which a country, company, or organization owes more money than it can pay back so that it cannot afford to make new investments.

During the boom, when credit is cheap, it seems silly not to borrow money. Even if you can’t think of anything productive to do with it! A bigger TV, maybe, or a once-in-a-lifetime vacation might seem like no-brainers when money is cheap.

Businesses and governments behave the same way. They borrow and spend. Sometimes on projects that might actually pay off in the long-term. Investments in improving facilities and infrastructure, education and training or real estate and construction might result in productivity increases.

Sometimes on less productive activities like massive Christmas parties or a corporate jet. Examples from the U.S. government are a lot stranger, like funding a mathematical model of defecation, or injecting puppies with cocaine.

When credit is cheap, it’s easy to make bad financial decisions.

Here’s the problem: Lenders don’t care what you spent the money on. They just want to be paid back! And a crisis among debtors, well, that leads to more of the same. Lower interest rates, easy money… The boom-and-bust cycle starts over again.

Opting out of the malinvestment cycle

The core of our economic struggles comes from the pervasive issue of malinvestment. This is a direct consequence of the Federal Reserve’s manipulation, primarily interest rate repression. When central banks set interest rates below their natural market levels, savers are punished. Consumption is promoted, and society makes unsustainable investment decisions. This unsustainable boom culminates in an inevitable bust.

The malinvestment booms-and-busts cycle not only undermines the stability of our economy but also erodes the very foundation of our economic liberty. Malinvestment in unproductive ventures makes the economy more fragile, setting the stage for severe economic crises that harm the average American the most.

It is imperative, therefore, for individuals to seek shelter from these artificial cycles of economic disruption. One historically proven method to preserve wealth and maintain purchasing power: Owning physical precious metals. Unlike the dollar, which can be manipulated and devalued by government and unelected bureaucrats alike, both gold and silver have stood the test of time as stores of value. Precious metals are immune to the whims of central bankers and their misguided meddling.

By diversifying your long-term savings with physical precious metals, you take a prudent step towards protecting your hard-earned purchasing power. You not only safeguard your own financial wellbeing, you also strike a blow for the principles of sound money and economic liberty.

Personally, I believe these principles are essential for a free and prosperous society.

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