Posted by: Dirk | March 26, 2007

Over-investment causes a boom, then a bust

Many people (Economists included) believe that business cycles arise because of cyclical over-investment, which via a fall in returns to capital then leads to a recession. This is actually classic Hayek, according to Hanke:

For the Austrians, things go wrong when a central bank sets short-term interest rates too low and allows credit to artificially expand. Interest rates that are too low-lower than those that would be set in a free market-induce businesses to discount the future at artificially low rates. This pumps up the value of long-lived investments and generates an investment-led boom, one that is characterized by too much investment and investment that is biased towards projects that are too long-lived and too capital intensive.

An investment-led boom sows the seeds of its own destruction and is unsustainable, however. Indeed, on the eve of the downturn investors find that the loanable funds for investments are too expensive to justify commitments they made during the preceding monetary expansion. Some businesses engage in distress borrowing, profit margins collapse under the weight of too much costly debt, and-if that is not bad enough-many businesses are saddled with excess capacity, resulting from what turned out to be wrong-headed investment decisions. With that, the investment-driven boom turns into a bust. In short, artificially-created investment booms always end badly.

Perhaps it was bad timing then that Keynes published his General Theory shortly after the bloom of Hayekian theory. Check your IS/LM model: An investment boom can cause a rise in national income, if loose monetary policy goes along. (This Blog is not called Econ101 for nothing.)

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