What is Malinvestment?

Once it is established that the rising prices of goods and services is a symptom, rather than a cause of inflation, we can see more easily why periods of high inflation are coincident with times of economic hardship. Inflation, as defined as an increase of money supply, is detrimental because it detracts money away from wealth-generators toward the holders of the newly created money.

This results in a misallocation of resources, which Ludwig von Mises termed 'malinvestment'-

Usually the first holders of this money created literally 'out of thin air' are the banks. As such they can direct a large proportion of the newly created wealth to themselves. Through the fractional reserve banking system new loans are created and the newly created money is passed on to various entrepreneurial activities. Some of these will be true wealth-generators, but some will not. However, because of the abundance of 'easy money' it is difficult in the early stages of the boom to determine which is which.

So far both the primary recipients and the secondary recipients have done well from the influx of new money. The secondary recipients will employ workers who will also benefit from the inflationary monetary policy. These new jobs and companies will create localized areas of prosperity. So far so good.

The problem arises because of the fact that one cannot get 'something for nothing'- As the new money trickles down it does so in a diminishing fashion. In fact, there will be people within the society that will never receive any of the newly created money! However, these very same people will be affected by rising prices in goods and services. They now face higher prices with the same amount of money as they had before. They will be forced to curtail their spending on certain items that may lead to a decrease in demand for those goods and services. This reflects the notion that the newly injected money is non-neutral - a 10% increase in the money supply will not lead to a simple 10% increase in prices across the board.

An Example---

To use an example, let us assume that the U-S- government decides to spend money on a new computer system for jets. Let us also assume that this money is newly created money - it wasn't collected through taxation or the issuing of government bonds (i-e. debt)- This newly created money first goes to the people involved with the company that designs and manufactures these said computer systems. Accordingly, these people become wealthier and have more to spend. Let us assume that they buy cars and wine. Now the new money has gone to those people involved with the making of cars and wine. They in turn buy books and shoes. Now those people become wealthier. And so on---

Now what about the average person who doesn't work in these industries. All he sees is an increase in cars, wine, books and shoes. He now has less to spend on beer and pretzels. So now the beer and pretzel industry experiences a downturn. New entrepreneurs, seek business opportunities within the car, wine, book and shoe industries and avoid the making of beer and pretzels.

So what we have is an unequal increase in the pricing of certain goods and services. Some go up, while others actually go down. We also experience a transfer of capital investment from some industries to others-