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The Price of Monetary Meddling

Here’s a letter to The Economist:

You are critical of F.A. Hayek’s thesis that “malinvestments” – investments poorly coordinated with the saving plans of households and hence the strength of future demands for consumer goods – can generate periods of high unemployment (“Hayek on the standing committee,” Sept. 15).  You then write that the “better lesson to take from Hayek” comes from “[h]is later works praising the price mechanism and fretting about economic planning.”

But what you call Hayek’s “better lesson” is the larger insight at the heart of his theory of malinvestment.  Hayek understood that successful mutual coordination of the economic decisions of millions of people occurs to the extent that prices – which guide people’s economic decisions – accurately reflect underlying economic realities such as resource scarcities and households’ preferences for saving.  He reasoned, therefore, that government activities that distort prices cause prices to ‘lie’ about underlying economic reality and, hence, cause prices to mislead economic actors into making an unusually large number of plans that are destined to fail.

In the case of malinvestment (note: not simple over-investment), excess money creation distorts the interest rate, causing it for a time to mislead businesses into producing too many long-lived capital goods and too few other goods.  For the economy to again thrive requires that these malinvestments be corrected.

Donald J. Boudreaux
Professor of Economics
George Mason University
Fairfax, VA  22030

One of the best modern books on the larger topic of which my letter above is only one application is Roger Garrison’s Time and Money.