Malinvestment in our Strange New Economic Environment By Les Nemethy, CEO, Euro-Phoenix Financial Advisors Ltd.

Interest rates are near zero in most of the developed world, sometimes negative, despite which new investment and velocity of money are falling; Governments continue to try to stimulate them. In many countries Governments are subsidizing loans (e.g. Hungary) and in others, guaranteeing bank loans (e.g. Italy). All this leads to malinvestment—investment that is not efficient (e.g. propping up zombie companies, or projects). This article discusses some of the perverse effects of malinvestment, and what actors in the economy might do to diminish malinvestment.

Just as the north star served ancient navigators as a compass, so too interest rates serve modern decision makers as a compass for making investment decisions. Prices are essential signals in a market economy. The interest rate is perhaps the single most important price or signal in every market economy. If Government distorts prices through monetary inflation or artificially low interest rates, a distortion in resource allocation is likely to occur: malinvestment1.

When I ran a telecom company, our board approved only those investments which generated a certain minimum return on investment (which of course was determined by our cost of capital at the time). So if interest rates and therefore cost of capital are lower, less productive investments would be undertaken. When this happens on a macro scale, this cannot have any other effect than reduce standards of living and well-being.

A loan is a way of binging forward an expenditure from the future to the present, and the lower the return, the more it will be at the cost of future generations. Investments undertaken at near-zero interest rates rob future generations to create an ephemeral present stimulus. Unless you assume that there is no intention of paying back loans in the future—just rolling them over, possibly even adding to them—which creates a different set of problems, discussed below.

Government stimulation of the economy with negative interest rates becomes counterproductive. Rather than accept negative interest rates (e.g. paying the bank to hold you money rather than vice versa), individuals may well prefer to hoard cash under the proverbial mattress (corporations opting perhaps to keep cash in the safe). This cannot serve towards any other purpose than further reducing velocity of money, effectively sterilizing savings, depriving the financial sector of its role transforming savings into investments.

While cheap interest is like a drug that stimulates the economy when interest rates are headed downward, when the direction of interest rates, particularly real interest rates begins to increase, many projects and companies that were formerly viable at lower interests lose their ability to service debt and collapse. This explains the addictive nature of low interest rates—it is a hard habit to kick without creating diminished output, unemployment, etc.

So what can we do to escape this cycle?

First and most importantly: Governments should wean the economy of artificially low interest rates. Over the past few years, the Fed had made feeble attempts to do this in the US, until Covid hit, which triggered another massive round of lower interest rates and monetary easing. As Ludwig von Mises, eminent economist from the Austrian school wrote:

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion or later as the final and total collapse of the currency itself.”2

In other words, if we continue issuing massive debt and printing money ad infinitum, at some point people may lose confidence in the currency, resulting in a collapse of the currency.

Bankers should pull the plug on zombie companies and investments, or even better, force their restructuring, even if this results in short-term pain for long-term gain. Furthermore, rather than devoting large amounts to safe investments like government bonds, banks should take on intelligent risk, backing good entrepreneurs with quality projects.

Entrepreneurs should use their business acumen to generate high rates of return—both for their own good, and for the good of society. There are still quite a few start-ups and technology investments that promise considerable returns.

Individuals, who ultimately save for retirement, will need to put aside a higher percentage of earnings, not only because interest rates are lower—but when equities trade at record price/earnings multiples, equities, too, are statistically likelier to appreciate less over the medium to long-term.

In short, malinvestment over the years means we have collectively dug a hole that is getting deeper. At some point, post-Covid, we must begin exiting the hole. To use the analogy of forest fires, the more debris and undergrowth exists in the forest, the more substantial the conflagration will be when it comes. We need to begin cleaning out the debris.
2Human Action, Ludwig von Mises, Chapter XX, section 8

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