To avoid being particularly adamant about a single point in the comments thread to a recent post by Peter Lewin, over at Coordinational Problem, I’ll try to re-state what makes the Mises–Hayek theory unique against other forms of what can only be defined as malinvestment from a much broader angle here. To provide some context, below I excerpt one of the final comments Bill Woolsey makes towards Peter Lewin,

I think there was a housing bubble that involved substantial misallocation of resources. Nothing worse than many other missalocations of resources, but substantial. I don’t think an excess supply of money was a significant cause of the housing bubble. And so, that part, (if any) of the housing bubble due to an excess supply of money was trivial compared to other misallocations for resources due to changes in technogology, international and domestic competition.

I don’t intend to comment on the possibility that unanticipated changes in technology, demand, and international competition undermined global markets. I find the idea preposterously at odds with “Austrian” theory of entrepreneurship; that is, the entrepreneur as a predictor and responder to these sort of changes. But, it leads me to the more important point: what differentiates malinvestment, within the context of the Mises–Hayek theory of industrial fluctuations.

One of Mises’ most valuable insights is the role of prices and monetary calculation in the use and distribution of resources. This formed not only the basis of his attack on socialism, the public ownership of the means of production, but also the foundation of his understanding of the workings of catallactics, or the market process. I think that this insight, for the most part, is lost upon non-Austrians (and maybe some Austrians, as well), and it makes it difficult to judge Austrian ideas. This is what seems to be occurring when Woolsey compares intertemporal malinvestment to any other form of investment which doesn’t pan out against the future. For him, what characterizes all these types and gives them their essence (forgive me, I’ve been reading Popper’s three piece “The Poverty of Historicism” series) is that they all end in loss. I don’t think this does the Mises–Hayek theory justice.

The entrepreneur tasks himself with risking resources against the uncertain future, and this can lead to either profit or loss. But, it’s profit and loss — in turn, related to monetary calculation — that helps the market coordinate by constantly redistributing resources to those who use them the best, or at least relatively profitably. It’s this process, in conjunction with the idea that the successful entrepreneur is the one which best predicts (even accidentally) and adapts to future conditions. Historically, I think, the evidence shows that the market has been stable, except for sudden periods of mass loss. This is what business cycle research seeks to explain, and I don’t think “random change” is a good explanation. Random change happens all the time, and as such it doesn’t make much sense to isolate specific years and suggest that these where when things changed the most.

Alternatively, we can look at changes in the underlying factors with simultaneous lack of change by part of entrepreneurs from the angle of Arnold Kling’s “patterns of sustainable specialization and trade” (PSST). I don’t find Kling’s explanation of the crisis very satisfying, because it doesn’t offer a robust explanation of why the profit–loss process suffers a sudden breakdown. In other words, it’s not strongly based on the foundations of monetary calculation that should describe any catallactic theory of industrial fluctuations. These kind of theories deny entrepreneurs the relative flexibility that theories of entrepreneurship accord them.

What makes the Mises–Hayek theory unique? Why does it get around my reservations placed on alternative explanations? The theory of intertemporal discoordination gets at the root of catallactics: monetary calculation. A net increase in the supply of money that targets the penultimate and previous stages of production changes the rate of profits between these interrelated firms, causing entrepreneurs to invest into lines which would otherwise be unprofitable. The time during which this occurs is variable and depends in part on two major factors,

The lag between the injection and the gradual distribution of income to the “original factors of production” (e.g. land and labor); The willingness for monetary authorities to continue injecting money.

Allow me to emphasize a crucial take away: the value of certain (capital) goods changes; i.e. they are distorted by ‘artificial’ changes in the rate of profit. What reveals the malinvestment is the sudden collapse of the value of these goods, caused by a drying up of the sources of what Hayek calls “phantom profits” — money injection. This phenomenon is what Hayek refers to as “capital consumption.” It doesn’t necessarily involve physical consumption of capital, but a reduction in the value of a particular stock or fund of capital (for an in-depth elucidation of this concept see “The Maintenance of Capital“).

Unlike other theories, the Mises–Hayek one suggests why a mass of loss can occur, and it involves the central and key concept of monetary calculation. All other theories based on change, structural or otherwise, are inadequate, largely because they isolate themselves from ideas that would automatically undermine their validity — e.g. the theory of entrepreneurship and the theory of monetary calculation. In this sense, the Austrian idea is the most complete.