From Wikipedia: Malinvestment is a concept developed by the Austrian School, a non-mainstream school of economic thought, that refers to investments of firms being badly allocated due to what they assert to be an artificially low cost of credit and an unsustainable increase in money supply, often blamed on a central bank.
Malinvestment is a concept that if you understand it will explain everything that has occurred in the last few years. It predicted and explains the dot com bubble, the housing bubble, why Japan is in a two decade recession and why the stimulus plan didn't work. Understanding what malinvestment is and avoiding it in your own life can be the difference between just getting by and truly getting ahead.
As a simple example lets say a family member comes to you and says if you invest five hundred dollars a month with him he will pay you back at a 10% interest rate. The money will be used to makeup for a five hundred dollar a month shortfall he has between his bills and his income. Essentially he needs your money to be able to pay his electric bill and car payment. With each payment of $500 that you give him he will give you a signed note promising to repay the $500 along with the specified 10% interest.
If you were to use these IOU notes as a savings plan for when you retire then for many years this would appear to be a great investment since on paper you would have a tremendous amount of money accumulating earning a terrific rate of interest. The problem with this situation should be obvious to anyone with a shred of common sense. Your family member has not been using the money to grow a business or to expand his home, the money has been spent on normal monthly living expenses. While the notes you hold may be legal contracts that entitle you to the money there is nothing of real value backing up those notes making them only worth something as long as you trust your family member.
Had you taken that same money and invested it with a different family member who used the money to purchase building materials to construct a business on a piece of land he owned then the value of your notes would be backed up by the heightened value of that land. By adding his idea and labor to your investment capital the value of the money you invested would actually have increased and would be generating sales to pay back the principal and interest you are owed on your investment. This is the idea behind the stock market, people invest money in companies they like and the companies use that money to expand their business. The price of the stock is then determined by how well that money is used.
Now that you have an idea of what malinvestment is lets apply that to some of the big financial bubbles that have ruined many people's retirement savings and our entire economy.
The dot com bubble of the 1990s
The internet created a tremendous boom in the economy in the late 1990s but much of that growth was simply paper gains similiar to our first family member example. What we had was a lot of investment money being applied to an industry with not very many really good ideas. Easy money meant that anyone with a .com idea could get investors to give them tons of cash to get their website off the ground. For every good business model such as Amazon.com there were ten pets.com getting huge sums of investment cash thrown at them. The more that stocks went up the more people wanted those stocks causing the prices to go even higher. As long as more and more money kept pouring in the price of stocks would just keep soaring.
There's a little problem in the financial world in that companies must disclose their accounting on a regular basis and it soon became very apparent that many of these companies had practically no sales despite all the money that had been invested in them. The money was gone, spent on programmer's salaries and computer equipment to make websites that nobody bought anything from. Once people began to see the problems with these companies and investors starting looking to get their money out the whole thing fell apart in a crash that is still long from over. At the height of the dot.com bubble, more than a decade ago, the technology heavy stock exchange known as the NASDAQ was well above the 5,000 level. Since the dot com crash it has still not gotten above 3,000. Many people lost almost everything they had invested.
Today, the Federal Reserve Bank, a government created institution has become a collector of malinvestments in order to create the illusion that our economy is in recovery. The Federal Reserve controls our money supply, they issue every paper dollar in existence. Take a look at any paper bill and you will see Federal Reserve Note written across the top. They are in fact a private company but all of their profits are returned to the US Treasury at the end of each year.
The Federal Reserve generates profits by issuing various types of loans to large banks and corporations with the interest charged on those loans being the profit they ultimately make. If a bank or corporation where to default on a loan this would end up being a loss for the Federal Reserve. The main purpose of the Federal Reserve is to be the lender of last resort for banks in the event that bank depositors attempt to withdraw more money than the bank actually has. This allows banks to loan more money out then they have in deposits creating our fractional reserve system of banking. You can search google or youtube for information on the Fed or fractional reserve banking if you want a deeper explanation.
What happened in the financial crisis of 2008 is that the Fed decided to rescue the financial system by buying toxic assets and Treasury bonds. That begs the question, what exactly is a toxic asset? The banks took home mortgages and bundled them together to create financial products that could be bought and sold like a stock. Most of these mortgages are based on highly inflated home values and also on variable rate sub prime mortgages. These bundled assets were advertised as extremely safe AAA investments. When home values crashed and foreclosure rates sky rocketed the drop in value of these mortgage based assets plunged and threatened to bankrupt the largest banks and financial institutions in the country(and worldwide).
The Fed made the mind boggling offer to buy these practically worthless mortgage based assets from the banks at their full face value. They ended up buying more than a trillion dollars worth of worthless paper in order to keep the banks from going under. The value of these assets has only dropped even more in the last three years. In addition to this madness the Fed went on a buying spree of longer term US Treasury bonds at a time when the price of these bonds was at an all time high and the interest being paid was at an all time low.
For two years the Fed simply sat back with over two trillion dollars in toxic assets and over priced treasury bonds waiting for the economy to recover. When it became clear in 2010 that a recovery was not going to happen they announced their intention to begin another round of US Treasury bond purchases which has since been dubbed QE2, short for Quantitative Easing 2 since it was the second time the Fed would directly buy US Treasuries.
Investors, being smart people knowing that the Fed would begin buying 100 billion in Treasuries every month starting in November pushed the price of Treasuries back to their all time high by November. If someone tells you they will buy a specific dollar amount on a specific day of any product are you going to set the price high or low?
If the Fed is forced to reduce their balance sheet below the trillions they currently have they will end up taking tremendous losses to the tune of hundreds of billions of dollars. Since the Fed is on the hook to return their profits each year to the Treasury then the same is true for their losses. That's right, the US Treasury which gets all its money from tax revenue would have to pay for the massive losses that the Fed knowingly and intentionally incurred. We cannot hide from the reality of our malinvestment forever. The housing losses must eventually be dealt with. The price of Treasuries will eventually return to real market value once the buyer at any price exits the market.
The financial crisis of 2008 never ended, it has simply been delayed and shifted from private banks to the Federal government. When this bubble bursts there will be no higher power to bail us out and we will truly learn what shared sacrifice is all about.