Goods and Bads

Investment or Malinvestment?
by Igor Karbinovskiy

Every administration wants to create jobs. There can never be too many jobs, if you ask them, so they're always interested in making more, even in times of low unemployment. Every administration, therefore, proposes its own jobs bill. Last year, for example, President Obama spent some time touring the country to promote his own jobs bill as a way to address the deepening economic crisis. This seems like a no-brainer. After all, jobs are clearly and unambiguously a good thing, right?

Suppose I write an article on the economy that no one wants to read, much less pay me for. Now suppose that the government pays me for it anyway — as part of a jobs bill. Presto! A new job has been created; a person who was previously unemployed is now working. Better yet, that person is me! This job certainly increased my standard of living. But what have I produced? What have I contributed to the economy? Because no one wants my article, the value of my contribution to the economy is zero. The time I've spent in writing, and the money the government paid me, have been wasted. Worse, because this money allows me to consume things that I (and other people) want — things like food and shelter — the net effect on the economy is negative: zero value in, positive value out. This, then, is an example of a "bad" job.

On the other hand, if someone wanted the article I'd written, at the price I was charging for it, then the situation would be quite different. My contribution to the economy would be positive; its value is determined by my customers, who prefer my work to the money they paid for it. I obviously gain the money, which I value higher than my labor. In this latter example, I was productive. In the former, I was not. This, then, is the difference between a productive job and an unproductive one: whether or not someone freely decides that its output is worth buying.

Everyone makes decisions based on an ever-shifting scale of personal preferences — a kind of mental shopping list on which we list all options available to us that we're aware of, in order from most desirable to least desirable. Economists call this the "law of marginal utility." We choose that option we find most desirable — why would we ever pick an option that is less desirable than another (whatever "desirable" means to us)? I am not suggesting that every choice we make is made with our personal, selfish benefit in mind, at least not material benefit. I am simply pointing out that anything we do in the absence of coercion — even giving gifts — we do because we want to do it. So if we go into a store and choose one product over another, it is because we valued that product more than the other.

If we accept that some products are desirable and others aren't, then it follows logically that the real estate, equipment, labor, raw materials, and money involved in their creation are also either desirably employed or not. Anything invested in creation of goods that no one wants ("bads," really) is wasted — as was my time in writing the unwanted article — and should be reallocated toward creation of goods people actually want. On the other hand, assets invested in the creation of goods that everyone wants most urgently are clearly put to best possible use, and any effort to reallocate them toward any other use would result in a reduction in everyone's standard of living.

It's not enough, then, to know how much money, equipment, time, etc. there is; you also need to know how much the end result is valued on the free market. Investors know this from experience, after watching the values of their investments fluctuate on the market. And how can we know ahead of time how much the final product or service will be valued on the free market? We cannot. There is only one way to test the quality of any investment — by putting it to the free market test: produce the goods or services; offer those goods or services for sale on the free market; if you make a profit, then your investment was productive.

All this is in complete contradiction to the commonly (though not universally) accepted economic theory that treats all investments the same, without regard to how desirable its end product is. Everything is lumped together blindly into a single aggregate. According to this theory, if you increase the aggregate, you increase the total level of wealth and hence the standard of living. Not surprisingly, economists who think this way are always calling for more inflation.

But if you increase the supply of money (inflation), and it is allocated into uses that are wasteful, then you don't create any wealth, and you don't increase the standard of living — even if you use the new money to create new jobs. When mainstream economists say that the economy has expanded, therefore, this should be taken with a grain of salt. A skeptical person should ask which part of the economy has expanded — the productive part? Or waste?

In the same way economic contraction is not necessarily a bad thing. Which part of the economy has contracted? The productive part or waste? When investments are misallocated into wasteful configurations ("malinvestments"), the result is losses to its owners (barring government bailout). The owners, then, are faced with the pressure to reallocate their wealth if they don't want to continue to hemorrhage cash. This usually involves cutting back on spending, letting employees go, selling property, etc. In other words, economic contraction. At the end of this process, the money is released to be reallocated, potentially into productive, wealth-building uses. The sum total of the economy may have shrunk, but the productive part of it has grown at the expense of the wasted part.

There is no way to know if a particular sum of money, machine, building, or worker is put to a valuable, productive use, other than to put them to the test of the free market. Outside the free market, investing capital is like throwing darts blindfolded when you don't even know which direction the dartboard is. What does that mean for a jobs bill? Far from rescuing the economy from crisis, it would only make it worse. Consumers, being the rulers of the free marketplace, must be free to decide — to buy or not to buy. To maximize productive capital therefore requires that consumers are free from any constraints on their decision making — and especially that nothing should interfere with the profit-and-loss signals sent out by these decisions. The sooner capital owners learn that their capital is allocated into wasteful uses, the better