Understanding Investment Bubbles

In the classic definition of gross domestic product (GDP), saving (income not spent) is always equal to investment (output allocated to capital rather than current consumption). Thus, in the simple case of an economy without government or foreign trade:

GDP = C + I = C + S

∴ I = S

Whether I represents an addition to productive capital is another matter.

Consider a self-sufficient baker who bakes 8 loaves of bread a week. He usually consumes 7 of the loaves and saves 1 in case he gets sick and isn’t able to bake enough to cover his consumption. The extra loaf is just an investment in inventory, not an investment in productive capital. To be an investment in productive capital, the baker would have to increase his rate of consumption for the purpose of fortifying himself for an expansion of his baking operation.

If the baker doesn’t get sick and his inventory of uneaten loaves continues to grow, some of the loaves will become inedible. In other words, the baker’s inventory will depreciate, and he will have wasted time and materials because he overestimated his own demand for bread.

In the extreme, if the baker never gets sick and effectively wastes a loaf of bread a week, his apparent output (GDP) is higher than his actual income — his consumption (C) — by 1 loaf a week. The baker has created an inventory “bubble” that he’s unlikely to sustain when the facts of his situation hit home. Until then, his real GDP will have been overstated because of the inventory buildup that was unwarranted by his own demand for bread.

Alternatively, the baker consumes the 8th loaf of bread every week and expends the resulting boost in energy by building another oven, which can produce another 8 loaves a week. He has invested in productive capacity, yes? Only if there is demand for the additional output. But there isn’t. After he has built the new oven, the baker reverts to his previous consumption rate — 7 loaves of bread a week — so his new oven stands idle. Superficially, the baker has invested in additional productive capacity. But in reality, he has created an investment “bubble” — the additional oven that doesn’t produce anything because there’s no demand for its output.

The inflated inventory and the unused productive capacity seem, on the surface, to represent investment. But both are bubbles: the wasted expenditure of resources (the baker’s efforts and materials). The bigger the bubble, the more waste there is.

Bubbles are inevitable in a complex economy, where there’s imperfect information about the demand for various goods and services. But markets quickly put an end to bubbles because they promptly fill information gaps.

Government interventions stifle the transmission of information, with the result that such interventions cause resources to be wasted in profusion. When government steps in to mandate low-income mortgages, for example, demand for housing is overstated to the extent that home-buyers are encouraged to buy houses which they can’t afford. Absent the mandate, fewer home-buyers would be tempted to borrow beyond their means. And fewer builders would hire workers and buy materials to construct houses that are foreclosed and stand empty for months and years.

The self-sufficient baker harms only himself when he bakes too much bread. Government harms millions of people when it pushes resources toward unsupportable uses.

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Related posts:
Mr. Greenspan Doth Protest Too Much
Monopoly: Private Is Better than Public
The Fed and Business Cycles
Government Failure: An Example
Money, Credit, and Economic Fluctuations
Lay My (Regulatory) Burden Down
“Big SIS”: A Review
How Not to Cope with Government Failure
Government in Macroeconomic Perspective
Greed, Conscience, and Big Government