In his masterpiece Economics In One Lesson, Henry Hazlitt distilled the whole of economics into a single sentence. Simply put, he said that economics “consists in looking not merely at the immediate but at the longer effects of any act or policy” and “tracing the consequences of that policy not merely for one group but for all groups.”
Then and now, his advice is largely ignored.
Consider the following piece of economic analysis from CBC News, entitled “Why a housing bubble is good (but maybe bad for you),” which happily purports to have found a silver lining in the bust phase of the business cycle:
High prices push up production, followed by a point when too much is being produced and prices fall. In the housing market, where the construction cycle of a single building can take at least two years and the product lasts decades, it is not so easy to turn off the tap. Market economists often complain that rent and price controls distort the market for property because underpricing fails to instruct the market to produce enough.
But the factors the ECB blames for inciting a boom — “including short-term interest rates, local and global money and credit developments, and the incidence of mortgage market deregulation” — can also distort a market the other way, producing too much.
And this, finally, is the good thing about a property bubble. While you may suffer personally when the price of your house falls, and while the wider economy may suffer a contraction when homeowners suddenly feel poor, the greater Canadian economy will benefit.
Here’s why: During bubbles, a country grows its housing stock, over-investing in the construction of new properties so that the supply is more than sufficient, allowing prices to fall relative to income. At the end of a bubble, finally and for quite a while afterwards, there is enough to go round.
Yes, nothing will benefit “the greater Canadian economy” (not to be mistaken with the “wider economy,” of course) like rampant foreclosures and a glut of empty houses. We should learn to emulate the good governance and prudent economic management of the city of Detroit. We’ll know we’re on the right track when we can buy a house on Zillow for $70.
In actuality, the boom phase of the business cycle is characterized by malinvestment; not overinvestment. It is crucial to distinguish the two in order to fully understand the fallout to the economy.
Every day, we are confronted by the reality of scarcity. After all, the array of goods available to us is not infinite. We are also constrained by time and the means – including land, labour, and capital goods – at our disposal. Because we can’t have everything, we are forced to make trade-offs. In the free market economy, signals conveyed by the price system optimize what is produced, how it is produced, and for whom it is produced. Simply put, malinvestment is investment in the wrong lines of production. It is the result of central bank and government intervention in the economy, and it inevitably leads to waste and losses.
Ludwig von Mises explained the malinvestment of the business cycle in the following way:
The whole entrepreneurial class is, as it were, in the position of a master-builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master-builder’s fault was not overinvestment, but an inappropriate employment of the means at his disposal.
Sure, price corrections in the aftermath of a popped housing bubble will present buying opportunities for some and also help to clear the market. But this certainly does not offset the squandered resources that were better suited for other areas in the production process. Despite the fact that these unrealized effects are unseen, the losses incurred are no less real.
It is not a good idea to observe the economy with rose-coloured glasses.