When governments and central banks inject new fiat money into the economy, they create the illusion of prosperity rather than genuine economic strength.  What appears to be growth is actually a period of distortion, because cheap credit and easy money signal to entrepreneurs that more real resources exist than are actually available.  Projects that once seemed unprofitable suddenly look attractive, and entire sectors begin expanding, not because consumers truly want more of those goods, but because monetary policy has manufactured the appearance of demand.  In reality, nothing fundamental has changed, the financial signals have been altered.

This process doesn’t lead to “overinvestment” in the sense of producing too much genuine wealth.  Instead, it leads to malinvestment, as capital flows into the wrong places and resources are pulled toward ventures that can’t stand on their own once the artificial stimulus fades.  New currency doesn’t create capital goods.  It merely chases existing resources and pushes them into avenues where they don’t belong.  Eventually, reality must reassert itself, and the illusion can no longer be sustained.

Ludwig von Mises compared this situation to a builder planning a project with limited materials.  If the builder believes he has more supplies than he actually does, he draws up plans that can’t be finished.  He may proceed confidently for some time, only to discover later that he lacks the necessary materials to complete the structure.  His failure didn’t come from excessive ambition, but from relying on false information about what was truly available.  If he realizes the problem early, he can scale back and redesign, but if he discovers it late, much of his work must be torn down.

Monetary expansion keeps the illusion alive longer than it should by masking scarcity with the continual creation of new currency.  Policymakers behave as though they can simply encourage the builder to continue as if resources were limitless, replacing honest price signals with deceptive ones.  This deception doesn’t increase real wealth, but merely postpones the inevitable reckoning and guarantees that the correction, when it comes, will be more severe.

As new money enters the system, it doesn’t raise prices evenly.  Instead, it first inflates the sectors into which it flows, such as housing, technology, or finance.  These areas appear to boom, profits rise on paper, speculation increases, and many people mistakenly interpret the situation as prosperity.  Yet those profits are fragile because they depend entirely on distorted demand.  Once the flow of money slows or stops, the projects built on false signals no longer make sense, businesses struggle, debts unwind, and workers must shift to other areas of the economy.

This phase is known as the bust, but it’s not the cause of the problem.  It’s the process through which the economy attempts to correct earlier mistakes and realign investments with genuine consumer preferences and available resources.  The longer the illusion persists, the more severe the eventual adjustment becomes, because money can always be created by decree, while real wealth never can.

Reference

Ludwig von Mises; Human Action