The Austrian business cycle theory (ABCT) is an economic theory developed by the Austrian School of economics. It seeks to explain the recurrent booms and busts (i.e., business cycles) as consequences of central banks intervention in the credit markets, primarily by fixing interest rates, arguably the most important price in the economy.
The theory views business cycles as the consequence of excessive growth in bank credit due to artificially low interest rates set by a central bank or fractional reserve banks. The Austrian business cycle theory has its roots in the 19th-century work of Eugen von Böhm-Bawerk on capital theory. It was later developed by Ludwig von Mises and Friedrich Hayek. Hayek won the Nobel Prize in Economics in 1974 (shared with Gunnar Myrdal) in part for his work on this theory.
According to Mises and Hayek, an expansion of bank credit, not backed by prior savings, pushes the market rate of interest below the "natural rate" that would coordinate savings and investments. This happens because capital is a highly disaggregated and specialized set of factors of production, and dedicating capital to different stages of production takes time and resources. The price of capital is interest rates, which reveal time preferences of money, and coordinate inter-temporal investments by entrepreneurs, who borrow from savers to make capital investments for producing output in the future.
Given the important role of interest rates, an artificial lowering of interest rates affects the market for loanable funds. As central banks try to inject liquidity into the economy, interest rates fall below their natural rate, affecting savings and investment and rendering the plans of savers and entrepreneurs inconsistent. Austrians argue that a credit-driven boom results in widespread malinvestment, as lower interest rates signal to businesses to borrow and invest to produce for the future, while consumers lower their savings and prefer to consume earlier, thereby reducing future consumption. A correction or credit crunch, commonly called a "recession" or "bust", occurs when the credit creation has run its course. The money supply then contracts (or its growth slows), causing a curative recession and eventually allowing resources to be reallocated efficiently.
The Austrian explanation of the business cycle differs significantly from mainstream understanding of business cycles and is generally rejected by mainstream economists. Austrian School theorists have continued to contest these conclusions. Several scholars have affirmed empirical evidence supporting the Austrian business cycle theory. Several noted economists, including former US Treasure Secretary and Chief Economist of the World Bank Lawrence Summers, who shared a similar perspective in his speech at the World Economic Forum in 2001,Reported as follows;
"This expansion, he (Summers) argued, has been more like pre-war cycles, or like that in Japan in the late 1980s: that is, driven by credit. The absence of rising inflation has allowed the expansion to go on for longer, but at the cost of a greater accumulation of debt. Others have pointed to the similarity to credit and asset-price booms in Britain and Sweden in the late 1980s. The unwinding of excesses was accompanied by severe recession." and had a similar expression for the 2008 financial crisis. The Economist noted in 2009 that "central bankers seemed to be coming around to Mr Summers' view of things—that low inflation and interest rates were enabling damaging bubbles and financial crises." Some have conceded that the wholesale rejection of Austrian ideas in the post-war era went too far.
Mechanism Malinvestment and boom
According to ABCT, in a genuinely free market random bankruptcies and business failures will always occur at the margins of an economy, but should not "cluster" unless there is a widespread mispricing problem in the economy that triggers simultaneous and cascading business failures.America's Great Depression, Murray Rothbard According to the theory a period of widespread and synchronized "malinvestment" is caused by mis-pricing of interest rates thereby causing a period of widespread and excessive business lending by banks, and this credit expansion is later followed by a sharp contraction and period of distressed asset sales (liquidation) which were purchased with overleveraged debt.Theory of Money and Credit, Ludwig von Mises, Part III, Part IV The initial expansion is believed to be caused by fractional reserve banking encouraging excessive lending and borrowing at interest rates below what full reserve banks would demand. Due to the availability of relatively inexpensive funds, entrepreneurs invest in capital goods for more roundabout, "longer process of production" technologies such as “high tech” industries. Borrowers take their newly acquired funds and purchase new capital goods, thereby causing an increase in the proportion of aggregate spending allocated to “high tech” capital goods rather than basic consumer goods such as food. However, such a shift is inevitably unsustainable over time due to mispricing caused by excessive credit creation by the banks and must reverse itself eventually as it is always unsustainable. The longer this distorting dislocation continues, the more violent and disruptive will be the necessary re-adjustment process.
Austrian School theorists argue that a boom taking place under these circumstances is actually a period of wasteful malinvestment. "Real" savings would have required higher interest rates to encourage depositors to save their money in term deposits to invest in longer-term projects under a stable money supply. The artificial stimulus caused by bank lending causes a generalized speculative investment bubble which is not justified by the long-term factors of the market.
Bust The "crisis" (or "credit crunch") arrives when the consumers come to reestablish their desired allocation of saving and consumption at prevailing interest rates.Manipulating the Interest Rate: a Recipe for Disaster, Thorsten Polleit, 13 December 2007 The "recession" or "depression" is actually the process by which the economy adjusts to the wastes and errors of the monetary boom, and reestablishes efficient service of sustainable consumer desires.
Continually expanding bank credit can keep the artificial credit-fueled boom alive (with the help of successively lower interest rates from the central bank). This postpones the "day of reckoning" and defers the collapse of unsustainably inflated asset prices.Saving the System, Robert K. Landis, 21 August 2004
The monetary boom ends when bank credit expansion finally stops, i.e. when no further investments can be found which provide adequate returns for speculative borrowers at prevailing interest rates. The longer the "false" monetary boom goes on, the bigger and more speculative the borrowing, the more wasteful the errors committed and the longer and more severe will be the necessary bankruptcies, foreclosures, and depression readjustment.
Government policy error Austrian business cycle theory does not argue that fiscal restraint or "austerity" will necessarily increase economic growth or result in immediate recovery. Rather, they argue that the alternatives (generally involving central government bailing out banks and companies and individuals favoured by the government of the day) will make eventual recovery more difficult and unbalanced. All attempts by central governments to prop up asset prices, bail out insolvent banks, or "stimulate" the economy with deficit spending will only make the misallocations and malinvestments more acute and the economic distortions more pronounced, prolonging the depression and adjustment necessary to return to stable growth, especially if those stimulus measures substantially increase government debt and the long term debt load of the economy. Austrians argue the policy error rests in the government's (and central bank's) weakness or negligence in allowing the "false" unsustainable credit-fueled boom to begin in the first place, not in having it end with fiscal and monetary "austerity". Debt liquidation and debt reduction is therefore the only solution to a debt-fueled problem. The opposite – getting even further into debt to spend the economy's way out of crisis – cannot logically be a solution to a crisis caused by too much debt.The Real Solution to the Debt Problem, David S. D'AmatoIceland Loses Its Banks, Finds Its Wealth, Tim Cavanaugh More government or private debt solving a debt-related problem is logically impossible.
According to Ludwig von Mises, "[t]here is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved".Human Action, Ludwig von Mises, Chapter XX, section 8
The role of central banks
Austrian School theorists generally argue that inherently damaging and ineffective central bank policies, including unsustainable expansion of bank credit through fractional reserve banking, are the predominant cause of most business cycles, as they tend to set artificial interest rates too low for too long, resulting in excessive credit creation, speculative "bubbles", and artificially low savings.Thorsten Polleit, Manipulating the Interest Rate: a Recipe for Disaster, 13 December 2007 Under fiat monetary systems, a central bank creates new money when it lends to member banks, and this money is multiplied many times over through the money creation process of the private banks. This new bank-created money enters the loan market and provides a lower rate of interest than that which would prevail if the money supply were stable.The Mystery of Banking , Murray Rothbard, 1983
History A similar theory appeared in the last few pages of Mises's The Theory of Money and Credit (1912). This early development of Austrian business cycle theory was a direct manifestation of Mises's rejection of the concept of neutral money and emerged as an almost incidental by-product of his exploration of the theory of banking. David Laidler has observed in a chapter on the theory that the origins lie in the ideas of Knut Wicksell.Laider D. (1999). Fabricating the Keynesian Revolution. Cambridge University Press. Preview.
Friedrich Hayek's presentation of the theory in the 1930s was criticized by many economists, including John Maynard Keynes, Piero Sraffa and Nicholas Kaldor. In 1932, Piero Sraffa argued that Hayek's theory did not explain why "forced savings" induced by inflation would generate investments in capital that were inherently less sustainable than those induced by voluntary savings. Sraffa also argued that Hayek's theory failed to define a single "natural" rate of interest that might prevent a period of growth from leading to a crisis. Others who responded critically to Hayek's work on the business cycle included John Hicks, Frank Knight and Gunnar Myrdal.Bruce Caldwell, Hayek's Challenge: An Intellectual Biography of F. A. Hayek (Chicago: University of Chicago Press, 2004), p. 179. Hayek reformulated his theory in response to those objections.