The Austrian Business Cycle theory aims to explain booms and busts through artificial credit expansion. According to the theory, economic boom and bust cycles aren’t due to flaws of the free market or natural occurrences but caused by artificially low interest rates.
The theory originates from the Austrian school of economics. Ludwig von Mises and Friedrich A. Hayek were notable proponents of the Austrian Business Cycle theory.
According to the Austrian Business Cycle theory, booms and busts are caused by central bank and government intervention in free markets. Rothbard, Murray N.: America’s Great Depression (1975), pp. 3ff. To understand the theory, we must first look at how Austrian economists understand interest.
According to Mises and other economists of the Austrian School of economics, interest is not just a monetary phenomenon but linked to time preferences.
When individuals or companies have additional resources and savings, they are more likely to lend them out. Instead of consuming the goods or money, people with a low time preference might decide to lend them to a third party.
When an entrepreneur borrows money, he expects to make a profit. Entrepreneurship, to a large extent, is about planning and predicting the future. Entrepreneurs that are good at planning and predicting the future are rewarded. The reward comes in the form of profit.
This includes predicting demand, foreseeing trends and allocating capital to projects that appear promising. When planning and predicting the future, entrepreneurs rely on signals such as prices and interest rates.
For example, an entrepreneur must know what the expected manufacturing costs are, assess supply and demand and find a way to sell products and services at a higher price than it cost to produce and deliver them.
The interest rate, according to the Austrian school of economics, provides entrepreneurs in a similar way with information about time preferences, savings and people’s ability to consume in the future.
As we have seen, interest rates provide information about people’s time preferences, savings and ability to spend. They are an important indicator to help entrepreneurs assess demand, plan for the future and allocate resources.
According to Mises, interest rates are not the result of supply and demand for money. Some other economic theories view interest rates as a primarily monetary phenomenon. But Mises and other Austrian economists view them as expressions of human action and personal preferences.
When someone has their immediate needs met and has excess savings, they are more likely to lend them out. The interest is the compensation or premium a lender receives for postponing immediate consumption and lending goods to a third party for consumption.
By having a high time preference, lenders are willing to delay immediate consumption. They allow someone else to consume the money or goods, under the premise that the money or goods are paid back. The possibility of not getting the lent out goods or money back further creates a difference in value.
From an individual’s perspective, consuming money or goods today has greater value than consuming them later. The interest rate is the difference in value attributed to consuming now versus in the future. Someone with a high time preference, who prefers consuming today, would only lend out goods or money at a high interest rate. Otherwise, the incentive to delay immediate consumption isn’t big enough for the person.
On the flip side, someone with low time preference might be willing to lend out goods or money at a lower interest rate. In this sense, people’s time preferences and the supply and demand of available goods and money determines interest rates.
One could conclude that if interest rates are low, a lot of people and businesses must have excess savings. This allows them to lend out their savings and earn interest in the first place. It also means people have a low time preference.
At least this is how interest rates ought to work in a free and healthy market according to Mises and other Austrian economists.
Interest rates give entrepreneurs an idea of how much savings exist in the economy. This is important, since entrepreneurs must be able to predict future demand for products as well as the ability for consumers and other businesses to afford them. The success of an entrepreneur’s venture depends on the accuracy of his predictions.
When central banks keep interest rates artificially low by setting the federal funds rate or engaging in quantitative easing, this distorts how people’s time preferences are “signaled” throughout the economy. Mises, Ludvig von: The Free Market and Its Enemies (2016), pp. 106ff.
By lowering interest rates below the interest rates that the free market would choose, and by engaging in quantitative easing, the supply of money is artificially increased. Central banks flush the economy with money. But this money doesn’t come from existing savings or resources.
Furthermore, artificially suppressed interest rates don’t accurately express savings and time preferences across the economy.
It appears as if individuals and companies have more savings and resources than they actually have. And it seems like people have a low time preference when in reality they might have a high time preference.
This artificial credit expansion through fractional reserve banking and central banks leads to entrepreneurs allocating funds based on distorted signals. They allocate money and resources to companies, business opportunities, products and investments that they wouldn’t if interest rates were higher.
The artificial credit expansion and low interest rates lead to what Austrian economists call malinvestment. Malinvestment is a miscalculated, unsustainable and ultimately unprofitable investment.
During periods of artificial credit expansion and low interest rates, many entrepreneurs invest in projects that under normal circumstances wouldn’t be profitable or considered too risky. This wave of investments leads to an apparent boom or expansion of the economy. But it isn’t sustainable long-term.
At some point, real savings, time preferences and resources of the economy don’t meet the level of investment made by entrepreneurs during the boom. This leads to the projects becoming unprofitable and the investments ultimately failing.
During an artificial boom, low interest rates “seduce” many entrepreneurs economy-wide into unknowingly making malinvestments. Once it becomes apparent that these investments are unsustainable, the economy contracts and the artificial boom results in a bust.
According to Austrian economists, these severe booms and busts aren’t due to natural fluctuations within the economy. General boom and bust cycles, which affect the entire economy regardless of seasonality and industry, require a general business cycle theory. Rothbard, Murray N.: America’s Great Depression (1975), pp. 3ff.
For Austrian economists like Mises, Hayek and Rothbard, the Austrian Business Cycle theory explains how many entrepreneurs end up making false predictions, judgments and investments at the same time.
Individual flaws in prediction, poor judgment and malinvestment are normal and healthy in a free market economy. But when governments and central banks meddle with interest rates, this distorts the signaling of time preferences. This leads to economy-wide misallocation of money and resources, poor judgment and malinvestment.
Using this model, proponents of the Austrian Business Cycle theory claim to have predicted several economic crises, including the Great Depression and the Global Financial Crisis of 2008. These predictions were based on the, for Austrian economists, unsustainable artificial credit expansion in the years and decades leading up to the crises.
Leading up to the Global Financial Crisis of 2008, the US government intervened in the housing market in several ways. Alan Greenspan, chair of the Federal Reserve at the time, lowered the federal funds rate to 1% between June 2003 and June 2004. Federal Reserve Bank of St. Louis: “Federal Funds Effective Rate” Accessed April 22, 2022.
The economy had just experienced the Dotcom Bubble and September 11 terrorist attacks. As a result, Greenspan aimed to stimulate the economy by lowering short-term interest rates.
When the Federal Reserve lowers the federal funds rate, other interest rates tend to follow suit. This includes mortgages. At the time, politicians pushed for lax lending requirements to increase home ownership equality across the United States. Woods Jr, Thomas E.: Meltdown. A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse (2009), pp. 11ff. Additionally, Government Sponsored Enterprises like Fannie Mae and Freddie Mac contributed to even easier access to mortgages.
This cheap and widely-available credit led to excessive home purchases and speculation. In some cases, people owned multiple homes. Others just bought properties to flip them. The housing market boomed and prices increased due to all the new money entering the market.
Individuals and businesses that otherwise wouldn’t invest in real estate properties, or at least not this aggressively, took excessive risks. The low interest rates “seduced” people into investing in real estate in a way that wasn’t sustainable.
Looking at the situation through the lens of the Austrian Business Cycle theory, mortgage rates were distorted. The artificially low interest rates attracted a lot of capital into malinvestments.
Once housing prices began correcting, interest rates increased and many home owners were unable to pay their mortgages. Countless home owners defaulted across the United States. Banks and mortgage companies that lent out the cheap money faced losses and in many cases bankruptcy.
The real estate boom came to an end and resulted in a bust. From the perspective of the Austrian Business Cycle theory, the Global Financial Crisis was the result of the artificial credit expansion that happened between 2000-2007. Together with lax lending requirements and other government interventions, this led to a classic Austrian business cycle.
The Austrian Business Cycle theory is mostly rejected by mainstream economists. Even free market proponent Milton Friedman rejected the theory. In general, the Austrian school of economics is a heterodox school of economics and its theories are mostly ignored or rejected by mainstream economists.
Milton Friedman said in an interview in 1998: Friedman, Milton: Mr. Market, In: Hoover Digest No. 1, 1999.
I think the Austrian business-cycle theory has done the world a great deal of harm. If you go back to the 1930s, which is a key point, here you had the Austrians sitting in London, Hayek and Lionel Robbins, and saying you just have to let the bottom drop out of the world. You’ve just got to let it cure itself. You can’t do anything about it. You’ll only make it worse. You have Rothbard saying it was a great mistake not to let the whole banking system collapse. I think by encouraging that kind of do-nothing policy both in Britain and in the United States, they did harm.Milton Friedman on the Austrian Business Cycle theory
Friedman is talking about the Great Depression and believes that letting the depression “cure itself” would have been the wrong approach.
While he was generally friendly with Hayek and agreed on many points made by the Austrians, some parts of their economic theories varied greatly.
Other critics of the Austrian Business Cycle theory mention that the theory assumes that investors are easily tricked into making “bad” investments. If interest rates can trick entrepreneurs this easily, one must assume that they don’t act rationally in the first place.
Furthermore, some Austrian economists like Rothbard strongly link the Austrian Business Cycle theory to central banking. However, critics point out that the Federal Reserve only existed since 1913. Booms and busts have a longer history than central banking, at least in the United States.
Many mainstream economists also reject the theory that interest rates are expressions of time preferences. They view interest rates as a monetary phenomenon, leading to alternative theories and conclusions.
In the wake of the Global Financial Crisis, the Austrian Business Cycle theory moved into the spotlight again. Proponents point out that the recent economic crises are the result of government intervention. They are not flaws or weaknesses of the free market.
Those in favor of intervention point out that these crises resulted from unhindered profit-seeking and speculation in the free market. They ask for more government intervention to help stabilize an otherwise unstable and flawed market to prevent further economic crises.
|↑1, ↑3||Rothbard, Murray N.: America’s Great Depression (1975), pp. 3ff.|
|↑2||Mises, Ludvig von: The Free Market and Its Enemies (2016), pp. 106ff.|
|↑4||Federal Reserve Bank of St. Louis: “Federal Funds Effective Rate” Accessed April 22, 2022.|
|↑5||Woods Jr, Thomas E.: Meltdown. A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse (2009), pp. 11ff.|
|↑6||Friedman, Milton: Mr. Market, In: Hoover Digest No. 1, 1999.|