The Austrian Theory of the Business Cycle

In our time, the most important contribution of the Austrian School of Economics is its unique theory of the business cycle. Rather than viewing the familiar boom-bust pattern as a necessary feature of capitalism, the Austrians blame it on the artificial expansion and contraction of bank credit. This process is exacerbated in modern times by the presence of a central bank, which is the Federal Reserve in the United States.

The Austrian theory of the business cycle was developed by Ludwig von Mises. His follower Friedrich Hayek won the Nobel Prize in 1974 (in part) for his elaboration of Mises’ explanation.

In a nutshell, the Austrian theory says that the way to understand economic recessions and depressions is by turning attention to the prior boom period. It is during the boom period when unsustainable investments are made, which ultimately must be liquidated during the bust.

In a typical cycle, the central bank will artificially lower interest rates by buying assets and flooding the banking system with new money. The lower interest rates are indeed a “stimulus” to investment and consumer spending, but the prosperity is not genuine, because the amount of true saving has not increased. The central bank can keep the illusory boom going for several years if it continues to provide easy credit, but ultimately reality reasserts itself.

The boom typically ends when rising prices causes the authorities to pull back on the monetary inflation, causing interest rates to rise and thereby rendering many projects unprofitable. At the higher interest rates, business owners realize they had been overly optimistic and begin laying off workers or shutting down altogether. The euphoric boom period turns into a miserable recession.

In the Austrian analysis, the way to avoid painful recessions is to avoid the preceding boom. That means during a recession, it is bad policy to slash interest rates and try to stimulate spending—which is of course the textbook “Keynesian” prescription. According to the Austrians, trying to ease the pain of the bust through the use of inflation and cheap credit will simply sow the seeds for the next bust.

In this post we have provided just a sketch of the Austrian theory of the business cycle. The following is further reading.

  • To see the Austrian theory applied to the mid-2000s housing boom, and to the subsequent policies by the Bernanke Fed, read Lara and Murphy’s book, How Privatized Banking Really Works (2010).