Austrian business cycle theory

The Austrian business cycle theory (ABCT) is an economic theory developed by the Austrian School of economics about how business cycles occur. 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 originated in the work of Austrian School economists 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.Grounded in the economic theory set out in Carl Menger's Principles of Economics and built on the vision of a capital-using production process developed in Eugen von Böhm-Bawerk's Capital and Interest, the Austrian theory of the business cycle remains sufficiently distinct to justify its national identification. But even in its earliest rendition in Mises's Theory of Money and Credit and in subsequent exposition and extension in F. A. Hayek's Prices and Production, the theory incorporated important elements from Swedish and British economics. Knut Wicksell's Interest and Prices, which showed how prices respond to a discrepancy between the bank rate and the real rate of interest, provided the basis for the Austrian account of the misallocation of capital during the boom. The market process that eventually reveals the intertemporal misallocation and turns boom into bust resembles an analogous process described by the British Currency School, in which international misallocations induced by credit expansion are subsequently eliminated by changes in the terms of trade and hence in specie flow. The Austrian business cycle theory (ABCT) is an economic theory developed by the Austrian School of economics about how business cycles occur. 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 originated in the work of Austrian School economists 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. Proponents believe that a sustained period of low interest rates and excessive credit creation result in a volatile and unstable imbalance between saving and investment. According to the theory, the business cycle unfolds in the following way: low interest rates from fractional reserve banks tend to stimulate borrowing, which lead to an increase in capital spending funded by newly issued bank credit. Proponents hold that a credit-sourced boom results in widespread 'malinvestment'. 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 back towards their former uses. The Austrian explanation of the business cycle differs significantly from the mainstream understanding of business cycles and is generally rejected by mainstream economists on both theoretical and empirical grounds. 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. According to the theory a period of widespread and synchronized 'malinvestment' is caused by 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. 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. Borrowers take their newly acquired funds and purchase new capital goods, thereby causing an increase in the proportion of aggregate spending allocated to capital goods rather than consumer goods. 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. Austrians 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. The 'crisis' (or 'credit crunch') arrives when the consumers come to reestablish their desired allocation of saving and consumption at prevailing interest rates. 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. 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. 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 of 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. More government or private debt solving a debt-related problem is logically impossible.