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Why The Austrian Business Cycle Theory Matters More Than Ever In Today’s Global Economy
By Adem Tumerkan of Speculators Anonymous
Monday, May 15, 2023 11:12 PM EDT
Longtime readers know that I’m rather agnostic when it comes to economics.

Meaning I don’t cling solely to a certain school of thought – such as Austrian (more free markets), Monetarist (central bank liquidity focused), or Keynesian (large government intervention).

I believe each has good – and bad – ideas and lessons worth learning.

But there’s one theory that’s grossly undervalued by the mainstream. Or has been completely ignored. . .

I’m talking about the Austrian Business Cycle Theory (ABCT).

This theory explains how the central bank’s policy is most responsible for widespread economic booms and busts. As well as spurring significant malinvestment and moral hazard.

I use this theory often when analyzing macroeconomics.

And you should also.

So let’s take a closer look into why I believe it’s so important.

The Austrian Business Cycle Theory: How Central Banks Are The Root Of The Problem
First, let’s start with a brief history lesson. . .

The Austrian Business Cycle Theory was first conceived by the little-known Austrian economist – Ludwig Von Mises – in the early-1900s.

But it was later expanded upon by his student and renowned economist – Friedrich Hayek – who put it into a full theory.

In short, Hayek hypothesized that economic cycles were caused by changes in the supply of credit from central banks, rather than changes in the demand for goods and services organically.

Meaning that when the central bank eased (increasing the supply of credit), it spurred an artificial and unsustainable boom in the economy. And it would self-reverse into a bust as credit eventually contracted (when the central bank raised interest rates or malinvestment and gluts spread).

The logic for this causal chain between monetary policy and booms and busts comes from how interest rates affect the price system.

Simply put, prices are collective information. Essentially where marginal demand and marginal supply find some sort of balance.

But since interest rates are also a price – the price of time and money.

Thus when central banks artificially tinker with rates, it affects the balance between consumption and savings (aka consumer time preference).

For instance, if the central bank cuts interest rates below the natural rate to try and spur growth, it leads to cheaper debt, greater consumption, higher asset prices, and less savings. (Vice versa for interest rate hikes).

Or – put in a more technical way – lower interest rates shift the aggregate demand (AD) curve to the right relative to the aggregate savings supply (ASS) curve.

The idea here is that when interest rates drop, it raises consumer spending power with cheaper debt. Which pushes prices higher amid great consumption.

And this creates a false signal for businesses to invest and increase capacity to meet the ‘expected’ greater demand.

Thus firms begin to binge on debt to over-hire, over-build, and over-produce. Fueling an economic boom in the process.

But the crux here is that this boom was only driven because of artificially lower interest rates. Not ‘real’ organic consumer demand.

Eventually, when growth overheats and inflation picks up, central banks will raise interest rates. And the malinvestment is exposed.

(Click on image to enlarge)

Or – even if the central bank doesn’t raise interest rates – the market will become saturated with excess capacity and unsustainable private sector debt. Creating a bust all on its own. (The Keynesian economist – Hyman Minsky – noted this in his Financial Instability Hypothesis – read here).

Either way, demand erodes relative to supply – or reverts below what it was before the lower interest rate boom – and prices collapse amid excess supply and weak consumption.

But it doesn’t end there.

Asset prices and investment returns also plunge. Corporate margins erode. Unemployment rises. Debt-defaults soar. And the financial system grows unstable.