– January 13, 2016

Many economists who have broadly free market views on money are sympathetic to the Austrian theory of the business cycle (ABCT).  As developed in the early part of the 20th century by Ludwig von Mises and Friedrich Hayek, and further refined in recent years by Steven Horwitz and Roger Garrison, ABCT links the business cycle to central bank behavior that inadvertently causes interest rates to send faulty signals.  In brief, the argument goes something like this: a central bank decides it wants to expand the money supply, perhaps because it wishes to lower unemployment and/or increase output.  In the short run, expansionary monetary policy can lower market interest rates due to the liquidity effect—newly created central bank money is injected into capital markets, increasing the supply of loanable funds relative to demand.  But this lowering of interest rates did not occur because there was a genuine increase in the amount of real savings; it is purely a monetary effect.  Investors respond to lower interest rates by increasing investment; consumers respond by borrowing more.  These behaviors are inconsistent.  Because real savings has not increased, the resources simply are not there to satisfy both consumers’ and investors’ desires, which have become misaligned due to the effect of expansionary monetary policy on interest rates.  Eventually, something has to give: projects are liquidated, workers are laid off, and the boom characterized by rising spending and investment gives way to the bust characterized by a groping process where entrepreneurs do the best they can to reallocate the factors of production back towards genuinely profitable uses.

ABCT is frequently criticized because the theory cannot explain the length or size of the boom and bust.  For example, some argue that it is not credible that swings in (short-run) market interest rates can result in extended downturns.  This critique is misplaced.  ABCT is not a theory that predicts how long the boom will last, or for how long the bust will last, or how big either of these are. These factors, while obviously important and deserving of study, are outside the scope of the theory.  ABCT is exclusively a theory of the unsustainable boom—an explanation for why central bank-driven booms must necessarily turn to busts.  In order to explain the size and length of the boom or bust, additional empirical detail is required.  For example, ABCT can explain the most recent boom and bust in financial and housing markets as a result of overly-expansionary monetary policy by the Fed following the dot-com bust in the early 2000s.  But it cannot explain why the malaise occurred in housing markets, and in derivative assets whose value was tied to mortgages.  In order to explain why these particular sectors and assets were so strongly affected, we need to discuss public policies that incentivized allocating Fed-created easy credit towards housing and mortgages.  This institutional detail is a complement to ABCT—a complete story of the financial crisis cannot be told without it—but is not properly a part of ABCT itself.

Like all theories, ABCT is limited in its explanations and predictions.  It is intended to explain why booms that have their origin in misleadingly low interest rates turn to busts.  That ABCT does not speak to the length or size of booms and busts is not an indictment of the theory, because it was never intended to explain these things in the first place.

Alexander William Salter

Alexander W. Salter

Alexander William Salter is an Associate Professor of Economics in the Rawls College of Business and the Comparative Economics Research Fellow with the Free Market Institute, both at Texas Tech University. He has published articles in leading scholarly journals, such as the Journal of Money, Credit and Banking, the Journal of Economic Dynamics and Control, the Journal of Macroeconomics, and the American Political Science Review. His opinion pieces have appeared in The HillThe American ConservativeUS News and World ReportQuillette, and numerous other outlets. Salter earned his M.A. and Ph.D. in Economics at George Mason University and his B.A. in Economics at Occidental College. He was an AIER Summer Fellowship Program participant in 2011.

Get notified of new articles from Alexander William Salter and AIER.