A Beginner’s Guide to Austrian Economics

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Example 2: The Cause of Recessions

Keynesians attribute recessions to “animal spirits” which drive consumer confidence and spending down, resulting in more of the Keynesian enemy: saving (or “hoarding”). According to Keynesians, saving results in “sticky wages,” layoffs, and less consumption and spending. Keynesians advocate even more deficit spending and artificially lowered interest rates as a remedy (think the 2009 “stimulus,” QE, and the last few years of near-zero interest rates, FDR’s “public works,” and Obama’s “shovel-ready” projects).

“What he (Keynes) really did was to write an apology for the prevailing policies of government.” – Mises

Austrians correctly attribute recessions to government and Fed intervention, not smoke-and-mirrors or “animal spirits.” The Austrian Business Cycle Theory (ABCT) accurately describes boom and bust business cycles. In short, here’s how it works:

• The Fed sets interest rates artificially low and creates new “cheap” money to pump into the economy;
• The cheap money typically channels into sectors of the economy already distorted by government policy intervention as the boom is underway (think the early-mid 2000s housing sector);
• These distortions make investments seem more profitable and valuable than they would be in a free market;
• The economy “busts” when interest rates rise as resources and savings diminish.

Austrians are in the right when they say the artificial “demand” created by the Fed—which caused the boom—stems from inflation, not from real savings. Austrians rightly see that the remedy is to eliminate intervention and let markets clear.

“The ultimate cause, therefore, of the phenomenon of wave after wave of economic ups and downs is ideological in character. The cycles will not disappear so long as people believe that the rate of interest may be reduced, not through the accumulation of capital, but by banking policy.” – Mises

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