Explaining Economic Crashes: A Lesson in Austrian Business Cycle Theory


February 23, 2015—Based on comments and questions regarding A Beginner’s Guide to Austrian Economics, it’s vital to highlight Austrian Business Cycle Theory (ABCT) as one of the more important contributions of Austrian Economics. In this article we’ll explain why.

Why is it important to understand Austrian Business Cycle Theory?

If more people understood ABCT, fewer lives and families would be destroyed by Fed-created boom/bust business cycles.

Krug-50-191x196Everyone reading this article most likely knows someone who was wiped out in 2008. It didn’t have to happen. Clearly people cannot depend on political “leaders” for economic guidance. The majority politicians either don’t care or are simply economically ignorant. Change can only come from the people. But change is only possible if the people understand how the Fed-created boom/bust cycle works against them. Here, we’ll briefly explain ABCT, apply it to the Crash of 2008, and touch on the implications for the future. Sources and suggestions are provided following the article.

Here is ABCT reduced to one sentence: Fed-engineered booms cause people to make dumb economic decisions, and the inevitable bust is necessary to clear markets, restore the health of the economy, and foster sound and sustainable economic decisions.

Of course the remedy is to eliminate the artificial boom created by the Fed in the first place. Now let’s take a closer look.

How does the Fed create the boom?

The Federal Reserve creates the boom by buying assets from banks throughout the banking system. This increasesKrug-50 money reserves in the banks. With the new money, the supply of credit increases, stimulating credit expansion, as the banks lend out the money. This is inflationary as it reduces the purchasing power of money as prices rise throughout the economy. It also artificially lowers interest rates. This process increases people’s “time preferences,” meaning people begin to value present consumption over future consumption. This distorts the savings, borrowing, spending and consumption patterns of people. (Note that the Fed buys assets with “money” the Fed itself creates out of thin air).

Generally, inflation and credit expansion cause prices of all goods to rise. The price of durable goods (goods that do not quickly wear out – cars for example) tend to rise sooner. Borrowing to buy cars and homes is typical, as are increases in the purchases of capital goods (durable goods used to produce other goods—machines, tools, etc.). It’s importantth1 to note that prices of all other goods do NOT decline during the boom, because inflation keeps demand for all goods stimulated. Now, in a free market scenario, without the Fed’s inflation, if demand for durable goods increased, demand for other goods would decrease.

Overall profits also rise. Higher prices for durable goods increase the profitability of producing durable goods. Think the housing boom of the early-mid 2000s. The Fed’s inflation and credit expansion bid up house prices. Builders’ bids for producer goods (goods used to produce other goods – steel, plywood, etc.) caused prices of producer goods to rise. (It’s important to note that government pro-home-ownership policies, including mandates for banks to lend non-discriminatory mortgages with lax underwriting standards, helped channel credit into the housing sector, fueling the housing bubble).

Also during the boom, the capital structure of consumer goods (food, clothing, etc.) lengthens because the shortest production processes are already being used in the higher-stage capital goods sector where there is relatively more profit.


How does boom turn to bust?

The capital structure buildup causes malinvestments (bad investments) because the inflation and credit expansion has distorted people’s preferences for when, on what, and how much they prefer to save, borrow, spend, and consume. InKrug-40 a free market economy, people’s natural, un-manipulated time preferences would determine interest rates. With the Fed’s manipulations, interest rates are artificially lowered by inflation and credit expansion. The capital structure lengthens and cannot be sustained because it cannot satisfy people’s time preferences. As people begin to restore their natural time preferences, malinvestments are revealed in specific lines of production (where there was greater promise for profit during the boom). It is revealed that there are not enough resources to complete all of the projects that were “stimulated” by the inflation and credit expansion. This is the beginning of the bust.

If the Fed’s inflation and credit expansion slows or stops, saving and consumption will begin to realign as people’s time preferences normalize. Interest rates will rise. Prices of sound assets will destabilize as financial markets become more fragile. Interest rates rise as demand and prices fall, and as capital, stock, and financial markets begin to collapse. Liquidation and reallocation ensue, as mergers, acquisitions, and bankruptcies follow. Banks fail, becoming illiquid and insolvent. Credit contracts, prices fall, and demand falls relative to supply. The bust is necessary to restore people’s natural time preferences and demands, to clear malinvestments, and to restore sound and sustainable economic fundamentals.

Next: The boom causes malinvestment that, when revealed, results in bust…