Explaining Economic Crashes: A Lesson in Austrian Business Cycle Theory

In short: the boom causes malinvestment that, when revealed, results in bust.

If the Fed tries to stave off the bust by continuing inflation and credit expansion to stimulate the economy, it runs the risk of hyper-inflation. Since 2008,krugman-sailing the Fed has continued inflation and near-zero interest rates to stave off the effects of the bust (more on this later).

Keep in mind that in real recoveries there is neither inflation nor deflation. If there is deflation, the cycle is still in the bust phase. If there is inflation, the economy is in the next boom. Real, sustainable economic progress occurs when natural, un-manipulated time preferences determine the amount of saving, investing and efficient allocation of capital in the economy (other factors negatively affecting economic recovery can include foreign and domestic intervention such as wars and regulations, as well as general regime uncertainty).

It’s also important to note the role of fractional reserve banking in worsening the severity also played a role in the 2008 Crash. With fractional reserve banking, banks are generally only required to hold some 10 percent in reserves. The consequences are obvious, should banks be confronted with a crisis or bank run.


Now, let’s apply ABCT to the 2000s housing boom/bust cycle.

First, many factors have been attributed as being the cause of the 2008 Crash by the mainstream media, and some certainly may have played a role to one degree or another. But the root cause was the Fed’s inflation and credit expansion. So leading up to 2008, how much inflation and credit expansion was the Fed pumping into the economy? First let’s look at the monetary base (the money supply, or amount of money in the economy, including coins, paper money, and commercial bank reserves at the Fed) and MZM (the measure of the supply of financial assets).

In January, 2001 the monetary base was $591 billion and by the crash in 2008 it was $901 billion —that’s an increase of over 50 percent in under 8 years. MZM in January 2001 was $4,799 billion and by August, 2008 it had risen to $8,722 billion—that’s an increase of over 80 percent. Bank credit during this periodkrugman-13 rose from $5,243 billion to $9,566—over 80 percent. Real estate loans—the beating heart of the housing bubble—rose from $1,663 billion in 2001 to $3,658 by 2008—over 100 percent.


Take a moment to think about this, then ask yourself: is there any wonder there was a housing bubble boom/bust?

Of course not, especially when also considering the role of the Federal Funds rate (the banks’ overnight lending interest rate as set by the Fed’s Federal Open Market Committee – FOMC): from 2000 to the end of 2001 the rate was lowered by the Fed from 6.53 percent to 2.09 percent. By 2003 the Fed had forced it down to 1.22 percent. By August, 2007 the Fed had jammed it all the way up to 5.02 percent. What could possibly go wrong?

Next: Clearly the Fed engineered the boom, and hence the Economic Crash of 2008…