Austrian Business Cycle Theory

The Austrian Business Cycle Theory (ABCT) is a prominent economic theory developed within the Austrian School of economics. This school of thought seeks to elucidate the development of business cycles by focusing on the role of government policies and central banking activities.

Core Concepts

Bank Credit and Interest Rates

At the heart of the ABCT is the belief that business cycles are initiated by excessive growth in bank credit, primarily due to artificially low interest rates set by a central bank. According to this theory, when a central bank or a fractional reserve banking system reduces interest rates below their natural market level, this induces an unsustainable boom in borrowing and investment.

Malinvestment

A key consequence of these artificially low interest rates is the phenomenon of malinvestment. Malinvestments are investments that are unsustainable and poorly allocated due to distorted price signals, leading to an eventual economic bust when market forces correct these discrepancies.

Role of Credit Expansion

The ABCT suggests that credit expansion distorts entrepreneurs' perceptions of the market, leading them to engage in projects that appear profitable under the artificially low interest rate environment. However, these projects are not sustainable in the long term, given the natural scarcity of resources.

Speculative Bubbles

The theory also posits that credit expansion causes speculative bubbles. These bubbles manifest as rapid increases in asset prices and eventually lead to economic downturns when investors realize the growth is unsustainable.

Criticism and Rejection by Mainstream Economics

Despite its comprehensive framework, the Austrian Business Cycle Theory is generally contested by mainstream economists who argue that the theory oversimplifies the complex nature of economic cycles. Critics also point out that the theory does not account for various real-world factors that contribute to business cycles beyond monetary expansion.

Prominent Figures

Several theorists have been instrumental in developing the Austrian Business Cycle Theory, including Ludwig von Mises and Friedrich Hayek. Their works have provided a foundation for modern Austrians to critique current economic policies.