Austrian Theory Of The Business Cycle

As we try to establish the basics of Austrian macroeconomics I will focus here on the Austrian theory of the business cycle. C. Jay has already explained some of the issues regarding money, central banks, and the emergence of fiat currency here. Now we want to pay attention to how specifically central banks influence interests rates, how the new money enters the economy, and how this all affects the structure of production. I hope for it to be basic enough for those unfamiliar with the Austrian school to understand yet nuanced enough for the well-read to enjoy. To do this I will use a version of Roger Garrison’s work in Time and Money to provide a visual diagrammatic conception of the theory (without hard values or empirical data) and then illustrate the business cycle by looking at the recent 2008-09 financial crisis.

It always seems helpful as Friedrich Hayek said that “before we can even ask how things might go wrong, we must first explain how they could ever go right.” Let’s suppose for a moment that we staring at a snapshot of a healthy economy with a natural rate of interest and stable hard currency. Entrepreneurs and households are constantly seeking to increase their profits and consumption by increasing their efficiency, anticipating where there is high consumer demand with under-priced factors of production, and to invent new technologies and products. Below is what is called The Production Possibilities Frontier(PPF):

Production Possibilities Frontier

In stable conditions a market will seek employ all available resources towards either present consumption or savings in the form of investment. Whatever is not consumed is saved, or invested, for the sake of greater future consumption. The graph illustrates what is possible given an economy’s current technological progress, capital stockpile, and consumer preferences. This emphasizes the scarcity of resources and the trade off between consumption and investment.  You cannot invest unless you do not consume, an initial increase in savings necessarily means a decrease in consumption and therefore is represented as a movement along the PPF. This movement represents a general trend in consumption, or a change in time preference: a general desire for greater future consumption or present consumption.

Now we can see how consumer time preference and savings levels affect the interest rate. Below shows how the Production Possibilities Frontier interacts with the Loanable Funds Market:

PPF to LFM 2

The market for loanable fund shows the supply and demand for money/capital with the demand curve showing investment and the other being the supply of savings. This is essentially your basic supply and demand given for any good, in this case money. Instead of showing price along the y-axis in dollars then it appears as the interest rate. The interest rate is the price of money; it is the price of present money in terms of future money. Like any price the interest rate, as Hayek explained and won the Nobel prize for, sends information, in this case it signals consumer time-preferences and the supply of savings. Now to be sure there is no one single interest rate but multiple interests rates for each quantity, risk, and duration of a loan. Savings, increasing along the x-axis, constitute the supply of loanable funds, the sector between the new equilibrium points on lower right quadrant loanable funds market shows the increase in available savings due to the decrease in consumption above. With increases savings and more loanable funds banks are willing to lend at lower interest rates which then spurs more borrowing. By a drop in consumption levels resources are freed up from being directed to consumers and are re-allocated to other production processes. To observe specifically how the increased savings and lower interest rates affects the structure of production we must become familiar with Hayek’s triangle, or what Rothbard eventual developed into the trapezoid:

Rothbardian Trapezoid

The diagram shows a summary depiction of all the stages of production and price/consumption levels as the goods move in time across the structure of production until their final stage as a consumer good. Austrian economics disaggregates capital intertemporally and recognizes capital as diverse and stage specific. Consumable output is produced by a sequence of stages of production, the output of one stage feeding in as input to the next. I use Rothbard’s trapezoid because I believe it more accurately represents the structure especially in its early stages since at no point can the price of the factors of production be zero (land, labor, natural resources). It is also compatible with other diagrams not shown here. As can be seen consumption levels (or the price level) increases as one goes from the beginning stages to the end, just as raw iron ore or steel is much cheaper than the car or equipment it eventually becomes.


As Garrison points out, two seemingly contradictory signals are sent during an increase in savings that affect the structure of production. One, people consume less dampening the demand for investment goods and service at later stages of production closest to consumer goods industries. Two, the lower interest rate lowers the cost of borrowing making it more affordable to engage in longer-term processes, which Garrison calls the time-discount effect. There is also a third signal which is that there will be increased consumption later, the demand for which those longer processes will fulfill. Below is diagrammatic conception of how the PPF, the LFM, and the Structure of production, along with the labor markets, affect one another intertemporally.

PPF to LFM to SOP2

The change in consumption and the increase in savings lowers the amount of consumption on the front of the structure of production but elongates it as a whole, due to the lowering of the interest rate. Savings has an effect both on the magnitude and the stage specific location of investment. The increased savings create new temporal pattern of capital creation that is future oriented. Firms switch resources from a focus on inventory, distribution, and retail and begin previously unaffordable projects, start long-term processes, and research and development for new products and efficiency in anticipation of future increased consumption due to the newly produced capital equipment, higher wages paid to early stage labor markets, and the eventual resuming of time-preferences.

Now we can use these interactive diagrams to illustrate actual growth in the economy as the newly created goods move through the structure of production. Notice how we have illustrated and explained not the steady-state equilibrium economy of other free-market schools but that of Mises’s evenly rotating economy (ERE), or what Robert Murphy calls “Dynamic equilibrium.”

ERE Growth

With an initial increase in savings, investment increases at the expense of consumption, after which both consumption and investment increase. Consumption falls while the economy restructures and adapts itself for even higher consumption levels than before.

Sustainable growth then is supported by savings. While this seems mundane to average the businessman or household budgeter, it is revolutionary in the academic world. Austrians and Keynesian fundamentally differ both in conception of the bust/recession and in how a healthy economy grows.

All of this and we have not even mentioned the business cycle yet. From these models however it should be clear just why the business cycle needs an explanation in the first place. It’s one thing if the market is simply inherently flawed and mistakes happen all the time, but if that is the case we would expect see individual businesses and industries going down here and there not a unified mass cluster of errors after seemingly profitable growth. Certainly Keynes’s proposal of “animal spirits” within investors will not do.  It is only the Austrian theory that explains how it is that the economy as whole can experience a boom followed by sudden bust revealing a cluster of entrepreneurial errors.

The Austrian business cycle is a theory of malinvestment and overconsumption due to the monetary calculational chaos introduced by central banking. The business cycle of booms and their inevitable bust is caused by inflationary central banks suppression of interest rates below what they normally would be by increasing the money supply. These ups and downs are not simply due to a general rise in the CPI (consumer price index) but in just how that money enters the market, namely through the banking system. Central banks flood the market with new money masquerading as savings which spurs business to be misled into investing in long-term and risky projects that are physically unsustainable and do not conform to consumer demand. As Salerno summarizes:

“the divergence between the loan and natural rates of interest caused by bank credit expansion systematically falsifies the monetary calculations of entrepreneurs choosing among investment projects of different durations and in different stages varying in temporal remoteness from consumers. But it also distorts the income and wealth calculations and therefore the consumption/saving choices of the recipients of wages, rents, profits and capital gains.”

At the same time that this is happening individuals continue to consume just as they did before and more. Consumers take advantage of lower interests rates and see an increase in their portfolios and net worth therefore actually cutting back on their savings in order to maintain previous savings levels.

What then is the actual mechanics of the Federal Reserve? There are several interest rates in the economy which the Federal Reserve controls or at least can influence through expanding the money supply. Conventional wisdom is that the Fed is a lender of last resort to banks in need of cash reserves, the dignified way of saying this is “providing liquidity” as Janet Yellen likes to say. This is called “discount window lending” the interest rate that the Fed charges banks for these reserves is called the discount rate. More important is the Federal Funds rate. There long-term rates, short-term rates, the discount rate and the federal funds rate. The federal funds rate is the rate that banks charge each other for reserves. The Fed controls the discount rate directly while the federal funds rate only through expanding the money supply in open market operations. How it does this has been done is a mystery to many, Rothbard himself may be surprised by the Fed entry into the securities, mortgage, and stock markets. Obviously the Fed does not simply drop money from a helicopter or divvy out the new into each person’s bank account equally. Instead new money is used to prop up asset prices, purchase insolvent mortgages, and to buy government debt thereby entering the economy through the banking system and only secondarily through wages and purchases paid out to the laborer and the consumer.

When the Fed wishes to lower interests rates (specifically short-term and Federal Funds rate) it engages in “open market operations” purchasing Treasury bonds, government backed securities and mortgages, and various other assets from private bankers. The Federal Reserve purchases these bonds largely by creating, whether through printing or digitally, money that previously did not exist. In other words it is buying government debt (this is called monetizing the debt) by printing or entering money into private bankers account, the interest of which is paid by the Treasury back to the Federal Reserve (they do have an assets balance sheet), which of course is financed by the selling  of more Treasury bonds (or T-Bills) to be later bought by the Federal Reserve directly or through private bankers. The government’s debt is financed, the banker’s accounts increase, and interest rates go down. Banks now having more reserve money to loan (monetary base) and demand remaining equal,  decrease the cost of the borrowing (the interest rate) and hence the price of goods increases, and now $1000 only buys what $800 use to. New money enters from the Federal Reserve through the banking system first into the monetary base (currency, deposits, and bank reserves) and by extension is lent out to then enter the market and into the money supply (or M2).

LFM Expanded

The supply of savings (S) remains the same but the central banks money is added (S+M). The new money, in the form of low interest rates, gives the illusion of an abundance of savings, that is as an increase in the loanable funds thus shifting to the right, the gap between these two points which used to represent the increase in available capital now represents the shortfall between apparent funds and actual funds. At the same time continuous present levels of consumption combines to give the appearance of actual economic growth. There appears to be more capital available in the economy as a whole, and that consumers are wealthier than they really are. The result is not simply overinvestment but also malinvestment. Long-term projects in mining, research, systems overhauls, etc. experience a large boom while capital maintenance, replacement, and infrastructure needs are ignored since there is also a rise in the need for consumer goods, retail stores, and inventory needs. Both the early stages of production and late stages of production (retail,etc.) grow rapidly and attempt to pull in opposite directions from the same small pool of resources thinking they are pulling from a much larger pool.

Boom Cycle

The crash comes when prices of the small pool of resources are bid up unsustainably and when credit from the banks inevitably contracts the projects and businesses show themselves to be unprofitable, laborers are let-go, loans are defaulted, houses foreclosed, and consumption plummets further revealing that the consumer goods industry had over-expanded beyond what was sustainable just as the capital goods market had. Large amounts of capital has been misallocated under the premise of the low interest rates deceivingly propping up profits. The recession then requires the liquidation of misallocated resources and termination of unprofitable projects. While things like labor are fairly fluid and quickly adjust other things like mining equipment and research projects take time to find a new productive purpose. The damage then is not during the bust, but the boom. It is the bust which attempts to reassert the true value of stocks and capital where cheap money had previously disguised profitability and loss.

Let’s consider this specifically in light of the recent housing and financial crisis. To set the stage Alan Greenspan (chair of the Federal Reserve from 1987-2006) had been dubbed “the mistro” after he had used interests rates to slow the heating economy in 97’, afterwards it resumed upward growth and Greenspan resumed printing money. He had inherited a fairly stable economy from Paul Volker who against all political pressure had eliminated inflation (hyper-inflation of the 70’s) by letting the market resume natural interest rates (it jumped to nearly 22%), but after resuming suppression of the interests rates, pumping in new money, and pushing internet and technologies markets through open market operations another bust was on its way.

With new money steadily streaming in Wall Street constantly searched for new avenues of financing and revenue and increasingly turned toward complex financial products like derivatives, and new products like portfolio insurance that was supposed to provide investors with protection and stress-free risk. It was this of course that nearly bankrupted Lehman Brothers in 1998 when in response to low interest rates, and despite the opposition of their own hedge fund manager and derivatives expert John Succo, heavily traded in long-term capital management derivatives, they were however bailed out by the Fed. This became known as the “Greenspan put,” that whatever higher risk you took in loans and in the stock market the Fed would be your backstop. In 2008 when the same CEO of Lehman Brothers had borrowed over $600 billion in the mortgage industry thinking the Federal Reserve would bail them out, it became one of the largest bankruptcies in history.

In 1999 a new Fed policy was in set in place, Greenspan testified before congress that “while bubbles that burst are rarely benign, the consequences need not be catastrophic.” Instead of pricking the bubble before it got out of hand the Fed would use rapid liquidity to pick up the pieces at the end. In the early 2000’s everyone and his mother was starting an internet business or company. Websites were being launched and invested in overnight with no business model, no recorded sales, and no profit forecast. But the Fed would soften the Dot-com burst by lowering rates and propping up the housing market. An old Fed chairman once said in response to Greenspan’s putting the brakes on the economy in ‘97 by raising interests rates that “the role of the Fed is to take away the punch bowl just as the party gets rolling.” If that’s the case the Greenspan plan in 2000-03 was to spike the punch bowl instead. From January 2001 to June 2003 Greenspan would slashed the federal funds target from 6.5% down to a ridiculous 1%.The blurred drunken vision of new money and rising household net worth would disguise the distortions in the economy.

FFR and M2

(all following charts and data from Salerno’s Reformulating the Austrian Theory of the Business Cycle, data from the St. Louis Fed)

An Incredible thing happened, a recession with no drop in housing prices. People interpreted this as an economic law, real estate is recession proof, home prices always go up. Bernanke in a television interview in 2005 confidently stated that it was impossible for housing prices to fall nationwide. Even seemingly obvious unsustainable price increases of 15% a year were touted as the strength of the real estate market. Paul Krugman himself advised in his NYT editorial in 2002 “to fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.” The response from the Federal Reserve to the Dotcom and the Nasdaq bubble institutionalized moral hazard with the unspoken promise of a “put” seemingly married to low interest rates and easy money.

housing prices

Alan Greenspan’s action would not only distort but entirely transform the U.S. economy. At the beginning (1987) of Alan Greenspan’s reign as the chairman of the Federal Reserve the financial sectors share of U.S. corporate profits was 17% by the end (2006) of the Greenspan era the financial sector would more than double to 45%. Companies that once produced and sold products, now made loans. GE (General Electric) essentially became a hedge fund, General Motors sought profits not so much in making cars as in financing cars. With institutionalized moral hazard, easy money, and low interests rates lending standards dropped dramatically. Banks borrowing money at 1% in an economy with 3-6% inflation meant actual real interest rates in the negative.

fin sector profits

In coordinated movement with the Fed’s effort to create a housing bubble to replace the Nasdaq bubble congress reinvigorated government mortgage programs like Fannie and Freddie Mac, Housing & Urban Development (HUD), and the Community Reinvestment Act (CRA) in 2003. Fannie and Freddie Mac (government/private hybrids) were involved in the secondary mortgage market buying mortgages from private banks enjoying tax breaks and special credit from the government with a special guarantee to be bailed out by the government. The HUD and CRA instituted anti-discrimination laws and regulations which require lenders to give mortgages to riskier inner-city individuals and minorities. Together they created an artificial stimulus to risk, banks received expanded credit to make loans they would otherwise not have.

mortgage rates

Greenspan went on to hold the Federal Funds target at 1% for over a year and then attempted to slowly let it rise back to 5.25% in June 2006. However the damage was already done, the real estate market had already peaked. By the end of 2007, long before many noticed the seismic cracks, the Federal Reserve would drop the discount rate from 6.25% to 5.75% and Citigroup, JPMorgan Chase, Bank of America and Wachovia each borrowed $500 million from the Federal Reserve discount window. An unsustainable housing and stock bubble had already been created and the air was starting to come out. The attempt to normalize interest rates only served as the contractional credit crunch to reveal the malinvestments in the economy. Real-estate, long-term construction, and long-term capital goods had over-extended themselves. The rising housing prices and net-worth had deceived many into a pattern of over-consumption and record retail sales at the same time that they drastically cut their savings.

net worth savings ratio

The overconsumption aspect of the Austrian theory was all too apparent in this boom. For many of us the boom and the bust are close enough in time to remember when Starbucks was expanding so rapidly they seemed to have stores kitty-corner from each other overnight. Rising asset prices and household net worth inspired everyone to buy at least one $5 coffee drink a day to do their part for the economy. We also remember when Starbucks closed over 600 stores in 2008 alone. By 2008-09 retail sales fell $20 Billion, Chrysler and GM filed chapter 11 bankruptcy, KB Toys (one of the largest toy retailers) closed 460 stores and filed chapter 11 bankruptcy, Circuit City closed all 575 of its stores and declared bankruptcy, CompUSA closed all 103 outlets, Ann Taylor closed 117, Foot Locker closed 140, and numerous others.

On the financial side the typical U.S. worker’s 401k dropped 24.3%, Lehman Brothers declared bankruptcy, Merrill Lynch, AIG, Washington Mutual, Freddie Mac, Fannie Mae, HBOS, Royal Bank of Scotland, Bradford & Bingley, Fortis, Hypo and Alliance & Leicester all had be rescued by the Federal Reserve in a $7.77 trillion bailout that dwarfed the $700 Billion TARP bailout signed by congress. There is an entire Wikipedia page of banks that became insolvent or were acquired after the great recession. This was a textbook mass cluster of error not due to entrepreneurial incompetency or the “de-regulation” of the mid 90’s but the calculational distortion produced by monetary expansion that created a self intensifying pattern of consumption and investment. It was the spiking of the punch bowl by the Fed in 2001-2003 precisely when the economy needed to slough off the bad investments and realign resources to those who could accurately forecast consumer demand.

Ludwig von Mises often used the analogy of a builder who assess what resources he has available and makes his plans accordingly. If he thinks he has more resources than he does he will build a much more elaborate and roomier house than if he had less resources. So he may start his project and have less resources than he thought and may not be able to finish the project. The sooner he finds out the better, and the easier it will be to either cut his losses or rearrange the project, or change the design. The sooner the builder knows the reality the better. The Fed’s answer has been essential to get him drunk, just liquor him up and hope he doesn’t realize he doesn’t have enough to finish the project until he grabs for another brick and finds himself empty handed.

In this sense the bust/recession is not the problem but the expansionary boom. Similarly the drunken builder’s problem  is not the pain of his hangover but his drunken stupor. The hangover is what purges the ill effects from his body, it is the painful but necessary correction. The Keynesian central-banking solution however is to cure the hang-over by drinking more. In response to a recession the central banks cut interest rates yet again (as Bernanke did) and engage in further monetary expansion. Asking how the Fed can solve an economic crisis is like asking how a drug dealer can cure someone’s heroin withdrawals.

The correction doesn’t just happen during the bust, the bust is the correction. Labor, equipment, and financing must be moved to find their most valuable location. Most importantly after having been duped by low interests rates, cheap money, and over valued assets entrepreneurs must regain confidence in their ability to accurately forecast, estimate capital stores, and conduct monetary calculation with some degree of certainty in a stabilized economy and monetary system. Money printing and suppression of interest rates only delays and exacerbates the  problem just as the Fed response in 2002-03 simply created a much worse financial crisis in 2008,-09.

Fiat money, the Federal Reserve, and the debasing of currency is the way of the fool, not the wise man. It’s an economy built on sand. You can’t print your way into wealth, it is only a race to the bottom. A penny saved becomes a penny lost in a fiat money system. We have created a “casino economy” oriented towards the trading of paper and titles and away from the true production of wealth. The Federal Reserve is trickle down poverty. Babylon “your silver has become dross, your princes the companion of thieves,” (Isaiah 1:22-23).

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