We (Lara and Murphy) are adherents to the “Austrian” School of Economics. Nowadays, the name has nothing to do with the economy of the country of Austria, but instead is a historical legacy from the fact that the School’s founders were from Austria. Indeed, many of today’s most prominent Austrian economists were born in the United States.
The Austrian School was founded in 1871 by Carl Menger, whose book Grundsätze (translated as Principles of Economics) was part of the so-called marginal revolution in economic thought. This marked the transition from the classical labor theory of value into the modern, subjective value theory of market prices. Some of the most important intellectual descendants of Menger are Ludwig von Mises, Nobel laureate Friedrich Hayek, Murray Rothbard, and Israel Kirzner. (See our list of Great Austrian Economists.)
The Austrian School is known for its focus on the individual and the market process; Austrian economists do not explain economic events using equations of aggregates or statistics. The Austrians are skeptical of government intervention in the economy, arguing that it often produces results that make the original situation even worse. What makes the Austrians unique is that they apply this logic even to money and banking. Indeed, the great Austrian economist, Ludwig von Mises, blamed the familiar boom-bust cycle not on laissez-faire capitalism, but instead on artificially low interest rates fostered by governments and central banks. Especially since the worldwide central bank injections of liquidity in 2008 and beyond, the Austrian theory of the business cycle is more relevant than ever.
It is crucial for today’s investors and financial professionals to understand the basics of how a market economy operates. We believe that the layperson’s time in this arena is best spent absorbing works in the Austrian tradition, as this is the quickest path to essential economic knowledge. The following books teach Austrian economics to different types of audiences, and we highly recommend them for the appropriate reader:
- Lessons for the Young Economist(2011), by Robert P. Murphy. An introductory textbook aimed at junior high students, but also applicable to adults who have never studied economics and wish to start at the ground level. Perfect for homeschoolers. (Free online version here, as well as teacher’s manual.)
- Economics in One Lesson (1946), by Henry Hazlitt. This short and eminently readable volume has taught basic economics to millions of people. Hazlitt was a journalist by trade and—contrary to most economic thinkers—could actually write. This book teaches the reader to “see the unseen” ramifications of apparently beneficial government policies. Hazlitt destroys the “broken window” approach to prosperity as well as other fallacious ideas.
- What Has Government Done to Our Money? (1963), by Murray Rothbard. Available for free here, this short booklet lays out the problem of government intervention in money. It explains that government is the source of inflation and the business cycle, and that the market’s money (gold) was much better than modern “fiat money” which is backed up only by the virtue of political officials.
- Choice: Cooperation, Enterprise, and Human Action (2015), by Robert P. Murphy. A mid-size book that boils down the essentials of Mises’ long treatise, Human Action, in accessible prose that assumes no prior knowledge of economics. It is aimed at undergrad economics majors, but is appropriate for any reader who wishes to truly understand Austrian economics. It concentrates on the areas of money, banking, capital, and interest, culminating in a comprehensive statement of the Austrian theory of the business cycle. Available on Amazon.com.
- How Privatized Banking Really Works (2010), by Carlos Lara and Robert P. Murphy. This work integrates Austrian economics with the Infinite Banking Concept (IBC) as developed by Nelson Nash. Rather than a work in pure economic theory, it places the essentials of free market economics in the context of the United States’ tradition of political liberty, and the financial crisis of 2008. Available here from the Nelson Nash Institute.
- Man, Economy, and State (1962), by Murray Rothbard. Murray Rothbard was a prolific economist as well as a political theorist, who was one of the pioneers of American libertarianism. He originally set out to write a more accessible guide to Mises’ Human Action, but ended up producing a new treatise in its own right. Man, Economy, and State is a long work, but it provides a comprehensive education in Austrian economics with a discussion of the related literature. Rothbard not only relays the insights of his predecessors (notably Mises), but he also develops innovations in economics such as his approach to monopoly price. (Free online version here, as well as Murphy’s study guide.)
- The Austrian Theory of the Trade Cycle and Other Essays (1978), edited by Richard Ebeling. Available for free here, this collection draws on some of the leading Austrian economists to explain (from their varying perspectives) how government intervention in banking can cause an artificial boom which must inevitably end in recession. Appropriate for those versed in mainstream economics, who wish to relate other approaches to the Austrian School.
- Human Action (1949), by Ludwig von Mises. The classic treatise that marked the rebirth of the Austrian School in the wake of the worldwide embrace of Keynesian economics in the 1930s. Although the language is formal and assumes some familiarity with economics, Mises writes for a general audience, not for other economists. In addition to teaching pure economic theory, Mises gives a comprehensive defense of the power of reason and the importance of liberty. (Free online version here, as well as Murphy’s study guide.)
The Austrian business cycle theory (ABCT) is an economic theory developed by the Austrian School of economics about how business cycles occur. The theory views business cycles as the consequence of excessive growth in bank credit, due to artificially low interest rates set by a central bank or fractional reserve banks. The Austrian business cycle theory originated in the work of Austrian School economists Ludwig von Mises and Friedrich Hayek. Hayek won the Nobel Prize in economics in 1974 (shared with Gunnar Myrdal) in part for his work on this theory.
Proponents believe that a sustained period of low interest rates and excessive credit creation result in a volatile and unstable imbalance between saving and investment. According to the theory, the business cycle unfolds in the following way: low interest rates tend to stimulate borrowing from the banking system. This leads to an increase in capital spending funded by newly issued bank credit. Proponents hold that a credit-sourced boom results in widespread malinvestment. A correction or "credit crunch" – commonly called a "recession" or "bust" – occurs when the credit creation has run its course. Then the money supply contracts (or its growth slows) causing a curative recession and eventually allowing resources to be reallocated back towards their former uses.
The Austrian explanation of the business cycle differs significantly from the mainstream understanding of business cycles and is generally rejected by mainstream economists, on both theoretical and empirical grounds.
Malinvestment and “boom”
According to ABCT, a period of "malinvestment" is caused by a period of excessive business lending by banks, and this credit expansion is later followed by a sharp contraction and period of distressed asset sales (liquidation) which were purchased with overleveraged debt. The initial expansion is believed to be caused by fractional reserve banking encouraging excessive lending and borrowing at interest rates below what full reserve banks would demand. Due to the availability of relatively inexpensive funds, entrepreneurs invest in capital goods for more roundabout, "longer process of production" technologies. Borrowers take their newly acquired funds and purchase new capital goods, thereby causing an increase in the proportion of aggregate spending allocated to capital goods rather than consumer goods. However, such a shift is inevitably unsustainable over time due to mispricing caused by excessive credit creation by the banks and must reverse itself eventually as it is always unsustainable. The longer this distorting dislocation continues, the more violent and disruptive will be the necessary re-adjustment process.
Austrians argue that a boom taking place under these circumstances is actually a period of wasteful malinvestment. "Real" savings would have required higher interest rates to encourage depositors to save their money in term deposits to invest in longer term projects under a stable money supply. The artificial stimulus caused by bank lending causes a generalized speculative investment bubble which is not justified by the long-term factors of the market.
The "crisis" (or "credit crunch") arrives when the consumers come to reestablish their desired allocation of saving and consumption at prevailing interest rates. The "recession" or "depression" is actually the process by which the economy adjusts to the wastes and errors of the monetary boom, and reestablishes efficient service of sustainable consumer desires.[not specific enough to verify]
Continually expanding bank credit can keep the artificial credit-fueled boom alive (with the help of successively lower interest rates from the central bank). This postpones the "day of reckoning" and defers the collapse of unsustainably inflated asset prices.
The monetary boom ends when bank credit expansion finally stops – when no further investments can be found which provide adequate returns for speculative borrowers at prevailing interest rates. The longer the "false" monetary boom goes on, the bigger and more speculative the borrowing, the more wasteful the errors committed and the longer and more severe will be the necessary bankruptcies, foreclosures, and depression readjustment.
Government policy error
Austrian business cycle theory does not argue that fiscal restraint or "austerity" will necessarily increase economic growth or result in immediate recovery. Rather, they argue that the alternatives will make eventual recovery more difficult and unbalanced. All attempts by central governments to prop up asset prices, bail out insolvent banks, or "stimulate" the economy with deficit spending will only make the misallocations and malinvestments more acute and the economic distortions more pronounced, prolonging the depression and adjustment necessary to return to stable growth. Austrians argue the policy error rests in the government's (and central bank's) weakness or negligence in allowing the "false" unsustainable credit-fueled boom to begin in the first place, not in having it end with fiscal and monetary "austerity". Debt liquidation and debt reduction is therefore the only solution to a debt-fueled problem.
According to Ludwig von Mises, "There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."
The role of central banks
Austrians generally argue that inherently damaging and ineffective central bank policies, including unsustainable expansion of bank credit through fractional reserve banking, are the predominant cause of most business cycles, as they tend to set artificial interest rates too low for too long, resulting in excessive credit creation, speculative "bubbles", and artificially low savings. Under fiat monetary systems, a central bank creates new money when it lends to member banks, and this money is multiplied many times over through the money creation process of the private banks. This new bank-created money enters the loan market and provides a lower rate of interest than that which would prevail if the money supply were stable.
A similar theory appeared in the last few pages of Mises's The Theory of Money and Credit (1912). This early development of Austrian business cycle theory was a direct manifestation of Mises's rejection of the concept of neutral money and emerged as an almost incidental by-product of his exploration of the theory of banking. David Laidler has observed in a chapter on the theory that the origins lie in the ideas of Knut Wicksell.
Nobel laureate Hayek's presentation of the theory in the 1930s was criticized by many economists, including John Maynard Keynes, Piero Sraffa, and Nicholas Kaldor. In 1932, Piero Sraffa argued that Hayek's theory did not explain why "forced savings" induced by inflation would generate investments in capital that were inherently less sustainable than those induced by voluntary savings. Sraffa also argued that Hayek's theory failed to define a single "natural" rate of interest that might prevent a period of growth from leading to a crisis. Others who responded critically to Hayek's work on the business cycle included John Hicks, Frank Knight, and Gunnar Myrdal. Hayek reformulated his theory in response to those objections.
Austrian economist Roger Garrison explains the origins of the theory:
Grounded in the economic theory set out in Carl Menger's Principles of Economics and built on the vision of a capital-using production process developed in Eugen von Böhm-Bawerk's Capital and Interest, the Austrian theory of the business cycle remains sufficiently distinct to justify its national identification. But even in its earliest rendition in Mises's Theory of Money and Credit and in subsequent exposition and extension in F. A. Hayek's Prices and Production, the theory incorporated important elements from Swedish and British economics. Knut Wicksell's Interest and Prices, which showed how prices respond to a discrepancy between the bank rate and the real rate of interest, provided the basis for the Austrian account of the misallocation of capital during the boom. The market process that eventually reveals the intertemporal misallocation and turns boom into bust resembles an analogous process described by the British Currency School, in which international misallocations induced by credit expansion are subsequently eliminated by changes in the terms of trade and hence in specie flow.
Ludwig von Mises and Friedrich Hayek were two of the few economists who gave warning of a major economic crisis before the great crash of 1929. In February 1929, Hayek warned that a coming financial crisis was an unavoidable consequence of reckless monetary expansion.
Austrian School economist Peter J. Boettke argues that the Federal Reserve is presently making a mistake of not allowing consumer prices to fall. According to him, Fed's policy of reducing interest rates to below-market-level when there was a chance of deflation in the early 2000s together with government policy of subsidizing homeownership resulted in unwanted asset inflation. Financial institutions leveraged up to increase their returns in the environment of below market interest rates. Boettke further argues that government regulation through credit rating agencies enabled financial institutions to act irresponsibly and invest in securities that would perform only if the prices in the housing market continued to rise. However, once the interest rates went back up to the market level, prices in the housing market began to fall and soon afterwards financial crisis ensued. Boettke attributes failure to policy makers who assumed that they had the necessary knowledge to make positive interventions in the economy. The Austrian School view is that government attempts to influence markets prolong the process of needed adjustment and reallocation of resources to more productive uses. In this view bailouts serve only to distribute wealth to the well-connected, while long-term costs are borne out by the majority of the ill-informed public.
Economist Steve H. Hanke identifies the 2007–2010 Global Financial Crises as the direct outcome of the Federal Reserve Bank's interest rate policies as is predicted by the Austrian business cycle theory. Some analysts such as Jerry Tempelman have also argued that the predictive and explanatory power of ABCT in relation to the Global Financial Crisis has reaffirmed its status and perhaps cast into question the utility of mainstream theories and critiques.
Empirical research by economists regarding the accuracy of the Austrian business cycle theory has generated disparate conclusions, though most research within mainstream economics regarding the theory concludes that the theory is inconsistent with empirical evidence. In 1969, Nobel laureate Milton Friedman found the theory to be inconsistent with empirical evidence. Twenty five years later in 1993, he reanalyzed the question using newer data, and reached the same conclusion. However, in 2001, Austrian economist James P. Keeler argued that the theory is consistent with empirical evidence.
According to most economic historians, economies have experienced less severe boom-bust cycles after World War II, because governments have addressed the problem of economic recessions. Many argued, prior to the events of 2008, that this has especially been true since the 1980s because central banks were granted more independence and started using monetary policy to stabilize the business cycle, an event known as The Great Moderation.
Reactions of economists and policymakers
According to Nicholas Kaldor, Hayek's work on the Austrian business cycle theory had at first "fascinated the academic world of economists," but attempts to fill in the gaps in theory led to the gaps appearing "larger, instead of smaller," until ultimately "one was driven to the conclusion that the basic hypothesis of the theory, that scarcity of capital causes crises, must be wrong."
Lionel Robbins, who had embraced the Austrian theory of the business cycle in The Great Depression (1934), later regretted having written that book and accepted many of the Keynesian counterarguments.
The Nobel Prize Winner Maurice Allais was a proponent of Austrian business cycle theory and their perspective on the Great Depression and often quoted Ludwig Von Mises and Murray N. Rothbard.
When, in 1937, the League of Nations examined the causes of and solutions to business cycles, the Austrian business cycle theory alongside the Keynesian and Marxian theory were the three main theories examined.
The Austrian theory is considered one of the precursors to the modern credit cycle theory, which is emphasized by Post-Keynesian economists, economists at the Bank for International Settlements. These two emphasize asymmetric information and agency problems. Henry George, another precursor, emphasized the negative impact of speculative increases in the value of land, which places a heavy burden of mortgage payments on consumers and companies.
A different theory of credit cycles is the debt-deflation theory of Irving Fisher.
In 2003 Barry Eichengreen laid out a credit boom theory as a cycle in which loans increase as the economy expands, particularly where regulation is weak, and through these loans money supply increases. Inflation remains low, however, because of either a pegged exchange rate or a supply shock, and thus the central bank does not tighten credit and money. Increasingly speculative loans are made as diminishing returns lead to reduced yields. Eventually inflation begins or the economy slows, and when asset prices decline, a bubble is pricked which encourages a macroeconomic bust.
In 2006 William White argued that "financial liberalization has increased the likelihood of boom-bust cycles of the Austrian sort" and he has later argued the "near complete dominance of Keynesian economics in the post-world war II era" stifled further debate and research in this area. While White conceded that the status quo policy had been successful in reducing the impacts of busts, he commented that the view on inflation should perhaps be longer term and that the excesses of the time seemed dangerous. In addition, White believes that the Austrian explanation of the business cycle might be relevant once again in an environment of excessively low interest rates. According to the theory, a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment.
Related policy proposals
Economists Jeffrey Herbener,Joseph Salerno,Peter G. Klein and John P. Cochran  have testified before Congressional Committee about the beneficial results of moving to either a free banking system or a free Full-reserve banking system based on commodity money based on insights from Austrian business cycle theory.
According to John Quiggin, most economists believe that the Austrian business cycle theory is incorrect because of its incompleteness and other problems. Economists such as Gottfried von Haberler and Milton Friedman,Gordon Tullock,Bryan Caplan, and Paul Krugman, have also criticized the theory.
Some economists argue that the Austrian business cycle theory requires bankers and investors to exhibit a kind of irrationality, because their theory requires bankers to be regularly fooled into making unprofitable investments by temporarily low interest rates. In response, historian Thomas Woods argues that few bankers and investors are familiar enough with the Austrian business cycle theory to consistently make sound investment decisions. Austrian economists Anthony Carilli and Gregory Dempster argue that a banker or firm loses market share if it does not borrow or loan at a magnitude consistent with current interest rates, regardless of whether rates are below their natural levels. Thus businesses are forced to operate as though rates were set appropriately, because the consequence of a single entity deviating would be a loss of business. Austrian economist Robert Murphy argues that it is difficult for bankers and investors to make sound business choices because they cannot know what the interest rate would be if it were set by the market. Austrian economist Sean Rosenthal argues that widespread knowledge of the Austrian business cycle theory increases the amount of malinvestment during periods of artificially low interest rates.
In a 1998 interview, Friedman expressed dissatisfaction with the policy implications of the theory:
- "I think the Austrian business-cycle theory has done the world a great deal of harm. If you go back to the 1930s, which is a key point, here you had the Austrians sitting in London, Hayek and Lionel Robbins, and saying you just have to let the bottom drop out of the world. You’ve just got to let it cure itself. You can’t do anything about it. You will only make it worse. You have Rothbard saying it was a great mistake not to let the whole banking system collapse. I think by encouraging that kind of do-nothing policy both in Britain and in the United States, they did harm."
Jeffery Rogers Hummel argues that the Austrian explanation of the business cycle fails on empirical grounds. In particular, he notes that investment spending remained positive in all recessions where there are data, except for the Great Depression. He argues that this casts doubt on the notion that recessions are caused by a reallocation of resources from industrial production to consumption, since he argues that the Austrian business cycle theory implies that net investment should be below zero during recessions. In response, Austrian economist Walter Block argues that the misallocation during booms does not preclude the possibility of demand increasing overall.
In 1969, economist Milton Friedman, after examining the history of business cycles in the U.S., concluded that "The Hayek–Mises explanation of the business cycle is contradicted by the evidence. It is, I believe, false." He analyzed the issue using newer data in 1993, and again reached the same conclusion. Economist Jesus Huerta de Soto claims that Friedman has not proven his conclusion because he focuses on the contraction of GDP being as high as the previous contraction, but that the theory "establishes a correlation between credit expansion, microeconomic malinvestment and recession, not between economic expansion and recession, both of which are measured by an aggregate (GDP)" and that the empirical record shows strong correlation.
Referring to Friedman's discussion of the business cycle, Austrian economist Roger Garrison stated, "Friedman's empirical findings are broadly consistent with both Monetarist and Austrian views," and goes on to argue that although Friedman's model "describes the economy's performance at the highest level of aggregation; Austrian theory offers an insightful account of the market process that might underlie those aggregates."
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- ^Economics Prize For Works In Economic Theory And Inter-Disciplinary Research
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- ^ abcTheory of Money and Credit, Ludwig von Mises, Part III, Part IV
- ^ abcdeHuman Action, Ludwig von Mises, Chapter XX, section 8
- ^ abManipulating the Interest Rate: a Recipe for Disaster, Thorsten Polleit, 13 December 2007
- ^Saving the System, Robert K. Landis, 21 August 2004
- ^ abAmerica's Great Depression, Murray Rothbard
- ^The Real Solution to the Debt Problem, David S. D'Amato
- ^Iceland Loses Its Banks, Finds Its Wealth, Tim Cavanaugh
- ^Thorsten Polleit, Manipulating the Interest Rate: a Recipe for Disaster, 13 December 2007
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- ^ abPiero Sraffa (1932). "Dr. Hayek on Money and Capital". Economic Journal. 42 (March): 42–53. doi:10.2307/2223735. JSTOR 2223735.
- ^Bruce Caldwell, Hayek's Challenge: An Intellectual Biography of F. A. Hayek (Chicago: University of Chicago Press, 2004), p. 179. ISBN 0-226-09193-7
- ^Garrison, Roger. In Business Cycles and Depressions. David Glasner, ed. New York: Garland Publishing Co., 1997, pp. 23–27. 
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- ^Hanke, Steve H. "The Fed's Modus Operandi: Panic | Cato Institute: Commentary". cato.org. Archived from the original on 16 July 2010. Retrieved 17 July 2010.
- ^ABCT and the GFC: Confessions of a Mainstream Economist by Jerry Tempelman
- ^Friedman, Milton. "The Monetary Studies of the National Bureau, 44th Annual Report". The Optimal Quantity of Money and Other Essays. Chicago: Aldine. pp. 261–284.
- ^Friedman, Milton. "The 'Plucking Model' of Business Fluctuations Revisited". Economic Inquiry: 171–177.
- ^Keeler, JP. (2001). "Empirical Evidence on the Austrian Business Cycle Theory". Review of Austrian Economics. 14 (4): 331–351. doi:10.1023/A:1011937230775.
- ^ ab"John Quiggin " Austrian Business Cycle Theory". johnquiggin.com. Retrieved 19 July 2010.
- ^Eckstein, Otto; Allen Sinai (1990). "1. The Mechanisms of the Business Cycle in the Postwar Period". In Robert J. Gordon. The American Business Cycle: Continuity and Change. University of Chicago Press.
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- ^Walsh, Carl E. (May 14, 1999). "Changes in the Business Cycle". FRBSF Economic Letter. Federal Reserve Bank of San Francisco. Archived from the original on 7 September 2008. Retrieved 2008-09-16.
- ^Stock, James; Mark Watson (2002). "Has the business cycle changed and why?"(PDF). NBER Macroeconomics Annual.
- ^Nicholas Kaldor (1942). "Professor Hayek and the Concertina-Effect". Economica. 9 (36): 359–382. doi:10.2307/2550326. JSTOR 2550326.
- ^R. W. Garrison, "F. A. Hayek as 'Mr. Fluctooations:' In Defense of Hayek's 'Technical Economics'", Hayek Society Journal (LSE), 5(2), 1 (2003).
- ^See pp. 728–731, Jesus Huerta de Soto(1998)
- ^Prosperity and Depression (1937)
- ^ abcEichengreen B, Mitchener K. (2003). The Great Depression as a Credit Boom Gone Wrong. BIS Working Paper No. 137.
- ^Land Speculation & The Boom/Bust Cycle – from www.henrygeorge.org
- ^ abcWhite, William (April 2006). "Is price stability enough?"(PDF). Bank for International Settlements. Retrieved 2008-10-08.
- ^ abhttp://financialservices.house.gov/UploadedFiles/HHRG-112-BA19-TTF-PKlein-20120508.pdf
- ^ abGordon Tullock (1988). "Why the Austrians are wrong about depressions"(PDF). The Review of Austrian Economics. 2 (1): 73–78. doi:10.1007/BF01539299. Retrieved 2009-06-24.
- ^Caplan, Bryan. "Why I Am Not an Austrian Economist". George Mason University. Retrieved 2017-05-27.
- ^The Review of Austrian Economics, 2008, vol. 21, issue 4, pages 271–281
- ^Robert P. Murphy. "Correcting Quiggin on Austrian Business-Cycle Theory – Robert P. Murphy – Mises Daily". Mises.org. Retrieved 2012-08-15.
- ^Sean Rosenthal. "When Anticipation Makes Things Worse – Sean Rosenthal – Mises Daily". Mises.org. Retrieved 2012-08-15.
- ^Interview in Barron's Magazine, Aug. 24, 1998 archived at Hoover Institution 
- ^Epstein, Gene (1998-08-24). "Mr. Market". Barron's. Retrieved 2017-08-16.
- ^"On Hummel on Austrian Business Cycle Theory"], William Barnett II and Walter Block. Reason Papers 30 (2008): 59-90.
- ^p. 495 (de Soto 1998)
- ^Auburn User (1982-10-25). "Plucking Model". Auburn.edu. Retrieved 2012-08-13.
- ^Milton Friedman, "The 'Plucking Model' of Business Fluctuations Revisited" Economic Inquiry April, 1993
- Thomas Woods (2009). Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse. Washington, DC: Regnery. ISBN 978-1596985872OCLC 276335198
- Evans, A. J. (2010), WHAT AUSTRIAN BUSINESS CYCLE THEORY DOES AND DOES NOT CLAIM AS TRUE. Economic Affairs, 30: 70–71. doi: 10.1111/j.1468-0270.2010.02025.x, online
- Roger Garrison (2000). Time and Money: The Macroeconomics of Capital Structure. New York, NY: Routledge. ISBN 0415771226