Imagine the economy as a roller coaster—a ride with thrilling booms that must be followed by the inevitable dread of busts, at least if the booms are artificially enhanced. Welcome to the Austrian business cycle theory (ABCT), a theory that translates these physical rules to economic ideas and explains the volatile ups and downs of an economy. This theory isn’t just an academic exercise, but it’s also a practical tool that helps us anticipate and prepare for economic fluctuations. By understanding the ABCT, we can better navigate the financial markets and recognize the signs of an upcoming downturn. It’s like having a map of the roller coaster, allowing us to brace ourselves before the steep drops.

Mechanism behind the Curtain

While the founding father of modern macroeconomics, John Maynard Keynes, with his profound insights identified animal spirits as the causative factor for depressions, the Austrian School of Economics is the only school of thought providing an actual explanation for the emergence of economic busts. Fundamentally, the ABCT posits that business cycles are largely due to a manipulation of interest rates combined with an increase of the money supply (i.e., the daily business of central banks), which leads to a misallocation of resources.

When interest rates are artificially low, investors are misled into making unsustainable investments, creating a boom. However, this boom is not based on genuine consumer demand or resource availability, leading to an inevitable crash. Artificially low interest rates in combination with printing money distorts the natural rhythm of the market, causing a ripple effect that impacts employment, production, and savings. This theory is all about unintended consequences. A hands-off approach would provide a great way to prevent these cycles of artificial booms and busts.

The Origins of the Austrian Perspective

Origins of the ABCT can be traced back to the early twentieth century, with economists Ludwig von Mises and Friedrich Hayek at the forefront challenging the prevailing economic theories of their time by arguing that central planning and interventionism are the culprits of economic instability. Their work laid the groundwork for what would become a comprehensive critique of Keynesian economics. Whereas their contemporaries largely followed a collectivist approach, the Austrian School’s emphasis on individual choice and market dynamics offered a stark contrast.

Mises and Hayek actually were some of the few economists predicting America’s Great Depression before it happened. Thirty years later, Murray Rothbard explained in detail how the Great Depression arose. In his treatise America’s Great Depression, he shows how inflationism created the crisis and challenges notions of “unstable capitalism.” Herbert Hoover’s interventionist policies, he demonstrates, were responsible for its long duration and immense intensity.

However, while these ideas have since influenced some economists and policymakers around the world, they are barely even mentioned in current discussions about the market cycle. Everybody knows what went wrong and where the state needs to intervene more proactively. Very few people express the idea of scaling back the government apparatus. Moreover, while there are some exceptions, politicians seeking office do not want to limit their own power.

How Society Suffers

Creating business cycles by pumping artificial money into the economy as well as keeping interest rates artificially low impoverishes societies. Now, you might say we as humankind have made incredible progress on many fronts in the last fifty years, which were years of increasing influence for central banks. However, comparing conditions now to conditions fifty years ago is erroneous. Comparing conditions how they are to conditions how they could have been is the proper way to comprehend this topic. Relatively free markets, which we had during this time, improved well-being even with such negative pressures.

Additionally, one can make the argument that some significant aspects of life have been impaired: Your grandfather was able to buy a house or get a college education without getting into unfathomable amounts of debt. Further, ABCT portrays past recessions in another light. For instance, the Great Depression, which diminished living conditions for most of the American and worldwide population, would not have happened if the Federal Reserve had not started increasing the supply of money and artificially lowering interest rates. In fact, extreme, long-running, intersectoral recessions are a phenomenon of the present and happened rarely before the Federal Reserve was founded.

As long as the populace keeps behaving short-term oriented, politicians will continue printing money. Albeit there are some rare exceptions, politicians do not look beyond the next election cycle, and people with a high time preference are made happy by focusing on the present and ignoring the future. Policymakers neglect the ABCT, which champions economic sustainability over short-lived prosperity. When the long-term consequences inevitably happen, they can be blamed on other events and overshadowed by acute problems demanding some more high-time-preference solutions.

Life Lessons from the ABCT

How does the ABCT apply to everyday life? It teaches us to be skeptical of “too good to be true” economic situations. It encourages prudent financial decisions, avoiding the pitfalls of credit-fueled spending sprees that lead to personal financial crises mirroring the larger economic busts. Always consider the long-term impacts of your economic decisions. Furthermore, this rule can be applied to life in general: Lower your time preference and start paying more attention to long-term consequences. It might not, for instance, be the wisest choice to excessively drink every week.

Financially, there are some ways to profit from understanding the ABCT too. Recognize artificial booms and invest accordingly, managing risk and divesting from overvalued assets. Invest strategically and for the long run instead of behaving like a hyperactive beginner trader.

Embracing Economic Sobriety

In summary, the ABCT offers a sobering reminder of the perils of economic interventionism. By understanding and applying its principles, we can strive for a more stable economic future, both personally and globally. Remember, next time you’re enjoying economic highs, the ABCT advises caution, for the track ahead may take a sudden dip. If we listened to the ABCT’s teachings, while we wouldn’t have the intersectoral fantastic booms, we could avoid severe economic busts. The ABCT paints a picture of the negative consequences of focusing on short-term gains and ignoring unintended long-term effects.


This article was published by the Ludwig von Mises Institute and is reproduced with permission.

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