Austrian Business Cycle Theory

The Austrian business cycle theory (or ABCT) is an economic theory held by the Austrian School of economics concerning how business cycles occur. The theory views business cycles as the inevitable consequence of excessive growth in bank credit, exacerbated by inherently damaging and ineffective central bank policies, which cause interest rates to remain too low for too long, resulting in excessive credit creation, speculative economic bubbles and lowered savings. 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 results 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 expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. It is argued that this leads to an unsustainable credit-sourced boom during which the artificially stimulated borrowing seeks out diminishing investment opportunities. Proponents hold that a credit-sourced boom results in widespread malinvestments. In the theory, a correction or "credit crunch" – commonly called a "recession" or "bust" – occurs when exponential credit creation cannot be sustained. Then the money supply suddenly and sharply contracts when markets finally "clear", causing resources to be reallocated back towards more efficient uses.

The Austrian explanation of the business cycle differs significantly from the mainstream understanding of business cycles and is generally rejected by mainstream economists. In contrast to most mainstream theories on business cycles, Austrians focus on the credit cycle as the primary cause of most business cycles. Economists Milton Friedman, Gordon Tullock, Bryan Caplan, and Paul Krugman have argued that the theory is incorrect.

According to Austrian economist Murray Rothbard, the Austrian business cycle theory attempts to answer the following questions about things which Austrians believe appear over the course of a business cycle:

• Why is there a sudden general cluster of business errors?
• Why do capital goods industries and asset market prices fluctuate more widely than do the consumer goods industries and consumer prices?
• Why is there a general increase in the quantity of money in the economy during every boom, and why is there generally, though not universally, a fall in the money supply during the depression (or a sharp contraction in the growth of credit in a recession)?