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9.10 The Austrian Theory of the Business Cycle

The previous two sections provide a stark contrast between Austrian and

Keynesian views. They show how an increase in saving can move the economy

along its production possibilities frontier, allowing for an increase in the

economy’s rate of economic growth (the Austrian view), and how an increase

in saving necessarily throws the economy off its frontier and into recession

(the Keynesian view). Simply put, markets work in one view and don’t work

in the other.

For the Austrians, the idea that markets work is not axiomatic. There is no

claim that markets are always guided only by the underlying economic reali504

ties – no matter what institutional arrangements are in place and no matter

what macroeconomic policies are pursued. In fact, the Austrian theory of the

business cycle is a theory about a policy-induced departure – first in one

direction and then in the other – from the economy’s production possibilities


For Keynes, increased saving leads to recession. This proposition, however,

did not transform his paradox of thrift into an excess-saving theory of

recessions. As already indicated, Keynes believed that saving preferences

were not likely to change. The recession-inducing changes, in his view, were

almost always spontaneous changes on the demand side of the loanable funds


Keynes and Hayek were critical of one another’s efforts to explain recessions,

but their assessments of one another’s books generated more heat than

light and failed to produce a head-to-head comparison of the contrasting

views. Despite all the interpreting, reinterpreting and reconstructing of

Keynesian ideas over the last three-quarters of a century, it is instructive to

compare (in this and the following sections) the Austrian and (original)

Keynesian views on the nature and causes of business cycles (see Garrison,

1989, 1991, 2002).

According to the Austrians, the market is capable of allocating resources in

conformity with intertemporal preferences on the basis of a market-determined

(natural) rate of interest. It follows, then, almost as a corollary that an interest

rate substantially influenced by extra-market forces will lead to an intertemporal

misallocation of resources. This latter proposition is the essence of the Austrian

theory of business cycles. The cyclical quality of the departures from the

economy’s production possibilities frontier derives from the self-correcting

properties of a market economy. Misallocations are followed by reallocations.

Note that the market is not judged to be so efficient as to prevent from the

outset all policy-induced misallocations. As Hayek (1945) has taught us, it

cannot allocate resources in accordance with the ‘real factors’ (consumer preferences,

technological possibilities and resource availabilities) except on the

basis of information conveyed by market signals, including, importantly, the

rate of interest. It is movements in the interest rate, along with the corresponding

movements in input prices and output prices, that give clues to the business

community about what those real factors are and about how they may have


The Austrian theory of the business cycle is a theory of boom and bust with

special attention to the extra-market forces that initiate the boom and the

market’s own self-correcting forces that turn boom into bust. We have already

seen that increased saving lowers the rate of interest and gives rise to a

genuine boom, one in which no self-correction is called for. The economy

simply grows at a more rapid rate. By contrast, a falsified interest rate that

The Austrian school 505

mimics the loan market conditions of a genuine boom but is not accompanied

by the requisite savings gives rise to an artificial boom, one whose artificiality

is eventually revealed by the market’s reaction to excessively future-oriented

production activities in conditions of insufficient saving.

As with the graphical depiction of saving and growth, the analytics of

boom and bust is begun with an assumed no-growth economy in an

intertemporal equilibrium. The initial (market-determined) rate of interest (ieq

in Figure 9.10) also qualifies as the natural rate of interest. An artificial boom

is initiated by the injection of new money through credit markets. The central

bank adopts an interest rate target below the rate of interest that otherwise

would have prevailed. Its operational target rate, of course, is much more

narrowly defined than the broadly conceived market rates shown in the diagram.

The central bank achieves its interest rate target by augmenting the

supply of loanable funds with newly created credit. The Federal Reserve’s

Open Market Committee buys securities in sufficient volume so as to drive

the Federal Funds rate down to the chosen target. With this action, market

rates generally are brought down to a similar extent – although, of course,

some more so than others. The fact that long-term rates tend not to fall as

Figure 9.10 A policy-induced boom and bust


S, I



rate Saving


Saving plus

credit expansion


Stages of production I

S = I

much as short-term rates may mitigate – but cannot eliminate – the general

effects of the credit expansion. Further, these general effects are independent

of which particular policy tool the Federal Reserve employs. Credit expansions

brought about by a reduction in the discount rate (now called the

primary credit rate) or by a reduction in reserve requirements could be

similarly described. All of the institutionally distinct monetary tools are

macroeconomically equivalent: they are all means of lending money into

existence and hence have their initial effect on interest rates.

For comparison, the central bank’s augmentation of credit depicted in

Figure 9.10 is set to match the actual shift in the supply of saving depicted in

Figure 9.8. Rather than create a new equilibrium interest rate and a corresponding

equality of saving and investment as was the case in a saving-induced

expansion, the credit expansion creates a double disequilibrium at a subnatural

interest rate. Savers save less, while borrowers borrow more. Note

that if this low interest rate were created by the imposition of an interest rate

ceiling, the situation would be different. With a legislated ceiling, borrowing

would be saving-constrained. The horizontal distance at the ceiling rate between

supply and demand would represent a frustrated demand for credit. A

credit shortage would be immediately apparent and would persist as long as

the credit ceiling was enforced.

Credit expansion papers over the credit shortage that would otherwise

exist. The horizontal distance between supply (of saving) and demand (for

credit) is not frustrated demand but rather demand accommodated by the

central bank’s injections of new credit. It represents borrowing – and hence

investment – that is not accommodated by genuine saving. In the final analysis,

of course, real investment cannot be in excess of real unconsumed output.

To say that credit expansion papers over the shortage is not to say that it

eliminates the problem of a discrepancy between saving and investment. It

only conceals the problem – and conceals it only temporarily. In summary

terms we see that padding the supply of loanable funds with newly created

money drives a wedge between saving and investment. The immediate effect

of this padding is (i) no credit shortage, (ii) an economic boom in which the

(concealed) problem inherent is a mismatch between saving and investment

festers, and (iii) a bust, which is the eventual but inevitable resolution to the

problem. (With this summary reckoning, however, we have got ahead of the


The double disequilibrium in the loanable funds market has as its counterpart

the two limiting points on the production possibilities frontier. Saving

less means consuming more. But with a falsified interest rate, consumers and

investors are engaged in a tug-of-war. If, given the low rate or return on

savings, the choices of consumers were to carry the day, the economy would

move counterclockwise along the frontier to the consumers’ limiting point.

The Austrian school 507

Similarly, if, with artificially cheap credit, the decisions of investors were to

carry the day, the economy would move clockwise along the frontier to the

investors’ limiting point. Of course, neither set of participants in this tug-ofwar

is wholly victorious. But both consumer choices and investment decisions

have their separate – and conflicting – real consequences. Graphically, the

participants are pulling at right angles to one another – the consumers pulling

upward in the direction of more consumption, the investors pulling rightward

in the direction of more investment. Their combined effect is a movement of

the economy beyond the frontier in the direction of a ‘virtual’ disequilibrium

point that is defined by the two limiting points.

Having defined the production possibilities frontier in terms of sustainable

levels of output, we can allow for the economy to move beyond the frontier –

but only on a temporary basis. People are drawn into the labour force in

numbers that cannot be sustained indefinitely. Additional members of households

may take a job because of the unusually favourable labour market

conditions. Some workers may work overtime. Others may delay retirement

or forgo vacations. Maintenance routines that interrupt production activities

may be postponed. These are the aspects of the boom that allow the economy

to produce temporarily beyond the production possibilities frontier. However,

the increasingly binding real resource constraints will keep the economy

from actually reaching the virtual disequilibrium point – hence the ‘virtual’

quality of that point. The general nature of the path traced out by the economy

– its rotation in the clockwise direction – will become evident once we

consider the corresponding changes in the economy’s structure of production.

The wedge driven between saving and investment in the loanable funds

market and the tug-of-war that pulls the economy beyond its production

possibility frontier manifests itself in the economy’s capital structure as clashing

triangles. In the case of a saving-induced capital restructuring, the

derived-demand effect and the time-discount effect work together to reallocate

resources toward the earlier stages – a reallocation that is depicted by a

change in the shape of the Hayekian triangle. In the case of credit expansion,

the two effects work in opposition to one another. The time-discount effect,

which is strongest in the early stages, attracts resources to long-term projects.

Low interest rates stimulate the creation of durable capital goods, product

development and other activities whose ultimate pay-off is in the distant

future. The excessive allocations to long-term projects are called ‘malinvestment’

in the Austrian literature. The derived-demand effect, which is

strongest in the late stages, draws resources in the opposite direction so as to

satisfy the increased demand for consumer goods. The Hayekian triangle is

being pulled at both ends against the middle. Skousen (1990) identifies this

same internal conflict in terms of an early-stage ‘aggregate supply vector’ and

a late-stage ‘aggregate demand vector’.

During the boom, resource allocations among the various stages are being

affected in both absolute and relative terms. As explained above, the economy

is producing generally at levels of output that cannot be sustained indefinitely.

And at the same time that the overall output levels are higher, the

pattern of output is skewed in both directions – toward the earliest stages and

toward the latest stages. Middle stages experience a relative decline and some

of them an absolute decline. While this characterization of the boom is

gleaned from Hayek (1967 [1935]) and Mises (1953 [1912] and 1966), there

remain some fundamental doctrinal differences (both terminological and substantive)

in the alternative expositions offered by these early developers of

capital-based macroeconomics (Garrison, 2004).

Richard Strigl (2000 [1934]), writing without reference to the Hayekian

triangle, provided an account of boom and bust consistent with the one

offered here. In his account, production activities are divided into three

broadly conceived categories: current production of consumables (late stage),

capital maintenance (middle stage), and new ventures (early stage). Policyinduced

boom conditions tend to favour current production and new ventures

at the expense of capital maintenance. The economic atmosphere has a ‘make

hay while the sun shines’ quality about it, and the economy seems to be

characterized by prosperity and rapid economic growth. However, the undermaintenance

of existing capital (the sparse allocations to the middle stages)

distinguishes the policy-induced boom from genuine, sustainable, savinginduced

economic growth.

In time, but before the new ventures (the early-stage activities) have come

to full fruition, the under-maintained capital (the attenuated middle-stage

outputs) must impinge negatively on consumable output. This is the essence

of intertemporal discoordination. The relative or even absolute reduction of

consumable output is dubbed ‘forced saving’ in the Austrian literature. That

is, the pattern of early-stage investment reflects a higher level of saving than

was forthcoming on a voluntary basis. The push beyond the production

possibilities frontier towards the virtual disequilibrium point is cut short by

the lack of genuine saving. The downward rotation of the economy’s adjustment

path in Figure 9.10 reflects the forced saving.

The forced saving is but one aspect – and not necessarily the first observed

aspect – of the self-reversing process that is characteristic of an artificial

boom. Increasingly binding resource constraints drive up the prices of

consumables as well as the prices of inputs needed to support the new

ventures. The rate of interest rises as overextended businesses bid for additional

funding. Distress borrowing (not shown in Figure 9.10) is a feature of a

faltering boom.

Many of the new ventures and early-stage activities generally are now

recognized as unprofitable. Some are seen through to completion in order to

The Austrian school 509

minimize losses. Others are liquidated. The beginning of the liquidation

phase of the business cycle is depicted in Figure 9.10 by the economy’s

adjustment path turning back towards the production possibilities frontier.

As boom turns to bust, much of the unemployment is associated with

liquidations in the early stages of production. Too much capital and labour

have been committed to new ventures. The liquidations release these factors

of production, most of which can be reabsorbed – though, of course, not

instantaneously – elsewhere in the structure of production. For the Austrians,

this particular instance of structural unemployment is not something distinct

from cyclical unemployment. Quite to the contrary: the cyclical unemployment

that marks the beginning of the downturn has a characteristically

structural quality about it.

Under the most favourable conditions, the bust could be followed by a

recovery in which the structural maladjustments induced by the credit expansion

are corrected by the ordinary market forces. The structurally unemployed

resources are reabsorbed where they are most needed, and the economy

returns to a point on its production possibilities frontier. But because of the

economy-wide nature of the intertemporal disequilibrium, the negative income

effect of the unemployment may initially propel the economy deeper

into depression rather than back to the frontier. This secondary, or compounding,

aspect of the downturn is likely to be all the more severe if the

general operation of markets is countered by macroeconomic policies aimed

at preventing liquidation and at reigniting the boom.

The following section puts the Austrian theory in perspective by using the

capital-based analytics to depict the Keynesian view of economy-wide downturns.

For Keynes, the negative income effect that can compound the problem

of a discoordinated capital structure becomes the whole problem, the origins

of which are shrouded in the cloud of uncertainty inherent in investment