Austrian Business Cycle Theory

In a dynamic market economy entrepreneurs are constantly adjusting to allocate the scarce resources of the economy. The entrepreneurs have a measuring stick for this – profit/loss if they are allocating the resources correctly, as the market wants, they will show a profit and continue what they are doing, however, if they allocate resources incorrectly they will lose money and will be run out of business or will necessarily adjust how they allocate these resources.

It follows logically from this that in a dynamic market economy there would be no mass error by entrepreneurs (remember the bad ones are weeded out) leading to a boom that creates a bubble and its inevitable bust. For the proper explanation of the boom-and-bust cycle one must then look not at anything inherent in the market system, but instead away from it and at the state.

To start, in a market there is a structure of production, capital is not just one big blob (as Keynesians and monetarists would like to assume), but is instead divided in a structure of production from lower order goods to higher order goods (think from seeds to a happy meal and so on).

Next, people naturally have a ‘time-preference,’ that is they prefer something now over later. This is why interest is charged on loans (be it loans to businesses for investment, or loans from entrepreneurs to employees in equipment and current paychecks, the interest here being paid in the profit that goes to the entrepreneurs). The interest in a market illustrates the current time preference in that economy and coordinates savings with investment.

This coordination is a must, because when people save they are necessarily forgoing consumption, so as their excess savings pushed down the interest rate entrepreneurs will have easier money to borrow and invest in lower order goods to provide supply not now, when consumers don’t want it, but in the future when the demand will come.

This is where the state comes in. When the money supply is artificially increased through fiat money and fractional reserve banking the increased amount of loans available for entrepreneurs pushes the interest rate below its natural level, and changes the structure of production.

So the result is mass investment in lower order goods to create supply in the future, when the demand is for now. This creates tons of malinvestments (think houses…) which need to be liquidated for the market to return to its natural level.

According to the Austrian School, the bust part of the cycle is not the bad part, the bad part happened when the fake money was pushed into the wrong areas of the economy creating a bubble, the bust is the necessary, though hard, part that returns the market back to where it should be.

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