Why Boom-Bust Cycles Validate Austrian Theory

One criticism of the Austrian School’s theory of recessions is that it doesn’t account for the expectations of entrepreneurs, who can anticipate central bank actions which precipitate economic busts. But, as Austrian economist Joe Salerno argues, this criticism betrays a fundamental misunderstanding of how recessions occur.

The following article was originally published by the Mises Institute. The opinions expressed do not necessarily reflect those of Peter Schiff or SchiffGold.

Since the introduction in 1912 of Ludwig von Mises’s Austrian business cycle theory (ABCT) in his book The Theory of Money and Credit, it has been subject to relentless criticism. According to the ABCT, the artificial lowering of interest rates by the central bank via inflationary credit expansion leads to a misallocation of resources on account of the fact that businesses undertake various capital projects that, prior to the lowering of interest rates, weren’t considered profitable. This misallocation of resources is commonly described as an economic boom. The process, however, is brought to a halt once businessmen discover that the lowering of interest rates is not in accordance with consumers’ time preferences.

As a rule, businessmen discover their error once the central bank—instrumental in the artificial lowering of interest rates via artificial credit expansion—reverses. This, in turn, halts the expansion and an economic bust ensues. It follows, then, that the artificial lowering of interest rates by the central bank sets a trap for businessmen by luring them into unsustainable business activities that are revealed once the central bank tightens its interest rate stance.