What is the Austrian Business Cycle Theory?

The Austrian Business Cycle Theory states that the business cycle can be manipulated, and even predicted, by analysts when a federal bank seeks to control monetary policy by artificially adjusting the interest rate. While the theory states that such manipulation can cause the economy to boom, it can also cause it to crash. Thus, the Austrian Business Cycle Theory notes these policies can be the cause of great harm.

In the normal course of events, a national bank, such as the U.S. Federal Reserve, keeps a tight control on the interest rate or, more appropriately, several different interest rates. This is done to spur the economy and control the economy so that it does not get too hot too quickly. Ironically, the very thing that the Austrian Business Cycle Theory says such policies cause, an extreme business cycle, is what they are trying to prevent.

To help spur the economy and prevent a long-term downturn in business cycles, the federal reserve may choose to lower interest rates. This causes credit to be eased. However, because this is an artificial easing of credit, it usually does not last very long. Once the economy starts to heat up, interest rates must rise accordingly to prevent unwanted inflation.

In some ways, the Austrian Business Cycle Theory may seem like an insignificant thing. After all, if the economy was due to slow down anyway, what's the difference if it slows down as the result of a monetary policy or normal cyclical activity? Some believe an attempt to delay the inevitable actually makes the downturn more severe. In fact, the developer of the Austrian Business Cycle Theory, Ludwig von Mises, wrote, "The alternative is whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

The reason the economy falls harder after an attempt to ease credit through interest rate reductions is due to the the bubble effect it creates. Often, during a business cycle, when a downturn comes it does so gradually. In a bubble, however, companies move more collectively, both up and down. This can cause a serious downturn quickly, according to the Austrian Business Cycle Theory. In fact, because the downturn takes longer to develop, it is amplified.

The only way to avoid Mises' theory may be to hope that the economic downturn is staved off long enough to allow a natural increase in economic activity to take place. However, given the fact that bubbles usually mask the symptoms, this will be harder to accomplish. After all, if the economy looks healthy, there will be fewer attempts to fix it.