Austrian Business Cycle Theory
According to Ludwig von Mises and his followers, the boom-bust cycle is notinherent in the free market, but is rather caused by the government'sinterference in the credit markets, specifically its manipulation ofinterest rates. The government causes the boom period when it injectsnew credit into the system (pushing down rates), and then theunsustainable, non-economic investment projects put into motionnecessitate a bust at some future date. (Here is a reading plan for this topic.)
The following chart illustrates the Misesian explanation. Note the chart does not include the recent September cut.
| Real Yr/Yr GDP Growth (blue, right)  |
Generally speaking, the chart indicates an inverse relationshipbetween the two series. This accords with the commonsense view thatcutting interest rates provides a stimulus while hiking them iscontractionary. However, what the Austrian approach provides is theunderstanding of the real forces behind the boom-bust cycle. In otherwords, most financial commentators think that today's interest ratesaffect today's economic growth, end of story. But if a previous boomperiod has led to massive malinvestments, there must be a bust period to liquidate the various projects (for which there is an inadequate capital structure to complete).
To put it another way, many commentators seem to believe that if theFed held interest rates low indefinitely, then we'd never have highunemployment, just rampant price inflation. And yet, the recentexperience shows that this is dead wrong. The Fed didn't cause therecent problems by "responsibly" hiking interest rates. No, rates hadbeen steady at 5.25% for some time, and then the housing bubble burstand the mortgage market faltered, thus "forcing" the Fed to take action.
Looking back at the chart above, we can see why the worst may be yetto come. In (price) inflation-adjusted terms, the early-2000s levels ofthe actual fed funds rate is the lowest since the Carter years. Andmany readers may recall the severe recessions of 1980 and 1982 thatfollowed that period.
Conclusion
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In the Austrian view, the boom-bust cycle is caused by the Fed'smaintenance of artificially low interest rates, which causes businessesto expand, hire workers, buy other resources, and so forth, even thoughthese projects are not justified by the true supply of savings in theeconomy. The greater the "stimulus" the worse the malinvestments.
From 2001–2004, the Fed kept (real) rates at the lowest they've beensince the late 1970s. One of the consequences that has alreadymanifested itself is the housing bubble. But a more severe liquidationseems unavoidable. The recent Fed cut may postpone the day ofreckoning, but it will only make the adjustment that much harsher.
Robert Murphy is the author of The Politically Incorrect Guide to Capitalism. Send him mail. See his articles. Comment on the blog.
