Austrian business cycle theory

The Austrian business cycle theory (ABCT) is an economic theory developed by the Austrian School of economics about how business cycles occur. The theory views business cycles as the consequence of excessive growth in bank credit due to artificially low interest rates set by a central bank or fractional reserve banks. The Austrian business cycle theory originated in the work of Austrian School economists Ludwig von Mises and Friedrich Hayek. Hayek won the Nobel Prize in Economics in 1974 (shared with Gunnar Myrdal) in part for his work on this theory. According to the theory, the business cycle unfolds in the following way: low interest rates tend to stimulate borrowing, which lead to an increase in capital spending funded by newly issued bank credit. Proponents hold that a credit-sourced boom results in widespread malinvestment. A correction or credit crunch, commonly called a "recession" or "bust", occurs when the credit creation has run its course. The money supply then contracts (or its growth slows), causing a curative recession and eventually allowing resources to be reallocated back towards their former uses. The Austrian explanation of the business cycle differs significantly from the mainstream understanding of business cycles and is generally rejected by mainstream economists on both theoretical and empirical grounds. Austrian School theorists have continued to contest these conclusions. According to ABCT, in a genuinely free market random bankruptcies and business failures will always occur at the margins of an economy, but should not "cluster" unless there is a widespread mispricing problem in the economy that triggers simultaneous and cascading business failures. According to the theory a period of widespread and synchronized "malinvestment" is caused by mis-pricing of interest rates thereby causing a period of widespread and excessive business lending by banks, and this credit expansion is later followed by a sharp contraction and period of distressed asset sales (liquidation) which were purchased with overleveraged debt.