Longtime readers know that I’m rather agnostic when it comes to economics.

Meaning I don’t cling solely to a certain school of thought – such as Austrian (more free markets), Monetarist (central bank liquidity focused), or Keynesian (large government intervention).

I believe each has good – and bad – ideas and lessons worth learning.

But there’s one theory that’s grossly undervalued by the mainstream. Or has been completely ignored. . .

I’m talking about the Austrian Business Cycle Theory (ABCT).

This theory explains how central bank interest rate policy is most responsible for widespread economic booms and busts. As well as spurring significant malinvestment and moral hazard.

I use this theory often when analyzing macroeconomics.

And you should also.

So let’s take a closer look into why I believe it’s so important.

The Austrian Business Cycle Theory: How Central Banks Are The Root Of The Problem

First, let’s start with a brief history lesson. . .

The Austrian Business Cycle Theory was first conceived by the little-known Austrian economist – Ludwig Von Mises – in the early-1900s.

But it was later expanded upon by his student and renowned economist – Friedrich Hayek – who put it into a full theory.

In short, Hayek hypothesized that economic cycles were caused by changes in the supply of credit from central banks, rather than changes in the demand for goods and services organically.

Meaning that when the central bank eased (increasing the supply of credit), it spurred an artificial and unsustainable boom in the economy. And it would self-reverse into a bust as credit eventually contracted (when the central bank raised interest rates or malinvestment and gluts spread).

The logic for this causal chain between monetary policy and booms and busts comes from how interest rates affect the price system.

Simply put, prices are collective information. Essentially where marginal demand and marginal supply find some sort of balance.

But interest rates are also a price – the price of time and money.

Thus when central banks artificially tinker with rates, it affects the balance between consumption and savings (aka consumer time preference).

For instance, if the central bank cuts interest rates below the natural rate to try and spur growth, it leads to cheaper debt, greater consumption, higher asset prices, and less savings. (Vice versa for interest rate hikes).

Or – put in a more technical way – lower interest rates shift the aggregate demand (AD) curve to the right relative to the aggregate savings supply (ASS) curve.

The idea here is that when interest rates drop, it raises consumer spending power with cheaper debt. Which pushes prices higher amid greater consumption.

And this creates a false signal for businesses to invest and increase capacity to meet the ‘expected’ greater demand.

Thus firms begin to binge on debt to over-hire, over-build, over-invest, and over-produce. Fueling an economic boom in the process.

But the crux here is that this boom was only driven because of artificially lower interest rates. Not ‘real’ organic consumer demand.

Eventually, when growth overheats and inflation picks up, central banks will raise interest rates. And the malinvestment is exposed.

Or – even if the central bank doesn’t raise interest rates – the market will become saturated with excess capacity and unsustainable private sector debt. Creating a bust all on its own. (The Keynesian economist – Hyman Minsky – noted this in his Financial Instability Hypothesis – read here).

Either way, demand erodes relative to supply – or reverts below what it was before the lower interest rate boom – and prices collapse amid excess supply and weak consumption.

But it doesn’t end there.

Asset prices and investment returns also plunge. Corporate margins erode. Unemployment rises. Debt-defaults soar. And the financial system grows unstable.

Thus according to the Austrian Business Cycle, the bust shouldn’t come as a surprise to anyone after an easy-credit boom.

Because it was always inevitable.

As Ludwig Von Mises once said, “There is no means of avoiding the final collapse of a boom brought about by credit expansion. . .”

Now, you may be thinking, “This makes sense. So why then do savvy investors and entrepreneurs seemingly always fall for this?”

Well, the Austrian economist – Murray Rothbard – has an explanation. . .

The Austrian Business Cycle And Murray Rothbard’s ‘Cluster Of Errors’

Murray Rothbard – although not as well-known as Hayek or Mises – was an incredible thinker, writer, and economist.

In fact, he wrote a book – America’s Great Depression – in the 1960s about the root causes of the great depression (a must-read in the Speculators Anonymous Reading List).

And he used the Austrian Business Cycle framework – how the government and Fed kept interest rates too low for too long – as a cornerstone in his thesis.

But Rothbard took it a step further.

He wanted to explain the interconnected mistakes that artificially low-interest rates led to – such as how all the brightest businessmen and economists were fooled together at the same time into a false boom.

He called this the ‘cluster of errors’ – and there’re five of them:

1. The first error in the cluster is the creation of artificial credit expansion through monetary policy. When central banks create credit out of thin air, they lower interest rates and incentivize borrowing and spending. This can lead to a false sense of prosperity, as businesses and households take on more debt and engage in risky investments.

2. The second error is the misallocation of resources that results from artificially low-interest rates. Businesses and individuals may invest in projects that would not be profitable under normal market conditions, leading to a buildup of malinvestments and overcapacity. This misallocation of resources can lead to a bubble, where certain sectors of the economy become grossly overvalued.

3. The third error – and most important here – is the failure to recognize the unsustainability of the boom and the need for an eventual bust.

Those who are benefiting from the boom – such as businesses and investors – may become complacent and fail to prepare for the eventual downturn. This can lead to a sudden and severe contraction when the boom turns to bust.

4. The fourth error is the expansion of credit beyond what the economy can sustain. As businesses and individuals take on more debt, credit expansion becomes unsustainable and leads to an inevitable credit crunch.

And when credit tightens, every area of the economy feels it.

5. The fifth error is the attempt to counteract the bust with further government intervention.

Instead of allowing the market to correct itself, governments may implement policies such as bailouts, stimulus packages, or price controls.

These interventions can keep prices distorted, prolong the downturn, and prevent the market from making necessary adjustments.

To put this into perspective, even Franklin D. Roosevelt’s own treasury secretary – Henry Morgenthau Jr. – said in 1939 that, “We have tried spending money. We are spending more than we have ever spent before and it does not work. . . We have never made good on our promises I say after eight years of this administration we have just as much unemployment as when we started and an enormous debt to boot!”

He essentially claims that FDR’s ‘New Deal’ – the decade-long aggressive government intervention in the economy to try and spur a recovery – turned the depression into a ‘great’ depression.

This further reinforces Rothbard’s thesis that the fiscal and monetary interventions didn’t allow the proper rebalancing. And instead prolonged the slump.

Thus Rothbard’s cluster of errors is an important – yet little-known – concept that I believe has significant value in understanding economic cycles and analyzing their patterns.

So, Why Is The Austrian Business Cycle Theory Still Important Today?

For starters – as I noted above – it helps explain why vicious economic cycles occur.

And by understanding the root cause of these booms and busts – and how the central bank influences them – consumers and investors may be better prepared to respond to changes in prices and the economy.

Since the 2000s, we have seen central banks around the world – from the U.S. to Europe and Japan – stimulate en masse. Whether it’s engaging in zero interest rate policies (ZIRP) or quantitate easing (QE).

Yet such aggressive easing is the seed for ‘false prosperity’ and the eventual bust.

In fact, there’s empirical evidence showing that when the Federal Reserve tightens credit (raises rates), something in the global economy or financial system most often breaks.

And this time is no different.

For instance – according to Bank of America – Fed tightening cycles trigger (or amplify) crises all over the world. From the 1929 Wall Street Crash to the 1982 Latin America debt crisis to the 2007 subprime housing bust.

And even recently, the Fed’s aggressive tightening in 2022 triggered regional banking fragility. Helping kick Silicon Valley Bank and others into failure (I’ve written more on the banking crisis and its causal link to the Fed – read here).

Now, was it all the Fed’s fault for the bank failures in 2023?

No, since the Treasury’s also to blame since it flooded the banking system with an enormous amount of deposits from the COVID stimulus.

But the interest rate policy is a major causal link here. And a big reason all banks are growing increasingly fragile. Especially with the massive amount of unrealized losses sitting on their loan books.

Meanwhile, we’ve already seen banks aggressively tightening credit over the last year across every major loan category. From consumer credit and auto loans to corporate debt and commercial real estate loans as they deal with higher funding costs and economic uncertainty. (Courtesy of the Fed’s hiking).

And I expect this tightening will continue to ripple throughout the economy. . .

In Conclusion

The Austrian Business Cycle theory is an important concept that helps explain the cycles of boom and bust in the economy.

And by understanding the role of interest rates and the impact of changes in the money supply, businesses and speculators can better anticipate market trends and adjust their strategies accordingly.

Remember that expanding the credit supply effectively means increasing debt. And more debt creates instability.

Thus whether you’re a business owner, investor, or just someone interested in economics, the Austrian Business Cycle Theory is a powerful tool that can help you navigate the ups and downs of the global economy. And avoid falling for false price signals.

Now, does the Austrian Business Cycle Theory explain everything?

Of course not. And everything I wrote is just a simplistic view. But it’s still an invaluable concept that will teach modern policymakers an old lesson.

So next time the Fed tinkers with interest rates, keep all this in mind.

And beware.

*NOTE: for more reading on the Austrian Business Cycle, I recommend some books. Such as ‘Austrian School Business Cycle Theory’ by M. Rothbard. ‘The Austrian Theory of the Trade Cycle and Other Essays’ by Ebeling, Hayek, Mises, and Rothbard. And ‘The Structures of Production’ by M. Skousen.