Howard Vane and Brian Snowdon, eds.
An Encyclopedia of Macroeconomics
Aldershot: Edward Elgar, 2002


Business Cycles: Austrian Approach

Roger W.Garrison

Originally conceived by Ludwig von Mises (1953) early last century and developed most notably by F. A. Hayek (1967) before and during the Great Depression, the Austrian theory of the business cycle is a theory of the unsustainable boom. Its logic is firmly anchored in the notion that the price system is a communications network. A miscommunication in the form of an interest rate held below its market, or “natural,” level by central-bank policy sets the economy off on a growth path that is inherently unsustainable. Given actual consumer preferences and resource availabilities, such a policy-induced boom contains the seeds of its own undoing. The temporal pattern of resource allocation is inconsistent with the preferred pattern of consumption. In time this inconsistency precipitates a bust.
        The uniqueness of the Austrian theory lies in the extra-market origins of the boom (central-bank policy) and in the self-reversing market process that turns boom into bust. Complications in the form of a possible spiraling downward of the economy into deep depression are only tangential to the Austrian theory. Similarly, the duration of the depression phase of the cycle, especially in the case of the Great Depression, depends upon many considerations (including the perversities of depression-born regulations on trade, industry and labor) that are not integral to the Austrian theory of the unsustainable boom.
        The interest rate is a price. It is the price that strikes a balance between people’s eagerness to consume now and their willingness to save for the future. Preferences relevant to this tradeoff are dubbed “time preferences” in the Austrian literature. And like preferences generally, time preferences can change: People may become more future oriented, for instance, because of increased life expectancy or out of concern for the well-being of their children. An increase in saving (a decrease in time preferences) has two mutually reinforcing effects: (1) It lowers the rate of interest, signaling to the business community that more and longer-term projects are now profitable, and (2) it frees up resources (that before were consumed) for carrying these projects through to completion. In this way, changes in intertemporal consumption preferences get translated into changes in intertemporal production plans.
        The market process that guides the intertemporal allocation of resources is inherently complex due to the radical heterogenity of capital goods, a point emphasized by Ludwig Lachmann (1978). But, for analytical tractability, Hayek (1967) assumed away many of the complexities and depicted the economy’s structure of production as a right triangle: one leg represents the time dimension of the production process; the other leg represents the value of the consumable output. The time dimension of this Hayekian triangle is divided into a number of “stages of production,” the output of one stage serving as the input to the next. A single “project” that converts (early-stage) raw materials into (final-stage) consumables involves the plans of many different producers–plans that are mutually coordinated by the price system, including (importantly) the rate of interest. A decrease in the interest rate, for example, causes resources to be transferred from the late and final stages to the early stages. The modified structure of production, depicted by a triangle with a longer time-dimension leg and an (initially) shorter consumable-output leg, causes the time profile of consumption to be skewed toward the future.
        An artificial boom is an instance in which the change in the interest-rate signal and the change in resource availabilities are at odds with one another. If the central bank pads the supply of loanable funds with newly created money, the interest rate is lowered just as it is with an increase in saving. But in the absence of an actual change in time preferences, no additional resources for sustaining the policy-induced boom are freed up. In fact, facing a lower interest rate, people will save less and spend more on current consumables. The central bank’s credit expansion, then, results in an incompatible mix of market forces.
        Increased investment in longer-term projects is consistent with the underlying economic realities in a genuine saving-induced boom but not in a policy-induced artificial boom. The artificial boom is characterized by “malinvestment and overconsumption,” a phrase used repeatedly by Mises (1966). With seemingly favorable credit conditions, long-term investment projects are being initiated at the same time that the resources needed to see them through to completion are being consumed. As the market guides these projects into their intermediate and late stages, the underlying economic realities become increasingly clear: Not all of the investment undertakings can be profitably completed. On the eve of the bust, distress borrowing allows some producers to finish their projects and minimize their losses. In this phase, the high interest rates bolstered by distress borrowing cause people to curtail their consumption and to save instead. The resources thus freed up constitute an explicit form of “forced saving”–a term used more broadly by Hayek to characterize all the boom-related commitments of resources that are at odds with consumers’ time preferences. With scope for sustaining the boom on the basis of forced saving severely limited, the economy is forced to adjust to a slower growth path.
        The liquidation of some incomplete projects frees up resources to help complete others. The period of liquidation involves higher-than-normal levels of unemployment. While unemployment beyond that associated with inherent frictions in the market is conventionally separated into “structural” and “cyclical” components, the unemployment that accompanies the initial downturn in the Austrian theory is actually a special category of structural unemployment, namely, the unemployment associated with a discoordinated capital structure.
        The sequence of malinvestment and overconsumption followed by forced saving and then liquidation and unemployment characterizes the intertemporal disequilibrium that is summarily described as a business cycle. The Austrian theory of the business cycle is consistent with the more broadly conceived Austrian vision of the market as a process and the price system as a communications network (Hayek, 1945). The theory allows for expectations to affect the course of the cycle and to cause each cyclical episode to differ in its particulars from the preceding ones. However, the assumption of “rational expectations,” as that term has come to be used in modern macroeconomics, would be inconsistent with the Austrian theory. That assumption would collapse the market process into its ultimate outcome on the basis of a supposed knowledge on the part of market participants of the structure of the economy.
        Unlike alternative treatments of the consequences of credit expansion, the Austrian theory focuses on the interest-rate movements and intertemporal resource allocation and only secondarily on changes in the general level of prices. In fact, the most straightforward application of the Austrian theory involves a price level that is not changing–because the increase in the money supply and the increase in real output have offsetting effects. The interwar episode of boom and bust is a prime example in which the economy did actually experience real growth while unduly favorable credit conditions caused the growth path to be unsustainably high. There was no significant price inflation during the 1920s, but the intertemporal misallocation of resources eventually brought the boom to an end.
        With no actual or expected change in the price level, the more common accounts of boom and bust, such as those that hinge on labor-market dynamics associated with the short-run and long-run Phillips curves or those that feature monetary misperception in a more direct way, are simply not applicable to the 1920s. Instead, the near-constant price level during that decade is seen as a hallmark of macroeconomic stability, and the troubles that began in the late 1920s are taken to be independent of the preceding boom. An extended contrast featuring Phillips curves and Hayekian triangles is provided by Bellante and Garrison (1988).
        In the Austrian view, a credit expansion strong enough to cause an actual price inflation does complicate the course of the cycle. Diverse judgments about the magnitude of the inflation premium that attaches to the interest rate can have discoordinating effects that compound the underlying intertemporal discoordination. And as Hayek (1978) notes, a possible lag of expectations behind actuality can allow the central bank to postpone the inevitable downturn. But the point of Hayek’s discussion of accelerating inflation is that there is no simple monetary fix for an economy that finds itself in the final throes of an artificial boom.
        Lionel Robbins (1934) made the case that Austrian theory fits the interwar experience well, though he later repudiated his Austrianism in favor of Keynesianism. Murray Rothbard (1963) drew on the Austrian theory in chronicling America’s interwar experience. Both Hayek and Rothbard (in Mises et al.) suggest that the theory has application to the postwar behavior of the macroeconomy, while contemporary proponents see clear application of the theory in the twenty-first century.
        Recent developments of the Austrian theory of the business cycle include new interpretations of the theory (Skousen, 1990) and reassessments of old debates (Cochran and Glahe, 1999) as well as renewed attention to the theory’s microfoundations (Horwitz, 2000) and a generalization of the business-cycle theory into a more comprehensive capital-based macroeconomics (Garrison, 2001).


Bellante, D. and Garrison, R.(1988), "Phillips Curves and Hayekian Triangles: Two Perspectives on Monetary Dynamics," History of Political Economy, 20(2), 207-234.

Cochran, J. and Glahe, F. (1999), The Hayek-Keynes Debate: Lessons for Current Business Cycle Research, Lampeter, Wales: Edwin Mellen.

Garrison, R. (2001), Time and Money: The Macroeconomics of Capital Structure, London: Routledge.

Hayek, F. A. ([1935] 1967), Prices and Production, 2nd edn, New York: Augustus M. Kelley.

________(1945), "The Use of Knowledge in Society," American Economic Review, 35(4), 519-530.

________([1969] 1978), "Three Elucidations of the Ricardo Effect," in F. A. Hayek, New Studies in Philosophy, Politics, Economics and the History of Ideas, Chicago: University of Chicago Press, 165-178.

Horwitz, S. (2000), Microfoundations and Macroeconomics: An Austrian Perspective, London: Routledge.

Lachmann, L. ([1956] 1978), Capital and Its Structure, Kansas City: Sheed, Andrews and McMeel.

Mises, L. ([1912] 1953), The Theory of Money and Credit, New Haven, Conn: Yale University Press.

________(1966), Human Action: A Treatise on Economics, 3rd  rev. edn, Chicago: Henry Regnery.

Mises L., Haberler, G,. Rothbard, M. and Hayek, F. ([1978] 1996), The Austrian Theory of the Trade Cycle and Other Essays. Auburn, Ala.: Ludwig von Mises Institute.

Robbins, L. ([1934] 1971), The Great Depression, Freeport, N. Y.: Books for Libraries Press.

Rothbard, M. ([1963] 1972) America's Great Depression, 5th  edn, Auburn, Ala.: Ludwig von Mises Institute.

Skousen, M. (1990), The Structure of Production. New York: New York University Press.