Economic fluctuations have existed throughout history (e.g., a failed crop or a technological innovation which disrupts a particular industry), but such fluctuations were not cyclical until the 19th century. Unfortunately, these business cycles coincided with the Industrial Revolution, and hence capitalism was blamed. But that century birthed another institution: central banking. Which is responsible for business cycles?
To be viable, a business cycle theory needs to explain three phenomena which are always observed:
- The cluster of error in judgment by businesses. Why do successful businesses, having survived their competitors by better planning for the future, suddenly suffer losses en masse?
- The greater cyclicality experienced by industries producing capital goods (e.g., construction, machinery & equipment, etc.) relative to that of consumer-goods industries (e.g., food, pharmaceuticals, etc.) Why do companies in the capital-goods industries perform better (during the “boom” of a business cycle) and then worse (during a recession) than companies in the consumer-goods industries?
- The rise and then fall in the money supply. Why does every “boom” period of the business cycle shadow an increase in the supply of money while there is sometimes (but not always) a reduction in the supply of money during a recession?
To explain these, the Austrian theory depicts a typical business cycle as follows: In the beginning, the government increases the supply of money, which artificially decreases interest rates. Interest rates are a universal market signal to all businesses, so suddenly investments which previously appeared unprofitable now make economic sense. However, the attractiveness of these projects is a mirage. These borrowed funds are actually being “malinvested” given the “true” level of interest rates absent the artificial stimulus. As investments in the capital-goods industry projects are the longest dated, they are the most sensitive to changes in interest rates. This makes them the most prone to downturns.
As the central banks continue to increase the money supply, they eventually risk significant inflation or a financially unstable banking system. At this point, the central bank may choose to limit their money printing, triggering an ensuing downturn and disruptive liquidation of the malinvestments made on the premise of artificially low interest rates. This is known as a recession. Recessions, while they may be postponed, cannot be avoided. As Ludwig von Mises wrote:
There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only 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.
To “fix” or “stop” a recession, central banks return to printing more money, sowing the seeds of the next boom and bust cycle. The Austrian theory of the business cycle thereby explains the cyclical nature of economic fluctuations. It also describes causes for the three phenomena observed in every cycle. Finally, the theory accounts for the historical timing of business cycles. Specifically, why they primarily originated in the 19th century and have become more pronounced in the U.S. since the establishment of the Federal Reserve in 1913.
Investors have been living in a world of increasing booms and busts as central banks continue to manipulate the system. However, today the stakes are much higher. The amount of money printed since the 2008 downturn makes this next recession even more dangerous for investors.
