The Austrian Business Cycle Debunked

This video, The Austrian Theory of the Business Cycle | Roger W. Garrison, from the Von Mises University does a good job of explaining the Austrian Business Cycle Theory (ABCT).  The key point is that increasing the rate of savings (capital) results in increased economic growth in the future.  The theory was worked out by Von Mises and Hayek.  The foundation of the theory is very similar to classical economics, which held that economic growth was the result of increases in capital.  The video has a number of charts and graphs to make it look more scientific, however no empirical evidence is provided to support the theory.  Other work may provide empirical evidence, but I know of counter evidence as well.

This article will first discuss ABCT of recessions and some small errors in the theory.  Then I will show that ABCT is incorrect about what causes economic growth and its failure to explain economic history, particularly the Industrial Revolution.

Austrians are always focused on showing that Keynes economic theories are wrong, and they are certainly right about this.  Austrians argue that there is a trade between investment and consumption, which they call the sustainable Production Possibilities Frontier.  Keynesian theory would say there is no difference between consumption and investment.  Certainly there is a trade between investment and consumption.  The Keynesians somehow argue that by eating your seed corn you will be wealthier.  However, a minor problem with ABCT is that it equates savings with investment.  The two are not necessarily the same.

ABCT then states that recessions are caused by Central Banks (the Federal Reserve in the US) arbitrarily lowering interest rates below the market rate, which causes mal-investment and reduces the saving rate.  Unless we narrowly define saving as putting money in a bank, savers have a number of choices which are not directly affected by interest rates.  For instance, savers can put their money in stocks or corporate bonds.  The return on stocks and corporate bonds is more related to the success of the underlying company than the interest rate set by the Central Bank, so the disincentive to save is not a strong as suggested by the ABCT.  The second question is why does this cause mal-investment but increased saving does not.  In both cases the investment intermediary is a commercial bank.  Now if we were talking about direct government spending then the case is clear.  In that case the government is not subject to the market.  However, commercial banks are subject to the market.  If interest rates are lower because of additional savings or because the Central Bank set them lower does not change their loan approval process.  In addition, the ABCT completely ignores tax and regulatory policy.  Are Austrians really saying that recessions can only be caused by Central Banks setting interest rates too low?  Why not too high?  This is why Austrians are obsessed with what Central Banks are doing and seem somewhat oblivious to other issues.

These are not my real complaints with the ABCT however.  My real complaints are 1) recessions happened before there were Central Banks and 2) economic growth is not caused by increases in capital.  Central Banks are a fairly new creation and fractional reserve banks did not exist in the world until around 1650s.  The United States did not have a Central Bank until 1913, but there were recessions before that in the US.  There were certainly recessions in the world before there were banks, including one huge one called the Dark Ages.  ABCT fails to explain the source of all recessions, including the recession of 2001.

ABCT is also wrong on what causes economic growth.  Robert Solow did an econometric study of the US economy to determine how much of the growth was due to increases in labor, how much was due to increases in capital, and how much was due to increasing levels of technology.  According to Wikipedia

[This] technique has been applied to virtually every economy in the world and a common finding is that observed levels of economic growth cannot be explained simply by changes in the stock of capital in the economy or population and labor force growth rates. Hence, technological progress plays a key role in the economic growth of nations, or the lack of it

Robert Solow won the Nobel Prize in economics for this work.  (This is not an endorsement of everything Solow says)

I would change the bolded part to state that the only way to obtain real per capita increases in wealth is through increasing levels of technology.  This becomes more apparent if you look over longer timeframes.  If we had the same technology as our ancestors in 1600, even with today’s total capital, would we be any wealthier than our ancestors?  We would not live longer, we would not be able to produce any faster, the only difference might be that we had more savings to fall back on or disseminate existing technologies.  However there was very little technological change at the time, so the increase in technological dissemination would have been small.  As a result, we would be essentially no wealthier than our ancestors.  Our standard of living is defined by our level of technology.  I discuss this in much more detail in my upcoming book, “Source of Economic Growth.”

Note that the ABCT does not account for technological change.  As a result, the theory should hold up in a technologically static world.  However, this is totally inconsistent with economic history.  The Industrial Revolution started in Great Britain and the United States.  There is no evidence that these countries had larger savings or capital stocks than say France or China or Holland or Japan.  The Industrial Revolution was really a perpetual invention machine, driven by inventions not by capital.  The source of all wealth is the human mind.  The application of the human mind to problems of survival is called inventing, which is how we increase our technological level.

Austrian Business Cycle Theory does not hold up under scrutiny.  Austrians have misidentified the source of economic growth and have a defective model for what causes recessions. Naturally they prescribe the wrong medicine.  Austrian Economics is not pro-capitalism, it is not consistent with the enlightenment, reason, and science, which I have described in other posts.



PS: I mentioned above that the Austrians misdiagnosed the recession of 2001.  They love to say that Greenspan created a bubble economy, which implies that in fact there was no real economic growth in the late 1990s.  The narrative that Greenspan created a credit bubble by holding interest rates too low does not fit the facts.  The economic growth of the late 1990s was built on new technologies that have made our life immeasurably better.  Real incomes and industrial production rose significantly in the late 1990s.  In addition, the effective Fed funds rate in the late 1990s was between 5.5 and 6.5%, which looks tight by today’s standards.  The Federal Reserve’s balance sheet was stable.  There was an inverted yield curve in 2000, which happened as Greenspan was increasing interest rates.  The commodities index was falling slightly in 1999 and rose slightly in 2000.  M1 was essentially flat in the late 1990s and M2 was growing slowly.  The evidence is overwhelming that the recession of 2001 was not caused by Federal Reserve “printing” too much money.  In fact the evidence points to the idea that Greenspan was too restrictive and caused an inverted yield curve in his desire to cause the stock market to cool off, which caused the recession.  It is true that the stock market had gotten ahead of earnings, but recent experiments in economics show this is a common with new investors and is not necessarily the result of easy credit.



6 thoughts on “The Austrian Business Cycle Debunked”

  1. I am a fan of Austrian Economics but enjoy all commentary for and against as that is how we learn and fine tune our understanding. I stopped reading you piece abruptly when you mentioned (not alluded to) action by a government agency. ANY action by the government used to justify ANY premise is prima facie evidence of wrong-headed thinking!

    1. I was a fan of Hayek and generally supported the Austrians for years. Then I found out that the Austrians rejected Locke’s formulation of property rights, which means they reject the very basis on which the United States was founded. Because of this Austrians are against property rights for inventors – patents. They pretend to be pro-Constitution, but the Constitution is clear that the rights of inventors are to be protected. They are also wrong on fractional reserve banking. I investigated why these errors were occurring and found Hayek’s epistemology is anti-reason. He states that Natural Rights are not based in reason, but a cultural social convention, which makes him a moral relativist. Von Mises insists that values and prices in the economy are subjective and he does not mean that each person makes their own decision, he means they are unconnected with reality. ABCT is incorrect. They are correct that the Federal Reserve is a huge problem, but they are wrong about the source of economic growth and that all recessions are caused by the Fed.

  2. The underlying reason that savings does not equate with investment is Federal Reserve control over the value of the currency. The value ascribed to newly printing dollars comes at the expense every dollar already printed. So the Fed is essentially stealing everyone’s savings to create these new notes and passing that value to the banks who lend it out for investment.

    Quantitative easing translates to investment (Mal-investment to be sure :)

    If the FED was not able to print money (based on buying treasuries) and interest rates were market based THEN savings would correlate with investment.

    Technology and increases in production due to technology is the only source of growth. The constant theft of the government (which appears as price inflation but is really the Deflation of the value of the currency hence prices must adjust upwards) is hidden by the deflation of prices due to technology. That’s the only reason the government can get away with it and not kill the economy.

    In the end everyone could have been 100 times richer, and the economy much larger, if the government didn’t take it all.

  3. Hi Dale

    I’m afraid if you’ve only watched Roger’s excellent video of the mechanics of the bust then you’re criticising a straw man, since your “real complaints are 1) recessions happened before there were Central Banks and 2) economic growth is not caused by increases in capital,” neither of which Roger tries to or is able (or is required) to address in a one-hour lecture, but both have been well addressed elsewhere, not least in Von Mises’s and Roger’s books.

    We know how frustrating it is seeing someone criticising AR without actually understanding her first. I’m afraid I see you doing the same here. I won’t labour the point here, because there’s plenty of good reading to do that will make the point well enough.

    1) You say “recessions happened before there were Central Banks”: Yes, they did, and as Mises points out in both ‘Theory of Money & Credit’ and ‘Human Action,’ the diagnosis is the same: an increase in fiat or irredeemable currency, which happened before there were Central Banks because there was fiat or irredeemable currency being issued before central banks.

    Simplest place to start here is Chapter XX of ‘Human Action’ especially Mises’ discussion of the debates between the British Currency and Banking Schools.

    For more pre-central bank history, try Rothbard’s ‘HIstory of Money & Banking in the USA.’

    2) YOu say “economic growth is not caused by increases in capital”: perhaps you meant to say economic growth is not caused ONLY by increases in capital, on which we — and Roger and Mises and Schumpeter and Joan Robinson and Roy Harrod and Solow and Uncle Tom Cobley and all — can surely agree.

    Neither Garrison nor Mises discounts the role of technological advance, far from it, but you can’t expect to hear everything in a one-hour video.

    Perhaps on this one start with his ‘Capital Supply & American Prosperity,’ to understand how capital and technological advances lean on each other. [Article is contained in his excellent book ‘Planning for Freedom’ ]

    Then read Garrison’s superb book ‘Time and Money’ for his full story of how growth happens, and busts follow from unsustainable booms, and (on pages 56-61) the role he sees for technology and invention in growth.

    And maybe read Objectivist Austro-Classical George Reisman on the same thing. I won’t try to give you all the pages, since the subject takes up more than a column in his book’s index, pages 1042-1043. [Download a PDF copy of his book at

    PS: Reagrding your last comment: Once again your brush is broader than your target. The Mises Institite had certainly come under the thrall of a particularly egregious scumbag called Kinsella, who persuaded many of them against intellectual property. But this is not an Austrian position. It is simply a Mises Institute position, and a wrong one.

  4. Hi Peter,

    Please post your reply in Galt’s Gulch ( also. I always appreciate your input.

    1) Not all recession are the result of expansive monetary policy, whether Central Banks, Fractional Reserve Banks, or fiat money. The 2001 recession in the US was caused by too tight of a monetary policy and the 2008 recession was caused by underlying regulatory issues first and foremost, particularly the changes to US patent laws, and Sarbanes Oxley. The easy credit was not the primary cause and really not the Feds fault, but the fault of Freddie and Fannie. Easy monetary policy did not create or at least continue the Dark Ages for that long.

    2) The Austrians’ position (or at least most Austrians) on the cause of economic growth is increases in capital, which was the standard classical economics point of view. Classical economists believed that inventions are the result of capital. Seems to be pretty much what the Austrians are saying. This is not correct. Inventions, new technology, create excess capital not the other way around. Raising man’s level of technology is the only way to increase real per capita income and inventions are how you increase man’s level of technology.

    The evidence for increasing levels of technology to be the cause of economic growth (for any large group of people or any extended time frame) is pretty overwhelming. From Robert Solow’s analysis of the causes of economics growth, to Paul Romer (not an endorsement of all of Romer or Solow’s ideas) and other’s refinements, to the fact that this explains where, when, and why the Industrial Revolution occurred, to the fact that this is consistent with man being a rational animal (not a capital animal). I provide extensive evidence on this point in my forth coming book, Source of Economic Growth.

    3) Austrians on property rights. Hayek was clear that he did not believe natural rights are derived from reason or “correct” in any fundamental sense. He stated that natural rights and property rights were the result of some sort of cultural evolution. So I think Kinsella’s point of view is completely consistent with Hayek. I am not as familiar with Von Mises and you, but I have searched and do not see that he presented a theory of property rights.

    I don’t think that I have misrepresented the Austrians’ position. Of course Austrians are not monolithic, so to some extent I am talking about the great majority of people who associate with the Austrians today. That group is not for Natural Rights, they believe in a utilitarian model of property rights, they believe in a subjective (disconnected from reality) view of prices and values in economics, they believe reason is limited fundamentally, not just is the sense that not all economic information can be discovered by one person. They also misrepresent what fractional reserve banking is and how it works and they ignore that this is essentially what a bond is.

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