Simple explanation of the Austrian Business Cycle

The austrian business cycle can shed light on a few of the reasons for our economic predicament. Most economists who work from this theory predicted the latest bust, long before anyone else. The basic frame starts with the understanding of the connection between people’s future needs and the investment activities that satisfy those needs in a healthy economy.

When people have future needs, like to buy a house, they will save money. They put money in the bank, and the supply of loanable funds increases in that bank. An interest rate is simply the price one can “buy” a loan of those funds, and the law of supply and demand tells us that if the supply of something goes up, the price will go down. So, as people save for future purchases, interest rates go down.

When interest rates go down, businesses can more easily borrow money to produce machines and tools that will provide goods in the future. Also, because of the nature of compounding interest rates, the lower the interest rate, the more likely a business is to purchase a long term loan. This means that at really low interest rates, they can engage in projects that will not produce goods for a longer time. These factors create an amazing natural coordination. As the more people save, the more investment we get to produce the goods people are saving for. When people save for longer terms, we get investment in longer term projects.

The second coordination in a healthy economy has to due with the labor force. As people save, they obviously spend less. When spending goes down, this frees up labor that was engaged in sales type activities. However, the simultaneous increase in investment in long term projects, creates a need for labor in areas such as mining, trucking, and construction. This is essentially how healthy economies shift needs in labor without causing unemployment problems.

Now lets see how a boom/bust cycle can be created. Instead of having free market interest rates, a central bank may dictate a lower than would be natural interest rate. In this case, the lower interest rate does not accompany real savings. People are not saving for future purchases, and may even be going into debt. Meanwhile, the low interest rates lures businesses to invest in long term projects anyway. This creates a strain in the economy requiring labor in both service and sales sectors, as well as mining, trucking and construction. The result is that labor will be pulled in from outside, and immigration exceeds normal levels. This situation is often viewed as a “boom”, but should be viewed as an unsustainable “over heating” of the economy.

Eventually, businesses start to finish their long term projects and roll out big fancy products that only a consumer base that had been saving could afford. In our case here, the consumers were not saving, may even be sunk in debt, and cannot afford the new products. The businesses do not get the sales they expected, and cannot pay their loans. Businesses begin to fail, banks start to fail, and the larger than normal labor force exacerbates the impending unemployment problem. This is the “bust”.

This is far from all the reasons our economy is in the shape it is in now. Unfortunately, it is not the only reason things will get worse before they get even worse, but I hope this post will help someone gain new insights into the problems we have.

Steve Young

About Steve Young

Steve Young is a business intelligence software developer and DBA, and founder of
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