According to Ludwig von Mises’s Austrian Business Cycle Theory (ABCT), the artificial lowering of interest rates by the central bank leads to a misallocation of resources due to the fact that businesses undertake various capital projects that prior to the lowering of interest rates weren’t considered viable. This misallocation of resources is commonly described as an economic boom.
Once the central bank reverses its stance this sets in motion an economic bust. It follows then that the artificial lowering of interest rates sets a trap for businessmen by luring them into unsustainable business activities that are revealed as such once the central bank tightens its interest rate stance.
Critics of the ABCT maintain that there is no justification that businessmen should fall prey repeatedly to an artificial lowering of interest rates. Businessmen are likely to learn from experience, the critics argue, and not fall into the trap produced by an artificial lowering of interest rates. Consequently, correct expectations will undo or neutralize the whole process of the boom-bust cycle that is set in motion by the artificial lowering of interest rates. Hence critics are questioning the validity of the ABCT.
Even Mises himself had conceded that it is possible that some time in the future businessmen will stop responding to loose monetary policy thereby preventing the setting in motion of the boom-bust cycle. In his reply to Lachmann he wrote,
It may be that businessmen will in the future react to credit expansion in another manner than they did in the past. It may be that they will avoid using for an expansion of their operations the easy money available, because they will keep in mind the inevitable end of the boom. Some signs forebode such a change. But it is too early to make a positive statement.
Do Expectations Matter?
According to the critics then, if one allows for the possibility of expectations this could prevent boom-bust cycles. If businessmen were to correctly anticipate that the artificial lowering of interest rates is likely to be followed sometime in the future by a tighter interest rate stance, their conduct in response to this anticipation will neutralize the occurrence of the boom-bust cycle phenomenon.
This way of thinking would be valid if the issue would have been only the artificial lowering and then lifting of interest rates. If this was the case then the critics of the ABCT would have a valid case. There is no doubt that businessmen would have quickly learned to disregard the ups and downs in interest rates and would have utilised some long-term average of interest rates in their investment decision process.
The ABCT however, is not just about plain variations in interest rates, but about variations in the monetary policy of the central bank, which amounts to changes in money supply, and in turn in interest rates. Furthermore, the key factor that businessmen respond to is changes in market conditions as reflected by relative changes in demands for various goods and services and not just interest rates as such.
Here is why.
In a free, unhampered market economy, there will be a harmonious and sustained change in the pattern of consumption with a rise in consumers’ real wealth. This harmony, however, is disrupted when the central bank loosens its monetary stance and sets in motion the expansion of commercial banks credit out of “thin air”. Now, the expansion in banks’ credit, i.e., credit out of “thin air”, begins with a particular individual or a group of individuals—there are always first receivers of money out of “thin air”.
The first borrowers are the greatest beneficiaries of the new credit since they are the first receivers of the newly created money out of “thin air”—their purchasing power has increased. The early recipients can now purchase a greater amount of goods while the prices of these goods are still unaffected.
Because the early recipients of money are much wealthier now than before the monetary injections took place, they are likely to alter their patterns of consumption. The increase in the purchasing power, while boosting the demand for goods and services of the early recipients of money, also gives rise to demand for goods, which, prior to monetary expansion, would not have been considered at all. With a greater purchasing power at their disposal, their demand for less essential goods and services expands.
(As a result of the loose monetary policy of the central bank, the composition of goods purchased is now likely to change. A greater proportion of luxuries in relation to basic goods and services is likely to emerge).
This change in the pattern of consumption is likely to draw the attention of entrepreneurs—after all, they are in the business of “making money”, implying that to succeed in this endeavor they must obey the wishes of consumers.
According to Mises,
“In the capitalist system of society’s economic organization the entrepreneurs determine the course of production. In the performance of this function they are unconditionally and totally subject to the sovereignty of the buying public, the consumers.”
Consequently, this sets in motion investments in the infrastructure to accommodate a greater demand for less essential goods so to speak; i.e., more luxurious goods.
Once loose monetary policy is reversed the transfer of real wealth towards the first recipients of money from the last recipients stops. This in turn lowers demands for various non-essential goods. All this in turn undermines various capital goods projects that sprang up on the back of the previous loose monetary policy and an economic bust emerges. (Remember the new infrastructure to accommodate the demand for more luxuries goods is now becomes idle – the demand for luxuries goods weakens in response to a tighter monetary stance of the central bank).
The question then is: how could correct expectations regarding the monetary policy of the central bank prevent the boom-bust cycle?
The job of businessmen is to stay on guard as far as consumers’ demands are concerned. So whenever they observe a growing demand they react to this. For instance if a builder refuses to act on a growing demand for houses because he believes that this is on account of loose monetary policy of the central bank and cannot be sustainable, then he will be out of business very quickly.
To be in the building business means that he must be in tune with the demand for housing. Likewise, any other businessman in a given field will have to respond to changes in the demand in the area of his involvement if he wants to stay in this business.
Hence, a businessman has only two options—either to be in a particular business or not to be there at all. Once he has decided to be in a given business this means that the businessman is likely to respond to changes in the demand for goods and services in this particular business irrespective of the underlying causes behind the changes in the demand. Failing to do so will put him out of business very quickly.
Furthermore, the knowledge of the ABCT does not imply that one can know the duration of the boom and hence when the bust will emerge. Without this knowledge however, the only way to neutralize the effect of loose monetary policy is by not participating in the boom, but this again means staying out of the business altogether.
Boom-bust cycles and the free market
The key to the ABCT is not that monetary pumping sets in motion the boom-bust cycle as such, but that this cycle is recurrent. Now, in a free market, without the existence of the central bank, if a particular bank decides to practice fractional reserve banking, i.e., lending that is not backed up by money proper then this bank can set in motion a boom-bust cycle.
However, it is doubtful whether the bank could practice this expansion for too long since it runs the risk of not being able to clear its checks and thus go bankrupt. In other words, in the framework of a true free market, without a central monetary authority, the phenomenon of boom-bust cycles would have difficulty in arising since the incentive to practice fractional reserve banking is not very attractive. Hence, contrary to popular thinking, boom-bust cycles cannot be regarded as part and parcel of the free-market economy.
According to Rothbard,
Banks can only expand comfortably in unison when a Central Bank exists, essentially a governmental bank, enjoying a monopoly of government business, and a privileged position imposed by government over the entire banking system. It is only when central banking got established that the banks were able to expand for any length of time and the familiar business cycle got underway in the modern world.
We suggest that the systematic intervention of the central bank sets the platform for the recurrent boom-bust cycles. For instance, when the economy is perceived as not expanding quickly enough the central bank loosens its monetary stance. This in turn gives rise to various bubble activities – an economic boom emerges. Once the boom is perceived as being too strong, the central bank tightens its monetary stance. This undermines various bubble activities that emerged on the back of previous loose monetary policy – an economic bust is now set in motion. Once the slump becomes too “painful”, the central bank loosens its monetary stance – setting in motion new economic boom. Therefore, the process of systematic intervention by the central bank generates new booms that follow by a bust.
The validity of the Austrian Business Cycle Theory (ABCT) remains intact despite popular claims that it breaks down once it is assumed that people learn from the past and are unlikely to commit the same errors repeatedly. Furthermore, boom-bust cycles are not a product of the free market economy, but on the contrary are the outcome of the existence of the central monetary authority. It is the systematic intervention of this authority, which sets in motion the phenomenon of recurrent boom-bust cycles.
 Gordon Tullock, “Why the Austrians are wrong about depressions”, The Review of Austrian Economics, vol 2, 1987. Also see Ludwig M. Lachmann, “The role of expectations in economics as a social science”, Economica, February 1943. Also, Salerno’s Comment on Tullock and Tullock’s reply to Salerno.
 Ludwig von Mises, “Elastic expectations and the Austrian Theory of the Trade Cycle,” Economica, August 1943.
 Ludwig von Mises, “Profit and Loss,” Libertarian Press, p 108.
 Murray N. Rothbard, The Austrian Theory of the Trade Cycle p. 78-79, Ludwig von Mises Institute. See also Jorg Guido Hulsmann, “Toward a General Theory of Error Cycles”, the Quarterly Journal of Austrian Economics, winter 1998, volume 1, number 4.