NCPA - National Center for Policy Analysis

Renewed Interest in "Austrian" Theory of The Business Cycle

January 30, 2002

Searching for the cause of the current recession, economists are rediscovering the "Austrian" theory of the business cycle, says syndicated columnist and NCPA Senior Fellow Bruce Bartlett.

This month the International Monetary Fund published a paper on the subject by economist Stefan Erik Oppers. And articles mentioning Austrian theory have popped up recently in Forbes, Barron's and the Financial Times.

There has also been renewed interest in the great Swedish economist Knut Wicksell, who believed there is a "natural" rate of interest which ensures that saving and investment are appropriately matched.

Following Wicksell's interest rate theory, in the 1920s Austrian economists Ludwig von Mises and Friedrich Hayek theorized that business cycles are caused primarily by central banks' use of monetary policy to lower the interest rate from its free market level. This leads to an economic boom, followed by the inevitable bust.

  • To the Austrians, the interest rate is the central price for the entire economy, because it establishes the discount rate for all investment decisions.
  • Business cycles are caused mainly by a misallocation of resources (or malinvestment) on the basis of interest rates manipulated by the central bank.
  • Once the bust comes, interest rates must be allowed to readjust to the natural rate while the economy reallocates resources properly.
  • The Austrian theory was very popular until the Great Depression, when the problem did not appear to be overinvestment, but underconsumption.

However, economists studying the current business cycle note that heavy capital investment in the Internet and high technology fueled the boom, which later collapsed. Since the end of last year, real nonresidential fixed investment has fallen 6 percent, explaining almost all of the decline in economic growth. By contrast, real consumption has risen.

Thus the Austrian theory appears to explain the current recession.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, January 30, 2002. See also Stefan Erik Oppers, "The Austrian Theory of Business Cycles: Old Lessons for Modern Economic Policy?" IMF Working Paper WP02/02, January 2002, International Monetary Fund.

For IMF paper


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