362

Revista economica No. 2 (55) /2011

BUSINESS CYCLE. AN AUSTRIAN VIEW

IFRIM Mihaela1, IGNAT Ion2
Junior teaching assistant, Faculty of Economics and Business Administration,Al.I.Cuza
University, Iai, Romania, e-mail mihaifrim@yahoo.com
2
Professor, Faculty of Economics and Business Administration,Al.I.Cuza University, Iai, Romania,
e-mail ignation@uaic.ro
Abstract: Approaching the economic cycle phenomenon is not an easy undertaking, because its explanations
is fundamentally linked to how each school of economic thought perceive the functioning of the market, the nature of
equilibrium and the role of the state. Moreover, even the theoretical approach to the business cycle is a cyclical one,
recessions being always periods in which these concerns abound. Various theories of business cycle often emphasize
the importance of one factor in triggering the crisis. Thus, the crisis is explained by climate fluctuations, innovation,
underconsumption, over-capitalization, excessive credits or consumer pshichological changes. The aim of our work is
to distinguish the economic fluctuation from business cycle and to analyze the cyclical recurrence from the Austrian
economists perspective.
Key words: business cycle, credit expansion, interest rate, misinvestition, Austrian School of Economics
JEL classification: E22, E32, E43

1. Cyclicity feature of economic life

It is important, first, to distinguish between business cycles and business fluctuations. Business
fluctuations are changes taking place continually in all spheres of the economy. Consumer tastes shift; time
preferences change; the labor force changes in quantity, quality; natural resources are discovered and others
are used up; technological changes alter production possibilities; vagaries of climate alter crops, etc. All
these changes are typical features of any economic system. We experience daily, weekly, seasonal and
annual economic fluctuations. If we often seem to neglect the daily and weekly fluctuations, when we talk
about business cycles, with its ups and downs and especially its inherent crisis, the perception is changing
and the concerns are certainly more intense
Economic activity have a certain daily cadence - factories have manufacturing activity in a certain
time frame and are closed in the afternoon when workers return to their homes, shops are open during certain
hours, service providers have an announced business hours. All these give a fast pace to economic activity
throughout the day, followed by a relative contraction during the night.
The same thing happens in the case of weekly fluctuations. We know that economic activity restrains
in the weekend and will resume their pace once the workers return to their activities. This type of fluctuation
is also typical for longer periods, for example the annual ones. Sales are higher every year around Christmas
and the largest number of registered unemployed is usually in February. This annual cyclicity is even more
evident when it comes to seasonal activities. Workers in agriculture know a peak of activity during the
summer months, followed by a tightening of activity with the coming of autumn and its termination during
the winter. Despite this obvious cyclicity, the daily, weekly and even annual economic fluctuations seem not
to generate major concerns for analysts or business men. The explanation lies in the fact that this economic
activity cyclicity is characterized primarily by regularity and predictability, by a natural succession of
periods of expansion and contraction. But things are different when we reffer to business cycles.
Unlike weekly or annual cycles, business cycles are not regular. Its phases, while repetitive, have
very different duration, intensity and scope. Business cycles usually extend over several years and cover all
production, commercial and financial activities of a society. If in the case of daily, weekly or annual cycles
habit is one of the defining elements, not the same thing happens with business cycles, which, even if assume
in their turn repetition, can not be caught in some safe pattern. This time, uncertainty is the feature that
always accompanies the business cycles phases.
While recognizing that the existence of some imbalances sometimes can anticipate crisis and
recession, it is very difficult to determine their magnitude, their phase synchronization and the necessary
adjustments. In other words, unlike the common fluctuations in daily, monthly or annual economic activity,
business cycles lack the "brevity, simplicity, regularity and reliability or predictability" (Burns, 1969, p.8).
Thus, although the business cycle is often a path to progress, it creates instability in society, being almost
impossible to estimate how long will it last, how many companies will close their doors and what will be the
number of people left without jobs.
362

Revista economica No. 2 (55) /2011

363

2. The business cycle causes and occurrence

Recessions are the most prosperous periods in terms of the economists' concerns for the business
cycle. They are seeking for culprits, make comparisons with older or newer crises and are discussing
possible remedies for the recovery of the economy. But even these concerns are cyclical, once the crisis
passed, the causes that determined it are forgotten and the measures to avoid a future contraction are
abandoned in the economists drawers.
The history of theories that have attempted to explain cyclical phenomenon already extend over two
hundred years, J.B. Say and David Ricardo being among the first who observe its causes and implications.
Although we had expected that this long period of searching for a better understanding of the business cycle,
its determinants and its propagation mechanism will provide solutions to prevent or tame it, the current
reality is far to confirm this supposition. Moreover, the impossibility of finding a solution for cyclical
recurrence of crisis puts in some places into question the very legitimacy of the market economy.
From the multitude of approaches to the business cycle, we stopped on its relationship with the
market economy. This is because there is a dual vision of this relationship, some economists believing that
economic cycles are phenomena closely related to the market economy functionality, an inherent part of the
market process, while others characterize them as rather disruptions of the free market process. We accept
the second approach, considering the business cycle is not an inherent phenomenon in the exchange
economy, but a result of some external factors intervention, namely the government.
The modern vision of the business cycle is linked to the name of Karl Marx, who observed the
recurrence of upwarding and downwarding phases in the same time with the industrial revolution and the
emergence of market economy. There were economic crises, for sure, even before the eighteenth century, but
the lack of a regular succession of expansions and recessions made Marx to consider the business cycle as an
inherent, profound feature, of the market economy. This doctrinal origin should put thoughts, given that
more and more schools of economic thought blame the market for the existence of business cycles, for its
inability to be self-regulating. If, according to Marx, recurrent recessions and their tightening will revolt
masses against the free market economy system, contemporary economists, representatives of the economic
mainstream, see in government the solution to respond to crisis. Unlike mainstream economics, the Austrian
economists advocate for limiting the role of the state, its intervention on the loan process being actually
considered responsible for triggering crisis.
Austrian business cycle theory is based on the connection between price theory, capital theory and
monetary theory. Its own elements are classified, according to Garrison (1986) in seven categories, with a
high degree of complementarity:
1. Prices are signals. Prices are a real communications network, providing signals about consumer
preferences, about the abundance or the scarcity of resources available, being in fact a basis for economic
coordination. When prices are subject to an inflationary process of credit expansion, they determine
discoordination in the economy.
2. The interest rate facilitates intertemporal coordination. The interest rate determines the equality of
savings - investment. The changing interest rates affect not only the overall investment, but also their
orientation, a low rate favoring investments with a longer time horizon. The interest rate coordinates
intertemporaly the preference to consumption with the preference to saving.
3. Money can masquerade as saving. Additional money in the economy through credit supply
eliminates the relationship between savings and investment. An artificially low interest rate stimulates
investors to borrow, while owners of income actually save less. Thus, it is lost the connection between
investment, savings and consumption preferences of the individuals. Lack of intertemporal coordination
translates into more investment in long-term projects, which practically are needless.
4. Capital is characterized by intertemporal complementarity. Capital goods are linked one with
another by different degrees of substitutability and complementarity. Investments involve a diversion of
resources from early stages of production to the late stages. Intertemporal discoordination determined by an
artificially low interest rate manifests itself initially as an overinvestment in higher - order capital goods.
5. The Ricardo Effect. This effect refers to the substitution of higher-order capital goods and lowerorder capital goods. This is necessary the following statement: Carl Menger (2007) is the one who developed
the concept of temporal structure of capital goods, according to which capital goods are different depending
on the time horizon during which they can be obtained. Lower order capital goods, such as inventory, are
those moving quickly into the economy. Higher ordered capital goods, such as real estate construction, have
a long period of production. Higher-ordered capital goods are the most sensitive to interest rates, as the asset
is held for a long time. In the initial phase of the business cycle, reduced interest rates encourage investments
363

364

Revista economica No. 2 (55) /2011

in higher-order capital goods. Simultaneously, increases the demand for complementary capital goods equipment, machines, etc.., which are increasing their prices. The additional need for funding translates into
pressure on credit markets and so interest rate rises. A higher interest rate would discourage further
investment in higher-order capital goods and will even contribute to the release of ongoing projects.
6. Mills Fourth Fundamental Proposition. According to Mill, a reduction in consumption does not
necessarily mean a reduction in demand for inputs. Increase savings justify a future increase in consumption
and an increase of the current demand of resources for future production. This observation is assimilated by
the Austrians to the fact that in some periods the consumer spending and investment have different
directions. There are, specifically, a shift of resources between consumption activities and investment due to
changes in intertemporal preferences for consumption.
7. Two kinds of knowledge. Entrepreneurs are oriented by the wrong signals from monetary
manipulation. This is possible due to the fact that economic agents do not know enough about consumer
preferences, resource availability or the plans of other market participants. Entrepreneurs know actually
some particular circumstances of time and place, lacking the knowledge about how the economic system
works. Consequently, they act according to price signals and when prices are distorted because of monetary
authorities' intervention, they act wrong.
In the Austrian School view, the monetary authorities distort economic reality through the policy of
bank lending encouragement and send wrong signals to the market operators which are oriented in wrong
directions. Although commercial banks are often indicated as being responsible for the uncontrolled
monetary expansion, they would never be able to do this without governamental, monetary authorities help.
So, banking sector, itself a product of capitalism, is far from causing alone economic fluctuations.
Governamental interference in the activity of banks, especially through the maintenance of fractional reserve
and expanded lending, is the one which creates turbulence in the economy (de Soto, 2010).
The responsibility of commercial banks in triggering economic boom is emphasized in the early
nineteenth century by David Ricardo, which examined the effect of inflationary credit expansion prices on
the balance of payments. Thus, massive outflows of currency due to increased demand for imported goods
and the declining competitiveness of domestic products causes an opposite reaction from banks, the credit
contraction placing the economy on a downward trend. The contraction of the economy leads to lower
prices, increase national competitiveness and reverse the balance of payments.
According to Rothbard (2000), business cycle theory should provide explanations for at least three
phenomena: why exists in the same time such a large number of entrepreneurial error, why capital goods
industries fluctuate more than consumer goods industries and why the money supply increases during the
boom. The response for the money supply growth is already offered by David Ricardo because of bank credit
expansion, expansion achieved with the direct involvement of the monetary authorities. In connection with
this expansion must be put the wrong orientation of the entrepreneurs toward unfortunate investment, which
economy actually do not needs. The large number of misinvestments revealed with the outbreak of the crisis
(as the entrepreneurial function of prediction has a very important role in natural selection of the
entrepreneurs) can be explained only because of wrong signals received by the economic agents. Injecting
money in economy at a low interest rate, without this situation to be determined by an increase of savings,
stimulate entrepreneurs to invest in longer production processes, in capital goods from a greater distance
from consumer. Investments are oriented from "lower" (near the consumer) goods to the "higher" orders of
production (furthest from the consumer), from consumer goods to capital goods industries. But this shift in
investment is not based on changing consumer preferences. Relationship between propensity to consume and
to invest has not changed, time preference is the same. Basically, consumers still prefer the consumption of
consumer goods. But this shift in investment is not based on changed consumer preferences. Demand will
shift back from the higher to the lower orders goods. Investments in capital goods industries prove to be
wrong because of the low demand for such goods. Wrong oriented investments must be liquidated. In this
case not underconsumption generates crisis, because not consumer goods, but the capital goods enter in a
contraction process. The lack of demand for capital goods, when their offer is not based on the consumer
preferences reality, is the one that determines crisis. And here it was because of business forecasting function
failure, following the wrong signals offered by the artificial, interventionist interest rate
The inflationary boom has generated distortion in the production and prices systems. Prices of labor
and raw materials in the capital goods industries have grown too much to be profitable. The fact that the
downward phase of the economic cycle is not installed immediately, and expansionary boom sometimes
takes years, is because lending is not a one shot process type, but a continuous one, retarding the growth of
costs in capital goods industries and relocate the naturally report between saving and consumption.
364

Revista economica No. 2 (55) /2011

365

Continued expansion of credit can be likened to the doping of an athlete who overcome itself on the short
run, but when the excitant is stopped, his performances are clearly lower. When banks begin to experience
problems, or when inflation is a phenomenon too worrying for the authorities, credit is limited and the
economy is undergoing a process of adjustment to eliminate the unfortunate oriented investments and to
ground on sound fundamentals. Depression is thus regarded as a "necessary and healthy" phase (Rothbard,
2009), which correct the wrong oriented investments, restoring the real proportion between consumption and
investment.
The question that arises naturally is why the cyclical phenomenon is a recurrent one? The answer
seems to be linked to the constantly appetite of banks for profit, to their natural inclination to expand credit.
But this would not be possible without a monetary authority, a central bank to encourage this expansion.
Encouraging lending determines, in addition to a general rise in prices in the economy, an artificially
reducing of the interest rate below its natural, free market level. The distorting effect of the interest rate
through credit expansion is one of the key elements of the Austrian business cycle theory. Its supporters
consider that the interest rate is an expression of time preference of individuals. A loan is a present good
which is changed for other future good, a document certifying the existence of a debt. But individuals always
prefer present money over those in the future, which makes current assets have a higher opportunity cost
than the future ones. This opportunity cost is actually the interest rate, its size varying according to the
individuals time preference. This time preference also affects the propensity for consumption to savings. A
low time preference decreases the demand for current goods, individuals preferring to save and invest more,
which contributes to lower interest rates. Decreased time preference and interest rate, is thus consonant with
economic growth. Things are not so when interest rates do not reflect the time preference of individuals, but
is the result of interference of the monetary authorities.
3.

Laissez-faire as measure against business cycle?

The outbreak of crisis, as part of the business cycle, is closely linked to government intervention,
through measures of credit stimulating. If the state does not encourage such practices, the economy would
work in its natural rhythm. Investments will always rely on savings and the entrepreneurs decision to invest
will be based on a natural interest rate, which correctly express the consumers time preferences. Credit
contraction during recessions appears therefore as a corrective measure of relocation the correct ratio
between consumption and saving. Prolonged monetary authorities intervention on interest rate in order to
maintain a high level of lending and continue basically to inject money into the economy, it will only delay
the inevitable. The market is one that imposes lastly its rules. Basically, the depression is a necessary
response to the previous expansion, a correction of the excesses and distortions generated by the previous
expansionary measures (Rothbard, 2009).
The Austrian view on the prevention of cyclical movements in the economy suggests avoiding
inflationary measures, even if they hasten the end of the boom and precipitate depression. This is however
seen as the only way to eliminate distortions in the economy and return to healthy growth. Government
should also refrain to save businesses affected by the crisis; his support will only prolong the agony of them.
To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which
brought it about; because we are suffering from a misdirection of production, we want to create further
misdirectiona procedure that can only lead to a much more severe crisis as soon as the credit expansion
comes to an end (Hayek, 2008).
To stimulate consumption by increasing government spending is also a measure which should be
avoided because it will only increase the consumption-investment ratio. The economy does not need more
consumption, but more savings, in order to validate some of the excessive investment during the boom.
According to Mises, the government should adopt a "laissez-faire" policy, meaning, in fact, to do nothing,
leaving the market to be self-regulated. Any action coming from the state will only hinder the process of selfregulation of the market, delaying economic recovery. Austrian prescription is opposite of the Keynesian
one: the state should limit its spending, stop inflation and raise its hands from the economy.
4.

Conclusions
The Austrian business cycle theory is, in fact, the economic analysis of the necessary consequences
of intervention in the free market by bank credit expansion. Intervention is the one that changes interest rate,
it loosing its role as a measure for individual time preference, as a ratio between consumption and saving.
Wrong signals transmitted by the low interest rate determine businessmen to invest in capital goods that
previously did not seem profitable. Additional money in the economy created through credit expansion
365

366

Revista economica No. 2 (55) /2011

contribute to the rise of wages in the capital goods industries, but how these money will be spent will be
based on actual ratio between the propensity to consume and to save. Individuals time preference has not
changed, they still preferring consumer goods, so investments in capital goods prove to be misdirected.
Summing up, the boom is the period of misdirected investment as a result of free market
manipulation by monetary authorities, through bank loans. Crisis occurs when consumers restore their
desired proportion between consumption and saving. And depression is nothing but the market process of
adjusting the errors caused by the artificially boom and reestablishing the optimum ratio of consumer
preferences.
The essence of the Austrian business cycle theory can be found in Fritz Machlup's statement that
"monetary factors cause the cycle, but real phenomena constitute it" (1976, p. 23). The focus is rather on
"relative prices matter" rather than famous claims "money matters". The changes induced by monetary policy
mainly affect relative prices, causing changes in the allocation of resources pattern. This is basically the core
of Austrian theory. Money injection into the economy, as a result of government intervention, affects the
allocation of resources over time, the intertemporal structure of capital, based on the interest rate. Cyclicity is
therefore based on a temporal disruption of the intertemporal market mechanisms (Garrison, 1989).
From this point of view, the Austrian business cycle theory is an exogenous one, considering that
perturbations are caused and not features of market economies. The endogenous element refers to prices
movement during recessions and to return to a normal state of the economy. In other words, a force outside
market, the central bank, can initiate an artificial growth, but inflationary boom contains the seeds of its own
decay, market forces brought into operation generating correction through recession.
Business cycles are not an inherent feature of the market economy, its reasoning being not the same
to common economic fluctuations. Crisis and depressions are both consequences of the authorities
intervention in the market mechanism and are basically the natural adjusting reaction of the economy. In
order to avoid crisis, economy should be let to follow its own path, without the state intervention. The
prescription is a simple laissez faire.
5.
References
Burns A.F. (1969) The Business Cycle in a Changing World, National Bureau of Economic
Research Book Series Studies in Business Cycles, p. 8. Available at
http://www.nber.org/books/burn69-1
Hayek F.A. (2008) Monetary Theory and the Trade Cycle, in Prices and Production and
Other Works:F.A. Hayek on Money, the Business Cycle and the Gold Standard, Ludwig von
Mises Institute, Auburn, Alabama
Garrison R.W. (1986), Hayekian Trade Cycle Theory: A Reappraisal, Cato Journal, vol. 6,
no.2, pp.437-459. Available at http://www.cato.org/pubs/journal/cj6n2/cj6n2-5.pdf
Garrison R.W. (1989), The Austrian Theory of the Business Cycle In the Light of Modern
Macroeconomics, Review of Austrian Economics, vol. 3, pp. 3-89. Available at
http://mises.org/journals/rae/pdf/rae3_1_1.pdf
Machlup F. (2003), Hayek's Contribution to Economics, in Machlup, ed., Essays on
Hayek. Routledge Library Editions - Economics, London, pp. 13-59
Menger C. (2007) Principles of Economics, Ludwig von Mises Institute, Auburn, Alabama
Mises L.v. (1998) Human Action. A Treatise on Economics, Ludwig von Mises Institute,
Auburn, Alabama

Rpke W.(1936), Crisis and Cycles, W. Hodge & Company, London

Rothbard M. N (2000) Americas Great Depression, fifth edition, Ludwig von Mises Institute
Rothbard M. N (2009) Economic Depressions, Their Cause and Cure, Ludwig von Mises
Institute, Auburn, Alabama
Soto J.H.de (2010) Moneda, creditul bancar i ciclurile economice, Editura Universitii
Al.I.Cuza, Iai

366