The Austrian business cycle theory and the crisis of 2008

Mohammad Aazab Banaras

Student thesis: Master thesis


The Austrian Business Cycle Theory (ABCT) is a theory that describes the events of boom and busts in an economy. It has it’s foundations with Carl Menger, Freidrich Von Mieser and Eugen Von Böhm-Bawerk. The theory begins with describing how an unsustainable boom occurs, as the Central Bank expands the money supply and suppresses the market interest rate. The interest rate is an important feature of the ABCT, as it provides the people with a signal that reflects their time preference. This interest rate is in Austrian terminology called the “natural” rate of interest. The Austrian theory sees the structure of production with several stages and capital as heterogeneous, containing both a time and a value dimension. Hayek elaborated on the work of the founders, and presented the ABCT in the famous Hayekian triangle. The ABCT is very controversial among mainstream economists as the theory has many flaws and no empirical testing. The Austrian school is against testing human action, as a matter of mathematical equations. The ABCT seeks to explain the occurrences of boom and bust cycles with the notion that money supply expands (by the Central Bank), the market rate of interest falls below the “natural” rate of interest and entrepreneurs get a wrong signal leading to them engaging in more long term investment projects. But as this altering of the production process isn’t backed by savings, the boom has to end in a bust leading to recession. The theory doesn’t find much credibility as it has some major flaws. The Austrians have a very narrow definition of money, which is somewhat misleading in a world where financial innovators develop complex derivatives, and trade them just like money. The Austrian schools belief that free markets are perfect as long as the government stays out the way is highly suspicious as well. They have furthermore a exogenously definition of money, which means that it is the issuer of money, the Central Banks, that have absolute power of how much money circulates the economy. The Austrian school is shown not to be able to explain the crisis in a satisfying manner as there is nothing in the Hayekian triangle, and therefore the ABCT that is measurable empirically. In the same time, they set forth too many assumptions in the theory that are quite dubious.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
Publication date2010
Number of pages93