A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis

The financial crisis and the events leading up to it have sparked a remarkable renewal of interest in Austrian Business Cycle Theory (ABCT). Interest in the theory was reinforced by the fact that a number of economists and financial commentators associated with the modern Austrian school had warned of an emerging housing bubble during the Greenspan era when the conventional wisdom was that the Federal Reserve System had matters well in hand. A number of mainstream macroeconomists, such as Paul Krugman and Brad DeLong, have noted and criticized this resurgence of interest in ABCT on the grounds that it cannot explain the positive correlation of consumption and investment that occurs over the course of the business cycle. In particular they allege that the theory predicts a slump in investment and capital goods' industries and a corresponding boom in consumer spending and retail sales during the recession. They therefore conclude that ABCT is manifestly in conflict with the stylized facts of the business cycle and should not be seriously entertained. In this paper I respond to these claims in two parts. First I argue that this interpretation grossly misrepresents essential features of the theory and is based on a single secondary source published in the mid-1930s which incorrectly portrayed ABCT as a “monetary overinvestment theory.” I show that this interpretation is manifestly in conflict with the presentation of the theory in the publications of its leading proponents. I then present an alternative version of the theory that is based on the works of Ludwig von Mises, Friedrich A. Hayek and Murray N. Rothbard. I argue that this version does satisfactorily account for the overconsumption boom and subsequent retail slump that were such conspicuous elements of the boom-bust cycle that played out over the past decade