Thursday, January 23, 2014


1. Austrian Business Cycle Theory and the financial crisis

The global financial crisis is, without doubt, the most important economic event of our time. Its depth, extent and duration have led many people to put into question the free market and capitalism. This, of course, has resulted in a very heated debate about its causes (and possible solutions). On one side are those who call for more regulations, institutional improvement and implementation of Keynesian policies and, on the other side, those who argue that the current crisis is the fault of governments and Central Banks because they, and not the market, created the “financial bubble” that eventually had to burst. In the view of this group, the crisis is not sample of the failure of neoliberal capitalism but rather of the interventionist paradigm, the unregulated free market is still the perfect way to organize the economy and if there are problems is not because the market doesn’t work but because the State has not allowed it work. Among those who advocate this position are obviously the Austrian economists. In fact, this view is at present strongly promoted by prominent Austrians such as Ron Paul and Peter Schiff, who claims to have predicted the crisis.

The theoretical basis of these economists to support their position is on the Austrian Business Cycle Theory. According to this theory, originally proposed by Ludwig von Mises and Friedrich von Hayek, crises are the result of “distorting action” generated by the State to intervene in the market. So, as the coordination capacity of the market is destroyed, is necessary a painful process of “adjustment” to restore the “spontaneous order” and, consequently, the crisis comes.

This is in a very general and abstract level. However, the most interesting formulation of the Austrian Business Cycle Theory is about the crises caused by “credit bubbles”. Here the “spontaneous order” is the correspondence between actual savings and investments of private agents. In this context, the State, through the Central Bank intervenes in the market to “stimulate” the economy by relaxing credit conditions. To do this is applied a monetary policy that determines a rate of interest below the “natural rate of interest”, that is, the one that would be configured under conditions of absolute free market. In this new “artificial economy”, consumers have access to more loans and entrepreneurs make more investments with respect to what would occur merely on the basis of actual savings and then the bubble begins to emerge. At some point, as already said, this bubble has to burst and the economy will have to “adjust” itself, and the crisis occurs. All this does not happen through the fault of free market but rather through the fault of the State intervention.

Like most economists, Austrians developed their analysis of the mechanism of causation of the crisis taking as main reference the U.S. economy. Specifically, they argue that the financial crisis was caused in 2001 when, precisely in the context of economic depression and loss of confidence after the attack on the Twin Towers, the U.S. Federal Reserve, to “stimulate” the economy, reduced the interest rates from 6.5% to 1.75% and then to a minimum of 1% in 2003. Also in June 2002 the U.S. government announced would guarantee to the companies Fannie Mae and Freddie Mac to help create liquidity in a secondary market for mortgages so that the vast majority of families can access the “American dream” of own home. This, argue the Austrians, was what created the credit bubble which would trigger the financial crisis in 2008.

This is the Austrian view of the crisis. The liberal Spanish economist Jesus Huerta de Soto, the most famous representative of the Austrian School in Spanish-speaking countries, puts it this way: “Economic depression is not a crisis caused by the market economy. This is something we have to remove of our mind definitively. The crisis is not a crisis of the market, it is a crisis of state intervention, state intervention which produced the current banking system and credit expansion, which has deceived entrepreneurs, which has distorted the production structure (...). Therefore, in a free market economy does not have to exist economic depressions”. (1)

The implicit assertion that “the market is always and necessarily perfect, and the State always and necessarily is at fault” is too radical and deserves to be examined. And this is the subject of this article: make a critical analysis of the Austrian Business Cycle Theory in the context of the current financial crisis.

To be continued...


1) Jesús Huerta de Soto, “Una interpretación liberal de la crisis económica”, Estudios de Economía Política, Unión Editorial Press, Madrid, 2004, p. 157.

You can contact the author of this article in: “Dante Abelardo Urbina Padilla” (Facebook) and (email)