There is no shortage of information on Austrian business cycle theory (ABCT) on the internet. I have come to find, however, that Jesús Huerta de Soto’s book Money, Bank Credit, and Economic Cycles is the single best source for the Austrian perspective, largely because it gives a great background on capital theory (pp. 266-312) and how a progressing economy expands organically through savings and investment (pp. 313-343), and then shows how artificial credit expansion can create distortions in relative prices, leading to recession (pp. 347-505). Pages 506-508 have a nice chart that summarizes the difference between artificial credit expansion and a growing economy from voluntary savings.

Yet, I wanted to find a way to convey Hayek’s version of the trade cycle (which was slightly different than Mises’) more distinctly by using specific terms usually associated with other theories that describe a particular sequence of effects. We can begin with an increase in the stock of money through the banking system which does not coincide with the voluntary savings of the populace.

The Liquidity Effect

When credit is made more available in the banking system by the central bank buying securities from the primary dealers, the money supply increases and this causes interest rates to fall. This causes businesses to borrow and invest in labor and capital to expand output, and since prices are slow to react to the increase money supply, unemployment falls while productivity and output rise due to the greater use of capital which was stimulated by the lower rates.

Cantillon Effects

When money is injected into the economy, there are two things that are often pointed out. 1) those who receive the increase money balances first benefit due to their increase in purchasing power before prices rise and 2) the non-neutrality of money causes relative prices to change and affects investment and spending decisions that would have otherwise not have occurred in the absence of the central bank. Thus, the location of the injection point of the increased money stock is of great importance. When a central bank buys bonds, reserves are added to banks’ balance sheets and, ceteris paribus, leads to more borrowing and lending, thus more spending. As money enters the system, it is spent and is received as income to those whose time preferences have not changed, and the particular direction of this spending cannot be known ex ante. There are short-run and “medium-run” consequences of these asymmetrical spending patterns.

Network/Bandwagon Effects

The Austrian emphasis on time preference and capital shows that by lowering interest rates, the present discounted value of the future income of capital and factors of production rises. This is what is known as the time-discount effect. It invites more investment into the higher stages of production and complimentary capital rises in market value as equity prices soar and stock market speculation runs rampant.

The Acceleration Effect

During the early stages of the boom, there is idle capacity and unemployed labor that can be combined with other factors to produce higher output, and in the short-run this will be seen as genuine growth as incomes, dividends, and profits rise. The demand for certain goods and commodities will be translated into the demand for the capital that produces them in the earlier stages of production. This is true particularly of consumer goods, since the demand for which has not actually decreased. However, early in the boom the time-discount effect outweighs the derived demand effect, allowing more investment in the higher-order stages of production.

The Wealth Effect

The increase in borrowing and rising capital asset prices enables a higher rate of spending than as if the investment being undertaken were financed by genuine savings. Instead, the excess supply of money affects relative prices, but more specifically the prices of capital goods relative to consumer goods due to the price Wicksell effect, at least at first. Due to rising stock prices, real estate values, increased dividends, rents, and profits (as well as rising wages), more spending is created from these gains by those who perceive them as a greater amount of wealth, providing more funds to spend on consumer goods industries.

Relative Price Effects

Money is non-neutral in the short-run, so the initial spending that is created by the wealth effect begins the reversal of time preferences that were falsified by the artificially low interest rates, and the flow of spending towards consumer goods industries becomes greater. This has several outcomes.

The Ricardo Effect

Hayek’s version of the Ricardo effect stated that as more money is spent on consumer goods, real wages fall, making the use of capital less attractive than labor in production. This will lead to falling capital values and demand in the higher and middle stages of production, lowering profits. This account is not quite correct as I point out in chapter 4 of my book (coming out this spring), but suffice it to say that the end result is still a trade-off between labor and capital that ends with the former being utilized to the detriment of that latter.

The Substitution (Intertemporal) Effect

When interest rates are artificially lowered, there is a waiting period until output can be expanded in the early stages of production because additional resources like machinery and labor must be acquired which takes time. A percentage of this capital will come from the stages closer to consumption, and even intermediate stages, thus starting a bidding war for the complimentary factors due to competition. Another name for this is the concept of derived demand, and the sound version of it is in direct contradiction with the acceleration effect we mentioned above. This slowly drives up the costs of production which, again, takes time. Businesses in the latter stages thus increase production now before the higher costs of labor reduce their profitability. The increased demand for consumer goods reduces entrepreneurial spending on the maintenance of capital. In addition, since labor is being used to a relatively greater extent because of the Ricardo effect, there is less demand for the capital good produced in the early and intermediate stages of production. This reduction lowers the value of specific capital goods while at the same time the costs of production are rising. This reduces the profitability of the early stages of production while consumer goods profitability rises at the expense of capital, i.e. capital consumption.

The Fisher Effect

As consumer demand rises, prices typically rise. A rise in the price level causes interest rates to rise due to the inflation premium charged on loans in which inflation is anticipated. It is at the peak of the boom that interest rates are typically at their highest, and this, in part, causes a further fall in investment in the early stages. Even so, entrepreneurs in the early stages will still attempt to borrow at even higher rates, but this demand for loanable funds raises interest rates even further, exacerbating the burden of rising labor and interest costs. Rising interest rates even lower the discounted present value of capital, causing accounting profits to fall in the early capital-intensive stages as the higher prices in consumer goods shows relative profits in the later stages. Factors of production are liquidated and specific capital is idled as numerous businesses either fail or restructure themselves in accordance with real consumer demands. This begins a recession.

The Real-Balance (Pigou) Effect

The typical Austrian prescription for a recession is to let markets clear; that is, to let the prices of capital, labor, and other goods fall to a level that meets the reduced demand for those goods and services. They will thus be reallocated to industries where they are better utilized in accordance with the demands of consumers. As prices fall relative to wages, real wages rise and thus consumption rises. Put differently, the real value of individuals’ incomes and wealth rises as prices fall, because nominal incomes don’t fall as much as the price level during deflation. Hence, with more disposable income in real purchasing power, consumers will feel more confident to spend rather than hoard their money. This increased demand influences businesses to hire more workers, purchase more equipment and capital, and increase output. This is the self-corrective process of the free market. In the long-run, many non-Austrian economists will agree with the validity of this process, perhaps with caveats.

The Income (Yeager) Effect

This is a slight variation of the Pigou effect, and explains it somewhat differently, but has the same point. Due to the Fisher effect, real incomes are not increased in the short-run, but they are increased in the short-run. Now, money is sometimes considered a normal good. So during a recession real incomes are falling due to falling assets prices and high unemployment, and as incomes fall so does the demand for money (because their is an excess supply of it). This means that as the recession proceeds, spending will slowly rise. Wealthier people typically want to hold more money (low time preferences), and people who are less wealthy tend to favor spending (high time preferences). At the end of this process, prices fall and the demand for money falls as well until output and employment recover, ending the recession.