In the last few years the Austrian theory of the business cycle has received a great deal of critical attention from non-Austrian economists as well as non-economist journalists and bloggers. In both in the professional journals and in the popular press–especially online–we Austrian economists have pointed out how well the boom-and-bust of the last decade-plus fits the Austrian theory. The results have been mixed. Some critics of the theory simply refuse to understand what it says and end up criticizing something other than the actual theory. But others have offered reasonable criticisms. I want to address one of those here.

Because the Austrian theory argues that inflationary monetary policy generates misleading interest rates that cause entrepreneurs to invest too much in the early stages of production, such as research and development, it seems to imply that the greater the inflation, the more such mistakes will be made. Since the theory also asserts that the bust, or recession, is the period in which those mistakes are corrected, it would seem to follow that a boom in which more mistakes are made will require a longer bust to correct those mistakes. In other words, the bigger the inflationary boom, the worse the recessionary bust.

The critics argue that this is empirically falsified by the Great Depression since the preceding inflation was fairly moderate. Some have made the same point about the Great Recession: The inflation of the mid-00s was notable, but not nearly what we saw in the 1970s, yet we arguably have had the worst recession since World War II.

Missed Step

The critics miss a crucial step in the argument. Larger inflations during the boom will lead to a deeper and/or longer bust, all else equal. In historical episodes, however, not everything else is equal. To understand why the Great Depression was so bad, we have to look at all of the policy responses taken once the boom turned to bust.

As I have argued elsewhere, the interventionism of the Hoover administration (particularly its convincing businessmen not to lower wages), the deflationary mistakes of the Federal Reserve System, and the further interventions and experimentations of the Roosevelt years all combined to turn what most likely would have been a sharp but short recession into the worst economy in U.S. history, costing us over a decade of economic growth.

In the Great Recession we have seen a variety of interventions that have slowed the pace of recovery, including the various bailouts and subsidies. In addition, the nonmonetary policies that fueled the Fed-induced boom made it bigger than it would have otherwise been by, for example, channeling the excess credit into housing and then building questionable financial instruments on top of that. When it all collapsed, distortions beyond those directly created by the inflation had to be corrected. That has taken time and has been slowed by the policies noted above.

The upshot is that whenever we try to explain why a recession was as bad as it was, the Austrian theory of the business cycle can only get us so far. It is really an explanation of why a bust occurred in the first place. Or as Roger Garrison puts it, it is a theory of the “unsustainable boom.” By itself the theory says nothing about the depth or length of the bust, other than that all other things equal, a larger boom should produce a deeper/longer bust.

Three Questions

Three distinct questions are in play in any specific historical episode: What factors caused the bust? What factors help explain why the bust was so deep? And what factors explain why the bust lasted so long or the recovery was so slow? The Austrian theory focuses primarily on the first question, though it can help with the second and third. For most historical episodes the answers to those will depend on a host of other factors having nothing to do with the Austrian theory per se.

Modestly keeping our claims about Austrian cycle theory consistent with what it can and was meant to do is both good economics and good defense against unjustified criticism.

Steven Horwitz
Steven Horwitz is the Charles A. Dana Professor of Economics at St. Lawrence University and the author of Microfoundations and Macroeconomics: An Austrian Perspective, now in paperback.