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The business cycle describes regularly occurring booms and and busts observed in economic life and the Austrian Business Cycle Theory (sometimes called the "hangover theory" or even shortened to ABCT) is an explanation of this phenomenon. Originally developed by Ludwig von Mises in the 1912 Theory of Money and Credit it was elaborated on by Hayek and others. In one classical rendition:
Banks expand credit well beyond their own assets and by the funds of their clients. This additional credit lowers the interest rate, and stimulates economic activity. Projects which would not have been started before, seem now profitable, creating malinvestment. They increase demand for production materials and for labor and their prices rise, which, in turn, leads to an increase in prices of consumption goods. If the banks would stop the extension of credit, the boom would be rapidly over. To prevent the sudden halt of this boom (and the resulting collapse of prices), the banks must create more and more credit, and the prices will rise even more.
But this expansion of credit cannot continue forever. There is no additional capital or labor; there is only more money. The means of production and labor which have been diverted to the new enterprises have to be taken away from others. Society is not sufficiently rich to permit the creation of new enterprises without taking away from others. As long as the expansion of credit is continued this will not be noticed, but it can't be pushed indefinitely. The inflation and the boom can last only as long as the public thinks that the prices will stop rising in the near future. When the public becomes aware, that there the inflation will not end, and that prices will continue to rise, panic sets in. Eventually, people will give up the currency.
The regularly occurring booms and and busts were observed from approximately late eighteenth century, along with the start of the Industrial Revolution. Sudden economic crisis, when some king made war or confiscated the property of his subject were known; but there was no sign of the modern phenomena of general and fairly regular swings in business fortunes, of expansions and contractions.
The Austrian cycle theory began with the eighteenth century Scottish philosopher and economist David Hume, and with the eminent early nineteenth century English classical economist David Ricardo. These theorists observed another crucial institution developing in the mid-eighteenth century, alongside the industrial system. It was the institution of banking, with its capacity to expand credit and the money supply (first, in the form of paper money, or bank notes, and later in the form of demand deposits, or checking accounts, that are instantly redeemable in cash at the banks). It was the operations of these commercial banks which held the key to the mysterious recurrent cycles of expansion and contraction, of boom and bust, that had puzzled observers since the mid-eighteenth century.
The English "Currency School" has tried to explain the boom by the extension of credit resulting from the issue of banknotes without metallic backing. But the school did not see that current accounts which could be drawn upon at any time via checks, play exactly the same role in the extension of credit as bank notes. Because of the legislation inspired by the Currency School (like the Peel's Bank Act of 1844 and similar laws in other countries), to prevent other economic crises, the issue of banknotes without metallic backing was restricted, but the expansion of credit through current accounts was unregulated. From this it was wrongly concluded that the English School's attempt to explain the trade cycle in monetary terms had been refuted by the facts.
The Currency School has also restricted its analysis to the case where credit is expanded in only one country while the banking policy of all the others remains conservative. The internal rise in prices would encourage imports and paralyse exports. Metallic money would drain away to foreign countries. As a result the banks would face increased demands for repayment of the instruments they have put into circulation (such as unbacked notes and current accounts), until they have to restrict credit. Ultimately the outflow of specie checks the rise in prices. The Currency School analyzed only this particular case; it did not consider credit expansion on an international scale by all the capitalist countries simultaneously. In the second half of the 19th century, this theory of the trade cycle fell into discredit, and the notion that the trade cycle had nothing to do with money and credit gained acceptance. The attempt of Wicksell (1898) to rehabilitate the Currency School was short-lived.
Since the cycles appeared on the scene at about the same time as modern industry, Marx concluded that business cycles were an inherent feature of the capitalist market economy. Many current schools of economic thought, regardless of other differences and the different causes that they attribute to the cycle, agree on this vital point: That the business cycle originates somewhere deep within the free-market economy, and it can be only solved by some form of massive government intervention.
It is sometimes held, that innovations cause the ups and downs of the business cycle. The most prominent defender of that view was probably Joseph Schumpeter. He stated that booms are due to technological or other innovations whose implementations at first seem to promise high profits. After a while, more and more entrepreneurs copy the strategy of the pioneer firms until competitive behavior forces profits to go down again and a depression begins, in which the market is cleaned of unprofitable firms. This is a brief description of the well-known process of "creative destruction" — a term made famous by Schumpeter himself. The new state of equilibrium is only maintained until a new innovation creates the foundation for another boom.
The industrial revolution, the appearance of railway tracks, or the rise of cheap automobiles can be interpreted as examples. Furthermore, the dotcom bubble at the end of the last decade could have been due to innovations like the internet. Even the current crisis can be regarded as the result of financial innovations.
However, it is not technological innovation that generates the boom, but the general boom that makes it possible for more and more firms to implement their innovative ideas. In every moment there exist many ideas for possible innovations and improvements. The latest innovation has not yet been implemented in every business. If there are always many ideas whose only problem is to get enough funds, then it is not technology, but savings that limit development. To implement them, the companies need capital. Society has to save first and then grant credit.
There is, of course, nothing wrong with using credit for an innovative project. The problem only appears when these credits are created out of thin air, thus inducing malinvestments. In an environment of monetary expansion, many innovative projects can be started that are in fact not sustainable. The clusters of innovative activities that seem to be the cause of inevitable depressions are in fact a symptom of the distortion of the market process that is introduced by fractional-reserve banks.
From a policy point of view, using political means to push forward new innovations (like "renewable energy sources") will not suffice to get the economy out of the slump. Moreover, it can be highly dangerous for the aid for such innovations to be flanked by expansive monetary policy.A recent study suggests that this was the case in Spain where a "green" bubble went boom and bust — with all its destructive side effects, including unemployment.
These are some of the more frequent or known criticisms of the theory.
Some critics point out, that the theory blames the business cycle on central banks, but the cycle has been well known throughout 19th century, well before central banking in the modern sense and the 20th century growth of the state. One particular example are the United States and its wide range of monetary and banking systems.
Many casual expositions of ABCT say things like, "The business cycle is not a feature of the free market, but instead is caused by the manipulations of the central bank." But it is far more accurate to say that ABCT blames the boom-bust cycle on fractional reserve banking. Specifically, when banks are allowed to issue paper money (or increase customers' electronic bank deposits) without an actual act of saving by somebody in the economy, then the resulting drop in interest rates is artificial. The false interest rate sets in motion an unsustainable boom period, which leads people to erroneously consume capital and which creates the inevitable bust.
Government intervention is still very much involved here. Were it not for legal privileges granted to banks, the practice of fractional-reserve banking would be "regulated" by market competition. Even if banks were legally allowed to extend more loans than they had cash (or gold) in the vaults, they would be very cautious with their overissue so long as a bank run would spell ruin. Yet time and again, even before the establishment of central banks, governments would allow the banks to "suspend specie payment" during panics. This practice of absolving privileged bankers of their legal obligations was simply institutionalized (in the United States) with the creation of the Federal Reserve. It is no coincidence that the worst boom-bust in US history occurred sixteen years after the formation of the modern American central bank. 
- See also: History of money and banking in the US
"If investors correctly anticipate that a decline in interest rates will be temporary, they won't evaluate long-term investments on the basis of current rates. So, the Austrian story requires either a failure of rational expectations, or a capital market failure that means that individuals rationally choose to make "bad" investments on the assumption that someone else will bear the cost. And if either of these conditions apply, there's no reason to think that market outcomes will be optimal in general."
First off, free individuals often make mistakes — even systematic mistakes. But even perfectly rational entrepreneurs who know a boom is underway cannot prevent their more reckless competitors from taking cheap (or now free) government loans and bidding away scarce resources. Workers don't care whether their paychecks come from genuine saving or from the printing press, and every few years there is always a fresh crop of naïve employers willing to borrow money and start new projects.
Second, Austrians emphasize that interest rates communicate information to entrepreneurs. In some critiques it seems that "everybody knows" that the true interest rate ought to be 5 percent, and so the central bank's efforts to push it down to 3 percent should be easily corrected. Yet nobody knows what the truly free-market interest rate is. That's why market prices are important in the first place, and why government distortions of these prices lead to real imbalances in the economy.
Entrepreneurs don't need to speculate about a change in consumers’ "rate of time preference", or about the "supply of capital goods". An individual entrepreneur is concerned only with a very small set of market prices, namely, the prices of the inputs she will need for her projects, and the prices for which these products will sell. That’s the whole point of relying on the market rates of interest and other prices — it eliminates the need for individuals to speculate about aggregates that are far too complex for any single mind to comprehend.
Also, some expositions of ABCT assume an initial free market state, and then analyze the impact of a one-shot intervention. But in reality the government of each major country intervene permanently in the credit market by the creation of a central bank (or a centralized system of banks). Actors in these economies have no idea what the free market rate of interest would be in the absence of such interference; even if the rates were raised, the new rate could still be below the "natural rate".
Investment vs. ConsumptionEdit
If booms are driven by mistaken beliefs that investments have become more profitable, and labor and other resources are channeled into projects not compatible with the overall level of real savings, then consumption should go down, say some critics. But booms are characterized by high, not low, consumption. If the government can't make the economy more productive by pushing down interest rates, how could businesses possibly produce more investment and consumption goods during the boom?
The answer is in the Austrian approach to capital theory. The low interest rates of the boom period mislead entrepreneurs into borrowing too much, but they also mislead consumers into borrowing too much and saving too little. This is physically possible because resources that otherwise would have gone into replenishing the capital structure are instead devoted to new projects or additional consumption goods. This "eating of the seed corn" can take a while to manifest in a complex, modern economy.
Unemployment in the boomEdit
In a similar vein, it is pointed out that there is generally no period of high unemployment when resources are transferred out of consumption-producing sectors into investment goods-producing sectors. There is no necessity that the transfer of resources out of investment goods-producing sectors be accompanied by high unemployment.
Suppose we start in an original equilibrium position, where unemployment is at the "natural" rate, reflecting the normal turnover of workers as some businesses fail, etc. Then a $100 billion in crisp new bills is printed, and handed out to bankers. The banks lend the new money to employers, who enter the labor market with the fresh wads of cash in their pockets. Armed with the money that was just created out of thin air, the employers bid up wage rates. Seeing the higher pay, many workers quit their current jobs and take new positions in the expanding sectors. Also, some previously unemployed workers end their job search and take positions with the employers who got their hands on the new $100 billion. There is no reason for unemployment to go up in the scenario just described.
But when the the influx of new money is cut off, the underlying economic fundamentals will reassert themselves. The workers who had been drawn into the expanding sectors by new money weren't supposed to move to those sectors. The employers in the boom sectors will lose their advantage over their competitors in other sectors. Without being propped up artificially by cheap money, the bloated boom sectors will realize their unprofitability. They will cut back on operations and lay off workers.
And why don't the laid-off workers move seamlessly back into the original niches from which they came? Why does a massive reservoir of unemployed workers build up after the bust, when no such reservoir built up during the boom? The answer is pretty simple: Workers are more eager to quit and take a better job than to be laid off and take a worse job. During the boom, workers are drawn into the expanding sectors by the promise of higher wages. They aren't forced into the expanding sectors by getting let go from their original position; instead they voluntarily leave. No less important is the capital consumption during the boom period. Society "eats the seed corn" through malinvestment.
There was no inflationEdit
Some critics point out, that if prices did not rise (the CPI did not rise excessively) there was really no inflation. There was no wave of rising consumer price inflation in the 2000s.
Expansionary monetary policy makes prices higher than they otherwise would have been. For example, the extraordinary interventions in late 2008 — in which the M1 measure of the monetary stock rose 12 percent over a three-month period — went hand-in-hand with falling prices. Prices should have fallen in response to the bursting bubble. Prices would have fallen more, were it not for a floor under them with an aggressive influx of new money. At the same time, house prices rose at unusual rates during the boom years.
- ↑ John P. Cochran. "The Hangover Theory?", Mises Daily, Friday, March 16, 2001, referenced 2009-11-14.
- ↑ 2.0 2.1 2.2 Murray N. Rothbard. "The Austrian Theory of the Trade Cycle and other essays" (pdf), "Economic Depressions: Their Cause and Cure", p.58-81, referenced 2009-10-27.
- ↑ 3.0 3.1 Ludwig von Mises. "The Austrian Theory of the Trade Cycle and other essays" (pdf), "The Austrian Theory of the Trade Cycle", p.23-32, referenced 2009-10-27.
- ↑ 4.0 4.1 Malte Tobias Kahler. "Do Innovations Cause Business Cycles?", Mises Daily, January 07, 2010, referenced 2010-01-07.
- ↑ Instituto Juan de Mariana. "Study of the Effects of Public Aid to Renewable Energy Sources" (pdf), pp. 19–20. March 2009, referenced 2010-01-08.
- ↑ Nelson D. Schwartz. "In Spain, a Soaring Jobless Rate for Young Workers", published December 31, 2009, referenced 2010-01-08.
- ↑ 7.0 7.1 7.2 John Quiggin. "Austrian Business Cycle Theory", posted on May 3rd, 2009, referenced 2009-11-11.
- ↑ 8.0 8.1 8.2 Robert P. Murphy. "Correcting Quiggin on Austrian Business-Cycle Theory", Mises Daily: Monday, May 25, 2009, referenced 2009-11-11.
- ↑ Robert P. Murphy. "The Rational Expectations Objection to Austrian Business Cycle Theory: Prisoner’s Dilemma or Noisy Signal?" (pdf), last updated May 25, 2005, referenced 2009-11-12.
- ↑ Tyler Cowen. "Paul Krugman on Austrian trade cycle theory", posted on October 14, 2008, referenced 2009-11-14.
- ↑ 11.0 11.1 Brad DeLong. "What Is Austrian Economics?", April 2010, referenced 2010-04-27.
- ↑ 12.0 12.1 Robert P. Murphy. "Austrians Can Explain the Boom and the Bust", Mises Daily, March 2009, referenced 2010-04-27.
- ↑ Robert P. Murphy. "Evidence that the Fed Caused the Housing Boom", Mises Daily, December 2008, referenced 2010-04-27.
- Austrian Business Cycle Theory on Wikipedia
- Austrian Business Cycle Theory: A Brief Explanation by Dan Mahoney, May 2001
- Why Don't Entrepreneurs Outsmart the Business Cycle? by Brian J. Stanley, August 2007
- Are the Austrians Too Harsh? by John P. Cochran, October 2010
- Putting Austrian Business-Cycle Theory to the Test by Robert P. Murphy, October 2010