The Essential Causal Element in the Austrian School's Theory of Business Cycles Is Falsified Loan-Market Signals

While a visiting scholar at New York University in 1923–24, Friedrich A. Hayek focused his attention on the ten-year-old American central bank. He watched the early phases of the 1920’s boom and saw a connection between Federal Reserve policy and the ramped-up economic activities. The early dynamics of that decade mirrored the dynamics of an unsustainable boom as set out briefly by Ludwig von Mises in his Theory of Money and Credit. According to Hayek, the seeds of the downturn were sown in the US in the form of easy money maintained by the Federal Reserve during the 1920s, the most salient consequence of which was the accelerating — and increasingly unrealistic — stock prices. The most insidious consequences, however, stemmed from the policy-tainted loan-market signals that created conflicts within the economy’s capital structure. Falsified loan-market signals can throw early-stage production processes out of line with the temporal pattern of consumer demand. This is the essential causal element in the Austrian school’s theory of business cycles. Policy-tainted interest rates give rise to internally conflicted production activities.

Artificially low interest rates stimulate early-stage — or, more broadly, interest-rate sensitive  —production processes, creating employment opportunities in those areas and hence raising incomes earned in those early-stage undertakings. Had the low interest rates been the consequence of increased saving rather than of policy actions by the Federal Reserve, the increase in early-stage capital formation would have been accompanied by a contemporaneous reduction of consumption — and hence a reduction in late-stage inputs and outputs. Accordingly, consumable output would have been shifted to the more distant future. This is the temporal pattern that characterizes sustainable, market-directed, economic growth. By contrast, a policy-induced boom as occurred in the 1920s and especially as it intensified near the end of that decade saw an increase in both early-stage production and contemporaneous consumer demand, creating a virtual tug-of-war centered on resources usable in both early-stage and late-stage markets — and with rising prices of those resources dimming profit prospects. These are the kinds of internal dynamics within the economy’s investment sector that lead to a crisis and warrant the charge that Keynesian theory is based on an overly aggregated macroeconomic framework.

—Roger W. Garrison, “Cycles and Slumps in an Overly Aggregated Theoretical Framework,” in What's Wrong with Keynesian Economic Theory? ed. Steven Kates (Cheltenham, UK: Edward Elgar Publishing, 2016), 93-94.