The Austrian Business Cycle Theory – Insufficient (but NOT Wrong) at Explaining the Current Financial Crisis

Recently a fellow Austrian commented on my post Austrian Economists Need to Get Their Business Cycle Theory Straight. I will post his statements from Correction on the Austrian Business Cycle Theory and comment on them when necessary:

One criticism that has come up is that the Austrian theory does not fit the fact that during the boom years there was both an increase in capital-goods and in consumer-goods. The assumption is that the Austrian theory suggests that during the boom years there is an increase in the production of capital-goods and a decrease in the production of consumer-goods.  This is incorrect.  The Austrian theory takes into consideration an increase in both, which is what causes unsustainable economic growth.

No, this was not my criticism. First of all, I am not criticizing the ABCT as such. It explains properly all the events that ensue upon credit expansion of credit that is used to purchase capital goods. But it leaves out the possibility that the majority of new credit might not be used to purchase factors of production, but to purchase consumer goods instead. In fact, such an event, as Rothbard himself admits does NOT fall under the workings of the ABCT:

Mises did not deal with the relatively new post-World War II phenomenon of large-scale bank loans to consumers, but these too cannot be said to generate a business cycle. Inflationary bank loans to consumers will artificially deflect social resources to consumption rather than investment, as compared to the unhampered desires and preferences of the consumers.

But they will not generate a boom-bust cycle, because they will not result in “over” investment, which must be liquidated in a recession. Not enough investments will be made, but at least there will be no flood of investments which will later have to be liquidated. Hence, the effects of diverting consumption investment proportions away from consumer time preferences will be asymmetrical, with the overinvestment-business cycle effects only resulting from inflationary bank loans to business.

I am merely pointing out that what happened over the past 20 years is simply not covered by a theory that primarily focuses on the excessive extension of business credit.

My criticism is not that it doesn’t explain why we had an increase in both capital and consumer goods. A theory that deals with government intervention doesn’t assert absolutes. It merely analyzes why certain developments deviate from what would have happened in the unhampered market. We may very well have both capital and consumer goods production rise in absolute terms throughout the entire episode of credit expansion.

What I am saying is that it doesn’t explain why over the past 20 years, inside the US businesses have produced more consumer goods than they would have, and produced fewer investment goods than they would have, had the market been unhampered. The relative ratio of consumer goods produced to capital goods produced grew, for the most part, constantly from 1981 through 2006:

By the way: Even if you wanted to count houses as capital goods for whatever reason, you would STILL end up with a relative growth in the production of consumer versus capital goods.

It is this phenomenon that the conventional ABCT simply doesn’t cover and, I may add to Mises’ defense, doesn’t want to cover. We will see later to what misconceptions, misinterpretations this leads when we try to apply Mises’ business cycle theory to current and recently past events.

The difference is that the Austrian theory forecasts that the capital-goods sector will be hit harder than the consumer-good sector, and so far that has proven to be true.

Ironically, it is precisely this that has not proven to be true. One look at the current employment and business landscape shows us: Most people are losing their jobs and most businesses are failing or reporting losses in real estate, residential construction, autos, and mortgage banking. In addition to that we are on the brink of a collapse in commercial real estate due to unprecedented shop and mall vacancies.

Throughout the boom years an excessive number of huses was built, and excessive number of homes were flipped, an excessive number of cars was produced, strip malls, nail salons, beauty salons, Starbucks cafes, and the like popped up left and right. Numerous people were employed in all these fields and in that field which fueled it all: banking.  Naturally everyone frets about a decline in the production of consumer goods, simply because this constituted until recently over 90% of production in the US (again, see chart above).

Meanwhile, we were able to witness the opposite trend when it came to the capital goods industry. Factories and production of machinery was, as a tendency, outsourced to China, Mexico, Germany, Japan, and other countries. It would be, at the very least, quite a stretch to say that our recent excesses were visible in the capital goods industry, while they were everything but screaming at you in the consumer goods sector.

Again, this change in ratio between consumer and capital goods production is not covered by the conventional ABCT.

In fact, the entire theory bases its argument on the fact that there was a decrease in the rate of savings during the years of the money supply boom.  It is believed that businesses are pushed to invest when there is a rise in the rate of savings, due to a fall in the interest rates of loans.  In the case of a credit boom, the artificial decrease of interest rates due to the expansion of the monetary base by the Federal Reserve leads businesses to invest.

… and to invest means to purchase factors of production, capital goods. And factors of production are purchased when loans for such purposes are made. But when the majority of excessive loans are made for the purpose of purchasing consumer goods, viz mortgage loans, car loans, credit cards and the like, investment falls behind, purchases of capital goods fall behind, and consumption along with the production of consumer goods gains in relative terms against the production of capital goods, as I explained above. Thus much more than pushing businesses to invest, the recent credit expansion pushed consumers to consume.

At the end of this boom, whether when the Federal Reserve decelerates the creation of money or when the people lose confidence in the value of the currency being used, businesses find that without a corresponding increase in the rate of savings their investments failed to pay off, because nobody put aside savings to purchase these once future-goods.  And so, it would only make sense that there was an increase in consumer spending during the boom years.

Again, the author is going to have a hard time to explain contemporary phenomena via the above paragraph. First of all, the boom came to a halt when lenders realized that money that was loaned out would not be paid back, when people began to foreclose on loans at an accelerating pace. The loaned money was spent on consumption, and thus did not increase the borrower’s productivity to pay off his loans. But contrary to what the author said above, these goods were already purchased. All the homes, cars, and credit cards that could never be paid off were already obtained in the past, it is not that people expected them to be purchased in the future. It is not true that “investments failed to pay off, because nobody put aside savings to purchase these once future-goods”. The goods were purchased in the past, what was lacking in the future was money earned to repay the loans made, due to a lack of increased productivity.

When it became clear that most loans would never be paid back a scramble for real, earned cash ensued along with evaporating credit claims, a deflation. This is the exact opposite of a “loss of confidence in the currency used”.

When people realized they hadn’t saved enough, they cut down on consumption. When they cut down on consumption, all those consumer based businesses that at this point made up over 90% of the US economy were facing inventory overhang, they now have to cut prices, cut production, some of them have to go out of business. This is what we are in right now. The only way the US is going to come out of this malaise it to cut down on the production of consumer goods from previous levels, and make room for the production of capital goods, a restoring of the balance back to historical averages in the ratio between the production of consumer vs. capital goods.

Economic historian Thomas Woods explains it for the layman:

The central bank’s lowering of the interest rate therefore creates a mismatch of market forces. The coordination of production across time is disrupted. Long-term investments that will bear fruit only in the distant future are encouraged at a time when the public has shown no letup in its desire to the consume in the present. Consumers have not chosen to save and release resources for use in the higher stages of production. To the contrary, the lower interest rates encourage them to save less and thus consume more, at a time when investors are also looking to invest more resources. The economy is being stretched in two directions at once, and resources are therefore being misallocated into lines that cannot be sustained over the long term (Woods, Meltdown, 68).

Interestingly I talked to Tom Woods about precisely this: Again, he correctly argues what happens during an expansion of business credit. Yes, I do understand it. I wrote about it myself in what I call the production business cycle. But he does not explain how increased consumption demand from consumers is actually met with increased production from producers of consumer goods vs. just price increases of consumer goods. He then pointed me to Robert Murphy’s article The Importance of Capital Theory, which is perfect because ironically it confirmed my thesis. In response to this article I wrote:

Robert Murphy’s Sushi is actually a perfect example for what I propose to call the consumption business cycle. In his example, more resources are allocated to the production of consumer goods (gathering rice, catching fish), and fewer are being allocated to the upkeep of capital goods (maintenance of boats and fishnets).

During the equilibrium state 25 people were employed in the capital goods industry. After Krugman’s advice it’s only 10 people, out of which only 5 perform the criucial task of boat maintenance. He perfectly explains the phenomenon of increased consumption and corresponding production of consumer goods, but it does not occur due to a channeling of resources away from short term projects toward longer term projects. In fact, it occurs due to the exact opposite. Resources are taken from projects that yield an output at a later point in time (maintaining boats), and are directed toward projects that yield an immediate output (collecting rice, fish, and combining the two).

The Austrians’ focus on the capital-goods industry is simply based on the fact that the capital-goods industry is usually hit worse than that of consumer-goods. At the end of the boom stage, ventures that were once considered profitable are found to be unprofitable. There is a sudden decrease in investment. Capital-goods which were manufactured for new investment projects are suddenly found unused, as businesses are no longer willing to risk investment.

But please, look around you. Do you think this crisis primarily came about due to an overhang in the production of industrial robots, unfinished production facilities, an excessive number of energy plants, oil rigs, and the like? Is this what you see when you walk through the streets, look at the news, read the papers?

Isn’t it rather obvious that we are primarily faced with a massive overhang in consumer goods, such as houses, cars, strip malls, Starbucks branches, nail salons, beauty salons, energy drinks, shampoos, fast food stores, kitchen appliances, flat screen TVs, etc. ?

Isn’t it, furthermore, obvious that we have, at least as a tendency, lost most of our productive capacity to foreign countries, precisely because we have neglected it relative to consumer goods?

You can change reality by squeezing it into a concept that doesn’t apply to what actually happened. But then you have done just that: You have changed reality. The purpose of scientific discourse, however, is to interpret reality, not to violate it. :)

This may come about due to an increase in the interest rate, or because it is a time of uncertainty (a more likely explanation for the current recession, given that interest rates are still near zero).  A drop in demand for consumer-goods necessarily follows. There is an increase in frictional unemployment, as workers which once labored in the capital-goods industry must find employment elsewhere (Rothbard, America’s Great Depression, p. 21).  Also, a degree of economic uncertainty contributes to an increase in the rate of savings, and households are forced to save due to an increase in household debt during the boom years (credit was easy to access, allowing households to spend beyond their paycheck).  Rothbard writes in America’s Great Depression:

A favorite explanation of the crisis is that it stems from “underconsumption”—from a failure of consumer demand for goods at prices that could be profitable.  But this runs contrary to the commonly known fact that it is capital goods, and not consumer goods, industries that really suffer in a depression.  The failure is one of entrepreneurial demand for higher order goods, and this in turn is caused by the shift of demand back to the old proportions (Rothbard, 19).

As can be seen the Austrians do not claim that during a credit boom there is a lack of increase in the demand for consumer goods.  In actuality, the claim is the exact opposite.  Austrians criticize the simultaneous increase in demand for capital and consumer goods, given that they believe that true economic growth is brought about through capital accumulation, or savings.

And again, this completely misses the point. I never said that the Austrians claim that there is a lack of increase in the demand for consumer goods. I said that the conventional ABCT, as even admitted by Rothbard himself, was not conceived to explain an expansion of consumption credit and the ensuing tendency in the economy to produce relatively more consumer goods than capital goods.

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Austrian Economists Need to Get their Business Cycle Theory Straight…

…or else their theory may appear inconsistent and impossible to validate. Don’t get me wrong, the Austrian Business Cycle Theory (ABCT) is great and applies sound economics every step of the way. But its application suffers from a deficiency: It is only part of a larger theory. I will explain what I mean by that and the inconsistencies it leads to.

When Austrian Economists talk about the business cycle they are actually referring to what I called the production business cycle. It is that business cycle which causes entrepreneurs to withdraw resources from the production of consumer goods and directs them toward the production of capital goods.

They never consider the idea of a consumption business cycle, at least I was unable to find it anywhere. But I can’t find a reason to dismiss the notion of such a cycle.

What does this lead to? It leads to problems when it comes to explaining historical events. If, say, the recession of 2008 was caused by excessive production of capital goods and a shortage of consumer goods then how can they explain the massive expansion of the production of consumer goods throughout the recent boom:

Click on images to enlarge.

In case you are wondering what the ratio would look like if we assumed that the entire trade deficit was due to consumer goods:

In fact, a much more realistic assumption is that the ratio of consumer vs capital goods is the same for imported/exported goods as it is for all of production, in which case the real ratio would be closer to the blue line or at least somewhere in between blue and green.

In fact the entire problem of an excessive production of consumer goods, of surplus strip malls, of Starbucks locations on every block, or of a glut in homes makes little sense when one tries to apply the concept of over production of capital goods. What makes even less sense when applying this theory is the fact that the production of capital goods throughout this entire period was utterly neglected, factories “shipped off to China”, etc.

The solution to this is simple. What Austrians currently refer to when they say business cycle has to be viewed as the production business cycle. Together with the consumption business cycle it forms a general theory of the business cycles which simply establishes that resources are misdirected as a result of government intervention. From where to where, however, highly depends on the types of loans made and/or subsidized.

This is what I established and outlined in detail in The Business Cycle Revisited, and I am open to feedback and constructive criticism from the Austrian community. :)

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The End of Consumerism

In a free society where individuals are allowed to make choices by themselves so long as they don’t infringe upon their fellow men’s life, health, and property, entrepreneurs use natural resources, transform them and/or combine them with previously produced factors of production, and turn them into either consumer goods or other factors of production. They employ workers in the process who provide the production factor labor.

They exchange consumer goods on the market against money obtained from consumers. They exchange factors of production against money obtained from other entrepreneurs.

Factors of production, once completed at some point in the future, enable entrepreneurs to produce more consumer goods during the same amount of time. But while factors of production are being built, workers and natural resources are being used in processes that don’t turn out any consumer goods. It is thus necessary to only employ workers and resources in the production and maintenance of factors of production to the extent that during this process individuals in society are willing to not consume the full output of their labor, and hence generate savings.

On top of that, it is necessary to maintain the existing stock of productive factors, lest their wear and tear cause a decline in the output of consumer products. Thus a continuous level of savings needs to be maintained by individuals in society.

Interest rates on the market give entrepreneurs an indication of the market participants’ time preference, meaning how much immediate consumption people are willing to forgo in exchange for the prospect of more future consumption. In other words, interest rates give an indication as to how much people are ready to save and thus contribute to the maintenance and new developments of factors of production.

If the the government pursues a policy of business credit expansion, the interest rate indicator is manipulated by force, as opposed to voluntary individual time preferences. The interest rate drops below the level that represents those actual preferences. If mostly consumer loans are pushed, the consumption business cycle ensues:

The Consumption Business Cycle

The central bank and fractional reserve banks create new fiat money and make it available in credit transactions to individuals who intend to use the money for the purposes of consumption. Examples would be car loans and home loans which made the US economy align its productive factors accordingly over the past decades. It is likely, but not necessary that interest rates for such credit instruments will drop initially.

Some individuals may now enter into these new credit transactions and use the new money to consume goods that they wouldn’t have consumed before. But they didn’t do so by reducing their savings, nor did anybody else sacrifice consumption to make this money available. It was created out of nothing. No additional consumer goods have been produced.

The prices for the goods demanded will begin to increase. Entrepreneurs will respond by abandoning the production of some additional factors of production and turn out more consumer goods instead. So long as more credit is channeled into the system, prices will continue to increase while entrepreneurs try to catch up. Fractional reserve banks will begin to earn more interest revenue and expand their operations and resource usage.

Businesses that produce consumer goods will report higher profits, while profits for businesses producing factors of production and basic materials will lag behind. A myriad of consumer goods based businesses will spring up over time. The alignment for immediate consumption vs. more/better future consumption continues so long as individuals continue to be able to pay interest on the credit transactions performed and expect to be able to do so in future.

But as explained above, making interest payments and paying off debt is only possible in the long run if the workforce, as a whole over time, becomes more productive per unit of labor. But the opposite occurs. Productivity per labor unit will be lower than the additional consumer loans appeared to indicate, since in an unhampered system credit can only come out of savings (which means someone somewhere forgoes immediate consumption, making room for more factors of production). After a certain period, the amount of debt and interest payments will become higher than consumers can afford. In addition, due to lower interest rates, a lot of rather risky loans were made to individuals that would not have occurred in the unhampered state. Individuals will begin to default on their interest payments.

They start realizing that they need to consume less and save more in order to not have this happen again. Their demand for additional credit drops sharply. Their demand for money to pay off the debt and/or generate savings rises.

The fractional reserve banks will begin to slow down the creation of additional credit. They begin reporting losses on existing consumer debt.

As excess consumption comes to a halt consumer prices begin to fall, businesses aligned for the production of consumer goods will see declining profits, some will start reporting losses. They realize that they will have to abandon some projects since the demand for consumer goods starts to fall back to sustainable levels that match everyone’s time preference and expectations. The desire to consolidate one’s finances takes priority over everything else.

This is what is currently happening in the United States. The end of consumerism really means the end of capital consumption. It means that people realize that they need to save more and consume less, so as to provide for economic progress and more efficiency in the future, and to restore balance to the economy as a whole. It means that people have understood that too much of the existing capital stock has been consumed and has deteriorated.

This is the causality that the majority of pundits and economics professors that one can hear talk every evening on the news simply don’t understand. All their theories and policies are ignoring this one crucial fact: That Americans are done consuming for the foreseeable future. The end of consumerism isn’t just a temporary ditch. It is here and now and it won’t go a way for a long long time. It is a once in a lifetime occurrence. This is why it is so hard to grasp and to accept. But it is very simple to understand when one approaches it with sane common sense. How many more Starbucks branches do we need in the streets of New York? How many more gas guzzling cars should each family posess? Three, four, ten …? How many more different brands of detergents, shampoos, toothpastes, and consumer electronics products do we really need?

Now, it is important that the reader doesn’t get this wrong. I do not oppose consumption. In fact, the entire material wealth of a person is ultimately determined by how much he can consume. Consumption, present or future, is what all humans ultimately work for. But if, in an environment of government induced credit expansion, people consume more than is sustainable in the long run so long as the music still plays, they need to cut back for a certain period once the music stops playing. If we had never embarked on the disastrous path of credit expansion and government intervention, if all factors of production were allocated as efficiently and effectively as possible, if the government had confined its scope to the protection of each individual’s life, health, and property, we would today be able to consume a lot more than we currently can.

Unfortunately this is not the situation we are in here and now. We do not live in a perfect free world. We need to respond to the reality around us rather than deny it. It is time to cut back and restore sanity and balance. Individuals have realized this and are doing the right thing. The government has not understood this fact at all. It is trying to keep alive failed businesses that should release resources for more demanded projects. It is trying to make up for the “lack of consumption” in the private sector. All these attempts will fail miserably. All they will accomplish is to slow down the corrective phase and turn it into a decade of agony.

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The Business Cycle

Note: To find out more about the differences between the consumption business cycle and the production business cycle read my newer post The Business Cycle Revisited.

All causes, effects and basic workings behind the Business Cycle have already been outlined by the theory of Credit Expansion.

This article shall elaborate on the detailed workings during the business cycle, from start to finish, divide it into phases, and establish a checklist for each phase during the cycle.

Phase 1: The Unhampered Market

The initial phase is a market system unhampered by central bank intervention. Consumers demand consumer goods. Entrepreneurs obtain savings money from capitalists in credit transactions and buy and combine factors of production and pay workers in order to produce those consumer goods. If the factors were withdrawn from less important uses and employed in more important ones, and on top of that there is still money left after paying interest to the capitalists, the entrepreneur earns a profit. Everyone who has earned money in this transaction, workers, capitalists, and entrepreneurs will then use part of the money earned and act as consumers which brings us back to the beginning. But with part of what they earned they act as capitalists and save it up for future consumption. Thus, as a whole,  part of their labor is available to  contribute to a stock of goods that are not consumed but rather aid in the production process, factors of production, via savings and investment. The more the immediate wants are satisfied over time, the lower the people’s time preference for present goods, and thus the more will people save, and the more capital will be available which increases the future output of goods per unit of labor. The unhampered market system, as a tendency, continuously provides for a rising standard of living for everyone who is involved. The government limits its scope to protecting the individuals on the market against aggression. It funds this activity via a minimal tax. Interest rates fully reflect the market participants’ voluntary time preferences, prices reflect voluntary value preferences.


  • True GDP expands significantly
  • A continuous and slow decline of interest rates
  • A continuous and slow increase of the savings rate
  • A money supply growth of 3% or less
  • A continuous decline in the money prices of consumer goods

Phase 2: The Bank Credit Expansion

Now the central bank appears and prints additional fiat money. It goes out on the market and asks capitalists, or banks who act on the capitalists’ behalf, to sell the debt they hold at a price based on the interest payments and riskiness of the security. Capitalists won’t be interested in the exchange since they genuinely desire to hold the debt as a means of obtaining interest income. Hence the central bank needs to offer a higher price for the debt. As a result, the debt is sold at a higher price. It is sold to an institution that has not generated genuine savings but rather printed fiat money out of nothing.


  • Interest rates for the debt instrument types bought by the central bank begin falling a bit faster
  • Overall interest rates remain untouched
  • Banks accumulate excess reserves
  • True GDP keeps rising
  • The savings rate is still increasing

Phase 3: The Business Credit Expansion

The capitalists and banks whose debt has been bought by the central bank now hold cash again. They will thus loan out money again since their time preferences haven’t changed. But the entrepreneurs they previously loaned money to don’t need additional capital. Thus they will try to loan out money to others. They will try to find a borrower from whom they can expect the same interest rate as they were earning previously, or at least an interest rate that is only slightly lower. Since they realized a premium upon their previous sales of debt, they will still be able to earn more interest income per month if the interest rate for the total loan only drops marginally. Slowly the rate for loans on the broad market begins to drop. Bank profit from interest earnings begins to rise consistently. The central bank, again, buys up newly created debt from the capitalists which the capitalists, again, loan out. The activity is repeated.


  • Interest rates begin dropping faster across the board
  • Banks loan out excess reserves
  • Banks begin to report higher profits
  • The money supply growth rate accelerates beyond 3%
  • True GDP keeps rising
  • The savings rate keeps rising

Phase 4: Entrepreneurial Activity Expands

Would-be entrepreneurs, who up to now were unable to obtain loans from the capitalists, because interest rates indicated that not enough voluntary savings were available to bridge the temporary shortfall in consumption goods that comes with investment, are now under the impression that the market provides enough factors of production to complete the projects they had been planning. With the borrowed money, they will begin obtaining factors of production on the market.

Since no additional savings and thus factors of production have been added to the market, the prices for factors of production will rise slowly. The factors are withdrawn from other occupations where they were obtained for less money, but were fulfilling demands based on true market data. Salaries for employees in these new production lines will go up.

However, the overall market is not yet fully permeated by this new activity. Lots of the previous operations remain active. The overall mood is positive. The new entrepreneurs are convinced their projects will be successful. The employees withdrawn from other occupations are happy about the raise in salary. They have not begun spending this new money yet. Prices for consumer goods have not begun to rise yet so it appears as though their real income rises. Their example catches others people’s attention. They, too, begin looking for new occupations. The ensuing reduction of the supply of consumer goods will not immediately be reflected in market data. The prospect of new and better goods in the future entices the majority. The central bank keeps on buying up additional debt.


  • The ratio of entrepreneurs to workers on the market increases
  • The money supply grows more sharply
  • Interest rates bottom
  • Prices for factors of production slowly start to rise more noticeably
  • Stock prices begin to rise more sharply
  • Talk about new industries and businesses in the media increases
  • Business sentiment turns more optimistic than before

Phase 5: The Credit Acceleration

The perpetuation of the central bank’s purchases now impels capitalists to make riskier loans than before. The ability to load loans off at the central bank at a premium reduces the relevance of risk assessment. A broad market for risky loans emerges, the junk bond market. The rise in the price of factors of production is starting to become more obvious on their main market, the stock market. Especially the markets for risky loans and stocks and for loans and stocks for projects that yield output in the farther future will suddenly appear much more lucrative to capitalists.

Entrepreneurs believe that the goods to be produced in these projects will meet a demand and that enough basic consumption goods are available at a low enough price to justify expenditures for the new future products. Profit expectations of the new enterprises appear reasonable.  As a result stock prices continue to rise. More capitalists will enter this market and realize gains. Established businesses will also begin changing their strategy and embark upon riskier and longer term projects.

It is not possible to determine from the outset which projects will be boosted more than others. If the government, for example, encourages home ownership via corresponding legislation and pushes home loans by itself, and if the central bank buys mortgage backed securities, it is rather likely that lending for the purpose of home ownership will increase and a housing bubble will ensue. But it is important to understand that such a housing bubble would only be one part of an overall reallocation of resources.

New would-be capitalists appearing on the market, who would usually have saved money and thus generated capital by abstaining from consumption no longer see their time preference reflected in the lower interest rates. Instead they will be compelled to buy stocks or houses as a means of wealth generation which at this point appears far more lucrative than loaning out money for less risky and shorter term projects. In addition they will be impelled to consume part of what they would have usually saved. Capital consumption as outlined in Savings and Investment ensues.

The number of resources withdrawn from the production of current basic consumer goods increases. Their employment in long term and risky projects increases. Meanwhile the true availability of savings has decreased. Production of basic consumer goods is neglected more and more as a result.

The additional money loaned and spent in salaries now visibly hits the market for consumer goods. The recipients of the money don’t save as much as the low interest rates indicated. And of the money they do save, part is diverted to risky or long term stocks. Due to higher consumption and less production, prices for basic consumer goods begin to rise slowly. The central bank begins to slow down its purchases of debt.

The entrepreneurs have gotten used to the easy access to credit. The overall sentiment will still be positive toward debt. Entrepreneurs will demand new credit once some of the initial loans are paid off. The lack of additional debt purchases from the central bank, coupled with the ever more prevalent shortage of savings will now cause interest rates to rise. Entrepreneurs will borrow money for more risky and longer term projects.


  • The junk bond market becomes more popular
  • Loans are being repackaged and sold at premiums
  • Profit expectations are revised higher
  • The savings rate peaks
  • The stock market soars
  • The money supply growth rate peaks
  • Interest rates rise
  • Prices of factors of production increase sharply
  • Prices for consumer goods begin rising slowly
  • True GDP peaks

Phase 6: The Credit Boom

Overall sentiment is very positive toward the projects that have been embarked upon. Factors of production are still priced based on the initial earnings expectations, meaning the expectation that their output would meet an expected demand. But the rise in consumer prices is no longer negligible. The raise in salaries is more and more put into relation with prices for consumer goods. Credit transactions will now take into consideration a significantly lower level of purchasing power, adding a premium to the interest. Interest rates begin rising more sharply. The rise of the prices of factors of production impels people to obtain them solely for the purpose of realizing a price gain and as a hedge against rising prices. Stock prices soar at an unusually high pace. Consumer prices rise more sharply. The central bank halts the credit expansion.


  • A euphoria emerges on the stock market, stock prices skyrocket
  • The money supply growth continues declining
  • Consumer prices rise more sharply
  • Interest rates rise further
  • The savings rate declines sharply
  • Stock prices peak
  • True GDP falls

Phase 7: The Credit Peak

Interest rates for loans keep rising sharply. The prices for factors of production increase which drives up cost for the new operations. The products they might at this point be launching are not the highest priority for the consumers. Due to a lack of immediate consumption products vis a vis  consumer demand, the prices for other consumer products begin rising sharply. Thus consumers need to cut back on extra consumption and confine their expenditures to basic consumer goods which are now more expensive. Thus revenue for the new operations falls. Rising prices and falling revenue will affect the profit of these operations. They will start to have problems paying interest to the capitalists and banks.

One by one, new businesses that produce less basic and more extra goods will begin defaulting on their loans and revise their earnings expectations down. First the riskiest ones, then the less risky ones. The capitalists will no longer extend additional credit. The market data now shows the capitalists and entrepreneurs what the true value and time preferences of the consumers are. Stock prices begin to fall, consumers refuse to change their consumption behavior while prices for basic consumer goods and commodities soar.

Resources need to be released from their current occupations. Since people will not immediately find new occupations, a rise in unemployment ensues.


  • Stock prices decline
  • Interest rates peak
  • Consumers complain about high prices for basic goods, such as gasoline or food
  • Business defaults increase
  • Commodity prices soar
  • Business sentiment turns less positive
  • The money supply growth keeps slowing down
  • Unemployment increases
  • True GDP continues to fall

Phase 8: The Credit Crunch

A general realization that the consumption demands were not in line with the actual amount of basic consumer goods available ensues. People will first of all begin consuming less, especially those who have been temporarily released from their occupation. Now the prices of consumer goods will reverse their gains begin falling sharply as well. The same realization reaches those people who are still occupied in more useful lines of production.

They will consume less and save more. More savings will be available. At the same time, as entrepreneurs still one by one liquidate their current failed operations, no additional credit is demanded. Existing loans are paid off or foreclosed upon. Businesses and consumers now rather want to consolidate their finances and save money so as to make available more productive factors for the production of basic consumption goods to get back to the level before the credit expansion began. A lot of money will initially be parked in very low risk debt securities, such as Treasuries. Their interest rates will begin falling first. Other debt securities will follow. The recipients of the money prefer to hold the cash until they are able to identify entrepreneurs who plan to produce more basic goods. Cash gains in preference to other goods.

The overall sentiment turns negative. Profit expectations are again revised down by the capitalists. They begin selling more of their stocks, factors of production are released from their current occupation and return to prices that truly reflect their usefulness to the consumers.


  • Stock prices crash
  • Commodity and consumer prices fall
  • The savings rate increases
  • Loan foreclosures increase significantly
  • Interest rates fall
  • Business sentiment turns negative
  • The number of bankruptcies increases
  • Unemployment increases
  • True GDP continues to fall

Phase 9: The Correction

Unless the government tries to counteract the processes that lead to a correction, in particular the liquidation of unprofitable operations, or attempts to perpetuate the process of credit expansion, prices will quickly return to levels where they represent voluntary value preferences. Otherwise the correction will also occur, but it will take much longer. Individuals have cut back on their consumption in order to save up money. The increase in savings lowers the rate of interest and thus indicates to entrepreneurs that a sufficient level of productive factors is available. Entrepreneurs identify operations that are profitable and obtain funds from the capitalists. They begin employing factors of production in these operations. The market returns to the unhampered state, albeit at a level of output and a standard of living that is lower than where it was before the credit expansion was started.


  • Stock prices bottom out
  • Interest rates bottom out
  • Consumer and commodity prices rise back to a certain level and then continue their slow long term decline
  • Unemployment declines
  • True GDP begins to rise again
  • Interest rates rise back to a certain level and then continue their slow long term decline

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