The Austrian business cycle theory claims that manipulating interest rates can cause economic booms and crashes. The Federal Reserve can lower rates to stimulate the economy, but this artificial credit easing is short-lived and can cause a severe recession. Delaying a recession through monetary policy can make it worse.
The Austrian business cycle theory states that the business cycle can be manipulated and even predicted by analysts when a federal bank tries to control monetary policy by artificially adjusting the interest rate. While the theory states that such manipulation can cause the economy to boom, it can also cause it to crash. Thus, the Austrian business cycle theory notes that these policies can cause great harm.
In the normal course of events, a national bank, such as the US Federal Reserve, maintains tight control over the interest rate or, more appropriately, several interest rates. This is done to stimulate the economy and control the economy so it doesn’t heat up too quickly. Ironically, what Austrian business cycle theory claims such policies cause, an extreme business cycle, is what they are trying to prevent.
To help stimulate the economy and prevent a long-term downturn in business cycles, the Federal Reserve can choose to lower interest rates. This causes a credit easing. However, because this is artificial credit easing, it usually doesn’t last very long. Once the economy starts to overheat, interest rates must rise accordingly to avoid unwanted inflation.
In one sense, the Austrian business cycle theory may seem like a trivial thing. After all, if the economy were to slow down anyway, what’s the difference if it slows down due to monetary policy or normal cyclical activity? Some believe that an attempt to delay the inevitable actually makes the recession worse. Indeed, the developer of the Austrian business cycle theory, Ludwig von Mises, wrote: “The alternative is whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a catastrophe final and total of the currency system involved. ”
The reason the economy falls more after an attempt to ease credit through lower interest rates is due to the bubble effect it creates. Often, during a business cycle, when a recession comes, it does so gradually. In a bubble, however, companies move more collectively, both up and down. This can quickly cause a severe recession, according to the Austrian business cycle theory. Indeed, as the recession takes longer to develop, it is magnified.
The only way to avoid Mises’ theory might be to hope that the economic downturn is held back long enough for a natural increase in economic activity. However, since blisters usually mask symptoms, this will be more difficult to accomplish. After all, if the economy looks healthy, there will be fewer attempts to fix it.
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