Austrian Business Cycle Theory

Introduction

In the fall of 2009, an economist from the Federal Reserve branch at Charlotte gave a talk at my university explaining the causes and consequences of the 2007–9 recession. He asked us to imagine the economy as a guy on a bicycle. As the bicyclist pedaled down the road, a car knocked him into a ditch. The Fed economist told us that what we needed to do was to get the guy back on the bike and start him pedaling again. It left me dumbfounded. While this was a succinct story, it was not an economic theory. Where did the car come from? Will it come back? Are there other cars? When I asked where these shocks (the cars) come from and how we can avoid them, the answers were “They come from outside of the system” (meaning that nobody, not even economists at the Fed, has any idea where they come from) and “These shocks are unavoidable” (meaning that the government always needs to be ready to leap into action). Despite my questioning, the Fed economist really did not answer these questions. Further complicating the situation, as economists like to do, he dressed up the terminology and talked over the heads of the audience. It is time to strip away the jargon and present a clear theory.

Modern macroeconomics does not actually have a theory of business cycles. In the Fed economist’s story, the car is what economists call “an exogenous shock”—meaning that something from outside of the model negatively impacts the economy. These shocks can be basically anything, from bad weather to new political regimes. One of the main tools used by modern macroeconomists is called the dynamic stochastic general equilibrium (DSGE) model. “Stochastic” simply means that there is a pattern in the aggregate data, and “dynamic stochastic” means that this pattern tends to occur over time. Anything outside of the model is “exogenous,” and anything that does not fit with general equilibrium is a “shock.” So when economists say that an “exogenous shock” impacted their DSGE model, they are saying that something unknown has disrupted observed historical patterns. In other words, they are basically telling you that they have no idea why this event happened, if it will happen again, or what steps can be taken to prevent it from happening in the future. The car is just gone, so now we need to focus on the bicyclist.

The Austrian School of economics rejects macroeconomics’ atheoretical approach. Austrian economists argue that macroeconomics must be built upon microeconomic foundations. Only once we understand how the smaller parts of an economy work together can we begin to understand how the larger system works.