An except from one of my grad school essays in my MSF program:

3.1 Austrian Business Cycle Theory (ABCT)

The ABCT maintains that central banks cause business cycles by reducing interest rates below their natural level. According to French (2009), the sequence of events in the business cycle usually occurs in the following manner:

1. An economic shock occurs. The shock can be exogenous (war, pandemic) or endogenous (debt crisis, bank failure). The central bank responds to the shock by precipitously cutting interest rates.

2. As the cost of funds falls, loan demand rises and eventuates in a credit boom.

3. The credit boom facilitates numerous economic distortions:

a) It shortens consumer’s time preference, artificially stimulating consumer demand, that is, consumer demand is elevated relative to demand derivative of a natural interest rate;

b) It leads to capital misallocations, e.g., (i) entrepreneurs make capital expenditures premised on elevated demand and (ii) are generally less disciplined and more speculative in their investments, given the low cost of funds;

c) It leads to consumer price inflation and asset price bubbles.

1. When the central bank raises interest rates, the credit expansion begins to contract: consumer demand falls, firms liquidate their malinvestments, inflation turns to deflation, and asset bubbles burst.
   

3.2 Austrian Business Cycle Theory: Application

There are myriad applications for the ABCT for financial analysts and for general business decisions. Two are described here. First, it provides the analysts with a macro-framework for understanding the cyclicality of economic phenomena. The recent boom and bust is comprehended perfectly in the ABCT framework: Covid shock to the economy → Powell expands Fed balance sheet to $9 trillion → VCs lavish funds on crypto and NFTs → Nasdaq increases ≈ 130% → CPI reaches 9% → Fed begins rate hike campaign → Nasdaq falls ≈ 35% → tech companies cut their workforce → FTX and SVB fail. An understanding of the archetypal business provides the analyst with a probable sequence of events and an admonishment that contractions follow expansions—that booms invariably go bust—which is contrary to the bullish sentiment, the speculative exuberance, that prevails during booms.

Second, ABCT is applicable to business executives, too, as it cautions against over-expanding business operations during a monetarily induced boom. The elevated demand is predicated on loose monetary conditions; it does not result from savings, and thus it is not sustainable. The recent layoffs in the tech sector suggest that management’s capital allocation decisions (R&D, M&As, PPE, share buybacks, labor force expansion, etc.) were misguided—they were malinvestments. And since many of the capital expenditures are non-recoverable, or difficult to liquidate, management elects to liquidate labor. All of this is to say, capital allocation decisions, being integral to business success and value creation, should be made with an awareness of the relationship between monetary conditions and the cyclicality of economic phenomena. The ABCT provides a framework for understanding this relationship and making prudent capital allocation decisions.

3.3 Austrian Business Cycle Theory: Complementarity with Other Theories

ABCT compliments the work of behavioral economists, such as Shiller (2015), who stress that humans are prone to cognitive biases and irrational economic behavior. The notion that human behavior is not rational is presented as a challenge to neoclassical economics, which postulates that humans are rational, utility-maximizing agents. ABCT complements the work of Shiller in two respects. First, ABCT explains why irrational financial behavior is clustered and not evenly distributed across time, i.e., it is a response to monetary inflation. Second, ABCT provides Shiller’s work with a precipitating cause of speculative frenzies, namely, monetary inflation. Shiller argues that much irrational behavior is memetic and amplified by feedback loops and narrative reinforcement, but he lacks a fundamental cause. ABTC maintains that speculative frenzies are fundamentally caused by interest rate policy and credit expansion. Thus, ABCT explains the precipitating cause of speculative frenzies, and Shiller explains the mechanism that amplifies investor exuberance.