1. Keynesian and Austrian Business cycles theories.
In this essay, I am going to outline Austrian Business Cycle theory and Keynesian
Business Cycle theory, compare them and in the end my opinion will be stated.
Firstly, I would like to determine what business cycle is.
Business cycle describes periods of economy growth and contraction. Generally
accepted that business cycle is consisted of four major stages: contraction,
trough, expansion and peak. However, the labels of these stages may vary. In
general, GDP’s growth rate, unemployment rate and interest rate are taken into
account in determining the stage of the cycle. Actually, the word cycle is not
appropriate, because business cycles does not have cyclical character, and
stages are barely predictable and they tend to have different length. Many
economists have been using collocation “business fluctuations”. Treatment,
analyzing, determining the causes of these stages are the main points of
argument between various business cycle theories. Keynesian and Austrian
theories differ mainly in determining which mechanisms should be used in order
to shorten recession period and avoiding occurrence of depression and
prolonging the periods of growth. Also they have different opinion on the causes
of fluctuations.
Keynesian theory focuses more on short run effects rather than on long run
effects because as John Maynard Keynes said “in the long run we are all dead”.
And because of this, Keynesians find the way out of depression in government
intervention into economy by aggressive adjusting fiscal or monetary policies,
more likely both of them simultaneously, while some theories believe that
economy should find the way out of depression by itself, so-called laissez-faire,
but it would take more time. Here is the main argument appears, Keynesians do
not want to wait too long for economy recover itself by means of market powers.
Keynesians find the increasing of aggregate demand as the way out of
depression. Keynesians have different patterns of how the government should
act in order to increase aggregate demand and subsequently increase
consumption and economy output. They suggest to governments spend more on
social policies in bad times, so-called “contra-cyclical fiscal policies”, when
economic activity is declining, for encouraging investments and increasing overall

2. consumption by lowering tax and interest rates. Because aggregate demand is
consumption plus government spending plus investments and net exports, and
when there is a decline in consumption, according to Keynesians, government
spending should be increased in order to remain the same aggregate demand.
Also government should keep economy from “overheating” by increasing tax &
interest rates and decreasing government spending in periods of growing
economic activity. Keynesians try to prevent business fluctuations and they
consider economic downturns as “economic maladies”, whereas classical
schools consider economic downturns as an inevitable period in healthy
economy. Keynesians claim that one of the reasons of Great Depression was
that US economy was producing much lower than its capacity. High rate of
unemployment was due to businesses had no funds to hire as many people as
they were doing, because they were liable to banks. And because of this people
could not afford the goods of those businesses because they had no job. It was
a paradoxical vicious circle. Keynes suggested that at such times, governments
should take an action in order to stabilize economy and encourage people to
spend more and to save less because by saving, they contribute less into
economy and this decreases aggregate demand, which is seen as one of the
most important causes of recessions by Keynesians. Keynes denied the idea that
cutting wages would cure recessions. He studied the explanations for this idea
and found them all wrong. He also considered the most likely consequences of
cutting wages in recessions, under various different circumstances. He
concluded that such wage cutting would be more likely to make recessions worse
rather than better. We can conclude that Keynesians are advocating a symbiosis
of aggressive governmental intervention during times of declining in business
activity and light adjusting of economy during times of stable growth.
Austrian business cycle theory find the main cause of business fluctuations in
distortion of interest rates by governmental interference and keeping them
artificially low. Austrians assert that the boom induced by savings is sustainable
whereas the boom induced by credits is not. These booms may have the same
effect in the beginning but ultimately, have absolutely different consequences.
Since, when the boom is induced by increased thriftiness of people, interest rate
lowers naturally and this stimulates businesses to invest and subsequently create

3. new jobs and increase overall output. And the fluctuations of this interest rate are
very smooth and slight, which do not harm economy. But when the boom is
induced by government by means of artificial lowering interest rates, businesses
are thinking that they can invest more although people do not want to save more,
and they think they have more money for spending. But “more money” is
produced by government just by printing excessive amounts of money or creating
digital money, which is not backed by gold, and when there is an increase in
money supply into economy it artificially decreases interest rate and this causes
“malinvestments”. “Malinvestments” are described as investments that would not
have been done in normal conditions, when interest rate is determined by
willingness of people to save and willingness of businesses to borrow, but once
they done, these “malinvestments” would be cut first when businesses would be
asked to repay their credits. Which undoubtedly will bring on dismissals and
consequently decrease in overall welfare. Distinctive features of
“malinvestments” are that they often overambitious and usually long-term, and
this aggravating results of liquidations of “malinvetments”. However, the upward
behavior of interest rate cannot remain forever and in such situation, fluctuations
would be barely predictable. More likely, interest rates would skyrocket that would
cause panic liquidations of “malinvetments” and incur huge losses to
entrepreneurs. Most of “bubbles” can be explained by the Austrian Business
Cycle theory. Austrians contend that the boom ends when bank credit expansion
finally stops – when no further investments can be found which provide adequate
returns for speculative borrowers at prevailing interest rates. They further argue
that the longer the credit-induced boom goes on, the longer and more severe will
be the necessary bankruptcies, foreclosures, and depression readjustment.
Austrians argue that all attempts of governments to maintain asset prices, bail
out banks, which have lost control over their speculative borrowings and credits,
or "stimulate" the economy with deficit spending will only make the
“malinvestments” worse, prolonging the depression and adjustment necessary to
stabilize growth. Von Mises said: “There is no means of avoiding the final collapse
of a boom brought about by credit expansion. The alternative is only whether the
crisis should come sooner as a result of the voluntary abandonment of further
credit expansion, or later as a final and total catastrophe of the currency system

4. involved.” Nevertheless, Austrian Business Cycle theory has been criticized by
mainstream economists, moreover some of them consider it as nonsense.
One of the points of critique of Austrian theory is that it is not backed by empirical
evidence. Milton Friedman made a conclusion that "The Hayek–Mises
explanation of the business cycle is contradicted by the evidence. It is, I believe,
false." Nonetheless, there are right predictions made by Austrian economists in
history, such as warning of Hayek about Wall Street crash in 1929, Austrians also
say that Housing Bubble of early 2000s was an illustration of Austrian Business
Cycle theory. Steve Hanke contends that recent Global Financial Crisis is the
outcome of the Federal Reserve Bank's interest rate policies as is predicted by
the Austrian business cycle theory. In my view, empirical evidence is not a good
criterion because after WWII Keynesian theory was dominant in Western world
and we cannot judge Austrian economists because there have not been a totally
free market, which is the market without artificial adjustments made by the
governments. Nonetheless, Economist Paul Krugman has argued in his article
“The Hangover Theory” that the theory cannot explain changes in unemployment
over the business cycle. Krugman argues that because total spending is equal to
total income in an economy, the theory implies that the reallocation of resources
during "busts" would increase employment in consumption industries, whereas in
reality, spending declines in all sectors of an economy during recessions. He also
argues that according to the theory the initial "booms" would also cause resource
reallocation, which implies an increase in unemployment during booms as well.
In addition, Quiggin, Australian economist, writes, “the Austrian theory didn’t say
much about labour markets, but for most people, unemployment is what makes
the business cycle such a problem. It was left to Keynes to produce a theory of
how the non-neutrality of money could produce sustained unemployment.” In my
opinion, there is less stress on labour markets, than apparently was expected by
Quiggin, due to another approach to defining the causes of business fluctuations,
which are excessive credits and “malinvestments”. Robert P. Murphy replied to
Quiggin’s criticism: “The persistence of high unemployment throughout the 1930s
is not a task for ABCT to explain. Rather, this was a consequence of the
destructive high-wage policies of both Hoover and FDR, not to mention massive
deficits and tax increases that further eroded worker productivity and made

5. employers less likely to hire people. It's a bit odd to say that only Keynes could
explain the persistence of unemployment in the 1930s, when after all Hoover and
then FDR were among the best Keynesians in US presidential history.”
Furthermore, Piero Sraffa stressed the fact that Hayek did not find the “real”
interest rate of free market at which depressions would be prevented. I think it is
directly related to the fact that I mentioned above, that in post WWII era
Keynesian theory was dominant in Western world, and it was impossible to find
the “real” interest rate of free market. Austrians tend to respond to criticism that
most of the adherents of other schools of economic thought misinterpret what
their theory says; of course, such thing may exist because Austrian theory has
been evolving since its establishment and there were many prominent
contributors and their works can be read differently. Also, Jeffrey Hummel wrote
in his paper (“Problems with Austrian Business Cycle Theory”): “Rumor has it that
at a recent strategy meeting, the top-flight Austrian economists decided that the
Austrian business cycle theory should be deemphasized in favor of other aspects
of Austrian theory. As is obvious from this paper, I think the exact opposite should
be done. We need more, not less, work on Austrian business cycle theory”.
To sum up, Keynesian theory is mainly criticized because of its assumption of
governmental intervention into economy, what contradicts with laissez-faire.
Notwithstanding, Keynesian theory is deemed as very good in explaining the
causes of Great Depression and in describing real-world business fluctuations.
Keynesian and Austrian theories regarding business cycles have conflicting
points, such as whether government should intervene into economy by means of
adjusting fiscal and monetary policies. Keynesians advocate increased spending
in times of recession, while Austrians advocate savings as a tool for finding the
way out of depression. This is undoubtedly opposite suggestions that cannot
coexist in one economy. However, I think that these differences are mainly
caused by essentially different approaches of defining causes of business
fluctuations. Of course, it may look very strange from the point of view of other
governments that their neighbour spending a lot in times of recession. But if we
understand that this spending is just a compensator of decreased aggregate
demand this can be seen reasonable and justified. However, this spending
cannot continue for too long, and such governments should rely on the fact that

6. economy is going to stabilize and the efforts of the government are not useless.
And the problem of Austrian theory is that it advocates laissez faire, and when
economy in recession it is impossible to government not to try to take measures,
and people would question the government why are they inactive. People are not
ready to wait for too long for economy being stabilized by means of market
powers. There is no precise consensus which theory should be used because
there exist more than just two theories, and I think there will never be.
References:
- Book Article or Chapter
Ludwig von Mises, 1998, Human Action, Chapter XX, section 8
- Reason Paper
Jeffrey Rogers Hummel, 1979, Problems with Austrian Business Cycle theory
- Encyclopedia Article
Alan S. Blinder, 2008, Keynesian Economics, In The Concise Encyclopedia of
Economics
- Book Article or Chapter
Ludwig von Mises, 1981, The Theory of Money and Credit, Part III, Part IV, edited
by H. E. Batson
- Book Article or Chapter
Roger W. Garrison, 1997, The Austrian Theory of the Business Cycle in Business
Cycles and Depressions, edited by David Glasner
- Journal Article
Steve H. Hanke, 2009, National Post
- Book Article or Chapter
John Maynard Keynes, 2008, The General Theory of Employment, Interest and
Money, Chapter 19
- Book Article or Chapter
Milton Friedman, “The “Plucking Model’ of Business Fluctuations Revisited”
- Book Article or Chapter
Paul Krugman, 1998, The Hangover Theory
- Journal Article

7. Piero Sraffa, 1932, Dr. Hayek on Money and Capital in Economic Journal
- Webpage
Manoj Singh, 2011, The Austrian School Of Economics
http://www.investopedia.com/articles/economics/09/austrian-school-of-
economics.asp
- Webpage
Economic Theories, 2008 Keynesian Business Cycle
http://www.economictheories.org/2008/11/keynesian-business-cycle.html
- Webpage
Brent Radcliffe, 2009, Can Keynesian Economics Reduce Boom-Bust Cycles?
http://www.investopedia.com/articles/economics/08/keynesian-economics.asp
- Webpage
Dan Mahoney, 2001, Austrian Business Cycle Theory: A Brief Explanation
http://mises.org/daily/672
- Webpage
John Quiggin, 2009, Austrian Business Cycle Theory
http://johnquiggin.com/2009/05/03/austrian-business-cycle-theory/
- Webpage
Robert P. Murphy, 2009, Correcting Quiggin on Austrian Business-Cycle Theory
http://mises.org/daily/3466