It’s no accident that Austrian economics is newly popular. It provides the best explanation for the business cycle we just lived through.

But the resurgent popularity of Austrian economics may actually be hampering the ability of the Federal Reserve to reflate the economy with low interest rate policies. Businesses, now aware of the dangers of a low inflation- sparked economic bubble, may simply be refusing to fall for the age-old boom-bust trap.

The Austrian theory of business cycles is rather straightforward:

1) In a market economy, lower interest rates are a sign that more wealth is available in society for new business projects. Either society is more wealthy—and therefore saving more without lowering spending—or its members are saving more—delaying current consumption in favor of future consumption, and incidentally providing loanable funds for projects that will be sold for future consumption.

2) In either case, the low interest rates are a sign of additional savings—and therefore a sign that more money will be available for future consumption. Businessmen respond to this by starting or expanding business lines aimed at future consumption—that is, projects that take time and larger amounts of money to complete.

3) Many of the projects seem profitable only because low interest rates make them cheap to fund and the assumption of future consumer spending out of increased savings promises demand for their products. For businesses, this is a kind of paradise: they get to borrow cheaply and sell to wealthier people in the future.

4) Low interest rate-fueled business expansion spreads through the economy. The cost of labor and materials goes up, which provides people with more money to spend or save. Retail businesses expand as well as the higher-order long-term manufacturing, investment and research & design projects. This creates what looks like a benign cycle: expansion fueling expansion.

5) When the low interest rates are caused by central bank intervention, however, this paradise turns out to be an illusion. The wealth that would have led to future spending does not actually exist—because the low interest rates aren’t caused by an increase in the amount of savings. Because we already know the interest rates weren’t caused an increase in the savings rates, it’s fair to assume that the additional wealth created during the boom mostly went to spending rather than increased savings. (Indeed, savings might actually have decreased as people anticipating future wealth rationally spend more now because they perceive less need for savings to finance future spending.)

6) As it is revealed that savings-fueled demand is lower than expected, many of the projects go bust. Investments in them need to be liquidated, some at a total loss. The investments in those long term projects now look like irresponsible speculation on an assumption of future growth. The Austrians call them “malinvestments.”

7) The liquidation of those malinvestments means the loss of value in the resources those investments would have used, including the loss of jobs in those businesses. This spreads the “bust” from the original speculative areas to cover the economy—in a reverse of the boom cycle.

8) A side note here: It’s sometimes asked why a consumer boom doesn’t follow a long-term project bust. After all, if the problem was an assumption by businesses of increased savings, shouldn’t learning the reality that people weren’t saving cause the retail sector to boom? Unfortunately, this doesn’t happen. In fact, the reverse is usually the case. The reason is straight-forward: the mistake wasn’t underestimating spending, it was overestimating savings. What’s more, the liquidation of malinvestments causes unemployment, often triggering consumers to start saving more and spending less.

9) The economy develops what looks like an output gap. It is producing far less than it once did and employment is at a far lower level. This is mainly because part of the old output was geared toward future consumption that is now understood to be impossible. The output gap is just a shadow of the old, unsustainable boom.

Okay. Let me say that this is a slightly modified version of the Austrian theory of business cycles. It’s been modified mostly to take out the shibboleths of Austrian economics—the kind of private language that people who have read a lot of Ludwig Von Mises use to talk to each other. No doubt they’ll strenuously object to one part of another of my description of what they like to call the ABC—Austrian Business Cycle.

Read More: http://www.cnbc.com/id/40340227/

ValueWalk Premium Subscription Includes:

  • 3 Write-ups per month (EXCLUSIVE content that you won’t find anywhere else)
  • Personal Track Record from Jacob’s Brokerage
  • Any question you have answered within 48 hours