The Austrian Business Cycle Theory was developed by the economist Ludwig von Mises to explain the phenomenon of business cycles. It provides crucial insight for understanding the cause of cyclical boom/bust cycles and their connection the government’s manipulation of the economy. To understand the Austrian Business Cycle Theory, an analogy is helpful:

Imagine an economy with just one actor: Robinson Crusoe on an island. Crusoe loves fish, so he spends half of each day fishing so he can enjoy fish in the evenings. Additionally, Crusoe spends Friday mornings maintaining his fishing dinghy and nets. In order to have fish on Friday, he must fish for an extra hour every other day of the week. In economic terms, Crusoe has a savings rate of one hour per day. His savings rate is also his investment rate, or the percentage of present income he sets aside to maintain or increase future consumption.^{1}

Crusoe doesn’t have a fridge, so he preserves his catch by throwing it in a small, dark pond. He can’t see how many fish are in the pond, so he keeps a stack of small rocks near it. Every time he adds a fish, he adds a rock, and every time he eats one, he removes one. The rocks are his money supply.

Suppose that Crusoe shares the island with some mischievous monkeys, who see Crusoe adding rocks to his pile. They decide to imitate him, so every time Crusoe ads a rock, they sneak in and add one as well. The monkeys are inflating the money supply by injecting currency into Crusoe’s investment fund.^{2}

One day, Crusoe suddenly notices that his “savings rate” of fish is double the usual. He decides to compensate by eating some of the fish he catches during the “savings hour.” This is the consumption-side of the boom phase of the business cycle. Crusoe also decides to take some extra time each day to start building himself a new hut. This is the investment-side of the boom phase of the business cycle.

Crusoe now believes that the cost of saving fish is half the usual, while in fact his savings rate is too low for the investments he is planning.

Before long, Friday comes around. When it comes time to eat his midday meal, Crusoe suddenly realizes that he’s out of fish – despite having a surplus of rocks. He’s exhausted his investment capital because the additional currency snuck into his money supply did not represent a real increase in his productivity or savings rate. He doesn’t have the capital (fish) to maintain his previous consumption rate, much less increase it. He is forced to cut his investment rate (he must spend some of his Friday fishing) just to have some fish for Friday’s dinner. He must also abandon his incomplete hut because he does not have the time to finish it. The abandoned hut is an extravagant expenditure that represents a loss of capital.^{3} This is the bust phase of the business cycle.

To review, here’s the overall impact of the monkey’s trickery: Sunday-Friday, Crusoe catches the same number of fish, but consumes more, and therefore saves less. That’s the boom period. Friday, Crusoe consumes less fish, and spends less time for maintaining his nets (capital). Some of his investment/consumption time must now be spent in production. That’s the bust period. If Crusoe’s initial savings rate allows him to just break even each week ^{4}, his nets will gradually get worse and worse and he will eventually go hungry.^{5}

**Notes**

- Crusoe prefers to enjoy his fish sooner rather than later, but he is willing to put aside some of his catch to get more fish later. The discount he gives to eating a fish Friday is his time preference, or his originary interest rate. (To that, he adds the risk that the fish will spoil by Friday to get the market or “real” interest rate.)
- As long as the monkeys keep contributing one stone for every fish, Crusoe can account for their trickery. But if the monkeys are unpredictable, it will be impossible for Crusoe to set the proper savings rate.In the real world, the originary interest rate reflects the average time preference of all savers. If someone starts monkeying around with the interest rates, it becomes impossible for investors (or the monkeys at the Fed) to know what the real rate of savings is even if they know that the rate is being manipulated.
- That abandoned hut represents investments which exceed the ability of the actual savings rate to complete. The resources it takes to build compete with worthwhile investments (such as repairing the fishing nets) by raising the prices for all capital. Ridiculous business models and sky-high salaries during the dot-com boom, as well as over-extended sub-prime mortgages likewise compete with legitimate business models, salaries, and mortgages. Manipulating the money supply makes it difficult to distinguish bad investments from good ones, so no one can escape the inevitable crunch.
- That is, zero net profit, an equilibrium rate of savings, or “the evenly rotating economy” in Mises’ terminology.
- Suppose Crusoe decides to ignore his hunger and work on his nets all Friday. In other words, he trades current production (and therefore consumption) for higher future consumption (that is, economic growth). If he does so voluntarily, there’s nothing wrong with that. But there’s nothing inherently more desirable or efficient in spending some of one’s time starving just to increase future production (that is, in valuing economic growth over present consumption.) Note that the longer Crusoe delays the shift back to production, the more severe the miss-allocation of resources (and his hunger) becomes. The monkey’s trickery does not actually make Crusoe to become a better saver – he is more likely to start saving less because of uncertainty over the future.

**Further reading**

- Austrian Business Cycle Theory: A Brief Explanation
- The Austrian Business Cycle Theory at Mises.org

This is great – a must link for the simpleton who cares not to divulge into economic theory but needs to know why our economy can apparently suck “for no reason”

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I don’t understand how, in the second paragraph, you came up with a savings rate of 22.5% – please explain

I don’t know either. If he works eight hours per day + one hour for Friday, it would be 9/8 = 12.5%. I just took it out.

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Much of this is just nonsense. To see why, let’s use some numbers.

Crusoe has the following “capital”: one dinghy, two fishing spears, a hut, some clothing and 15 hours of his time a day to spend keeping himself alive. He spends 7 hours each day catching fish, the others collecting, preparing and eating coconuts and yams (and the fish), fixing up his hut, for personal hygiene, and napping.

Crusoe likes to eat 6 fish for dinner every night. It takes him 1 hour to catch a fish (he is remarkably consistent), so he spends 6 hours every day to catch the fish that he will eat for dinner that night. But since he takes one day (Friday) off a week from fishing to do maintenance on his fishing gear (dinghy and spears; we’ll start with him spear fishing), he must catch an extra fish every fishing day to have the 6 for Friday, so he spends 7 hours every day fishing, Saturday through Thursday. His savings (investment) rate is 1 hour per day, but on Friday he “cashes in” all of his savings (investments) and starts anew the next week; this is not an investment rate in any sense, it will not maintain or increase future consumption, it merely allows him to skip one day fishing a week. The time he spends maintaining his dinghy and spears are his actual investment rate since that activity does maintain his future consumption. Note that Crusoe could, if he wanted, spend 6 hours a day fishing and 1 hour a day maintaining his fishing gear.

Notice also that this means our friend Crusoe is not an idiot; he knows how to count and he knows how to use a calendar (and, presumably, he has one). He knows how to add and subtract, and he knows how to plan. He knows that he has to maintain his tools (“capital”) if they are to be used in the future.

Since he preserves his catch in a pond he cannot see into, he uses rocks to track the number of fish in it. He comes back from fishing, puts his 7 fish in the pond and adds 7 rocks to his pile. He then goes and takes a nap until time to prepare dinner, at which time he returns to the pond, removes 6 fish from the pond and 6 rocks from the pile. The rocks are his “money” supply only in sense of being an accounting device so he doesn’t have to remember how many fish are in the pond. They are not “money” in the sense of being a medium of exchange (as there is no one to exchange with) or as a store of value (he cannot use a rock as he would a fish; he cannot eat it). The fish in the pond are his “store of value”.

Over time, Crusoe notices a consistent pattern. On Friday, after removing the fish from the pond and the rocks from the pile, he has no rocks left in the accounting pile – there are no fish left in the pond. On Saturday, he has one rock left, on Sunday, two rocks left, etc. until Thursday he has 6 rocks left – representing the 6 fish in the pond for Friday’s dinner. He realizes that he doesn’t need his calendar anymore because he knows what day of the week it is by how many rocks are left in the pile each evening (but he decides to keep the calendar anyway so he’ll know when it’s Christmas).

Now the mischievous monkeys begin to interfere. On Saturday, they notice Crusoe adding 7 rocks to his pile (a “pile” that had no rocks in it before), and, after Crusoe departs for his nap, they add 7 rocks to the pile, one for each that Crusoe has added. The monkeys are not “inflating the money supply by injecting currency into Crusoe’s investment fund”; they’re messing with his head by screwing up his accounting system. And, Crusoe, coming back that evening to get his dinner, notices this right away (remember, he’s not an idiot). He takes 6 fish from the pond and 6 rocks from the pile (note that there’s no statement that the monkeys remove any rocks from the pile ever, and besides Crusoe is standing right there so if they tried at this time he’d see them), and immediately wonders what day of the week corresponds with the 8 remaining rocks in the pile (7 + 7 – 6 = 8); he’s never had 8 rocks left in the pile after taking his evening fish. But he leaves the 8 rocks and goes to have dinner, scratching his head all the while.

The next day, the same events occur: 7 fish added to the pond and 7 rocks added to the pile by Crusoe, 7 rocks added to the pile by the monkeys, 6 fish removed from the pond and 6 rocks removed from the pile by Crusoe. Now Crusoe definitely knows something is amiss; he’s staring at a pile with 16 rocks in it (8 + 7 + 7 – 6 = 16)! His “savings rate” hasn’t doubled (gone up by a factor of 2, i.e., 2 rocks instead of 1, 4 rocks instead of 2, etc.), it’s gone up by a factor of 8 (8 rocks instead of 1, 16 rocks instead of 2, etc.)! If he believed the “rocks”, he’d decide right then and there to take the next 2 days off from fishing because he’s got 16 fish in the pond. But he’s never had 16 fish in the pond at any time before (12 would have been the most, just before dinner on Thursday). He knows someone (or something) is messing with his rock pile. He suspected that yesterday, but now he knows it for sure.

So this isn’t the “consumption-side of the boom phase of the business cycle”. And Crusoe isn’t taking any extra time off to build a new hut (“investment-side of the boom phase of the business cycle”). What Crusoe is doing is reducing the number of fish he catches each day to 6, reducing the number of fish he eats each day to 5 (except on Friday), and using the extra hour a day of his time to make a net to catch the mischievous monkeys (a net he can use to fish with later on); he’s reducing his consumption (fish eaten) to invest in additional capital (the net), and the net represents a “technological advance”.

So he works on the net, and, a couple of weeks later, starts capturing the monkeys with it. He captures and eats one monkey a day (he’s giving up fishing for a while), until the monkeys wise up and depart for other regions. Then he starts using the net to fish with and finds out that it only takes him an hour to get his 7 daily fish. His 14 hours of invested labor (in making the net) are now returning him 6 hours every day of additional free time, a huge return on his “investment”. He uses some of that time to start building a tree house; he never liked that old hut anyway. But he does miss the monkey meat.

Notes on the Notes

1. Crusoe prefers to eat 6 fish a day, but since he isn’t going to fish one day a week, he has to catch an extra fish on the other days and keep them until his day off (that’s his plan). Originary interest rate expresses to what extent people are prepared to forgo consumption in the present as against consumption in the future (“What is interest?” http://www.acting-man.com/?p=2133). Crusoe isn’t foregoing any consumption in the present (he’s still going to eat 6 fish), he’s just doing some additional work now so he won’t have to do it in the future. When he decides to only eat 5 fish a day while he makes his net, then he has decided to forgo consumption.

2. If the monkeys are unpredictable in how they add rocks, Crusoe still knows that something is wrong with his accounting system because the number of rocks left at the end of the day no longer follow the accustomed pattern (0 on Friday night, 1 on Saturday night, etc.); remember, he’s not an idiot. Crusoe still knows how to set the proper “savings rate”; it’s exactly one fish a day. Who knows what this means in the “real” world, or what to do about the “monkeys at the Fed”; as previously noted, this example is nonsense.

3. Perhaps manipulating the money supply does have dire consequences, but there’s no money supply being “monkeyed” with in this example.

4. But Crusoe does, before the monkeys interfere, have exactly a zero net profit, he is just breaking even (or, perhaps in other words, living a sustainable life style). His dinghy and fishing spears (and, eventually, his net) will not gradually get worse and worse until he eventually goes hungry; he’s maintaining his gear (that’s what he does on Friday).

5. Suppose Crusoe does decide to ignore his hunger and work on his fishing gear all day Friday. Wait, what about the 6 fish he’s got in the pool from the other days fishing? None of this discussion makes any sense with respect to the opening statement. What it does make sense with is his decision to forgo one fish a day for the two weeks that he makes his net. He’s not starving; he’s still eating 5 fish a day. And there is something desirable in doing this. Remember, the whole point of the Austrian school is that man acts to fulfill an end using means, and if Crusoe has decided to “get the monkeys” by “making a net”, then that is his decision. Is it inherently desirable; would all men do this? That’s not the point; Crusoe has decided to do it and, from the Austrian point-of-view, that makes it “desirable” (to Crusoe).

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