Financial Risk in the Austrian Theory of the Business Cycle

Abstract

The ABCT is a description of the boom and bust of an economy following a reduction in the banks’ interest rate to a level below the equilibrium or natural rate. While descriptions of the theory emphasize the imbalance between consumption and investment that ensues the artificial decrease in the interest rate, often the driving force that impels firms to embark in new investment projects that will subsequently reveal themselves unsustainable is obfuscated. This initial decrease in the interest rate makes the present value of investments and assets rise, thus inducing an upsurge in investment, but also causes both the debt/equity ratio and the number of risky projects to increase, causing an intensification in the financial risk of the overall economy. At the same time, as some prices are less flexible, like wages and depreciation costs, this, added to the reduced interest rate, accentuates a rise in nominal profits that seems to validate an increase in investment and consumption. But as the real demand of the economy starts to reveal the unsustainability of those investments, the great exposure of the economy to financial risk creates an increase of defaults in payments and a subsequent reduction in credit bank which, in turn, increases banks’ market interest rate, reduces money supply, increasing the real value of debts which, added to the fact that profits lose steam due to the catching-up of costs with revenue prices, leads the economy into a recession.