Meeting my own goal: A post on the Austrian Business Cycle Theory

Developed by Ludwig Von Mises and Friedrich Hayek, the Austrian Business Cycle Theory (ABCT) says that an artificially low interest rate, created by the government or a central bank, induces more investment in a production sector because investors now can find more money with an interest rate that is lower than a natural rate of interest. The artificially  low interest rate creates a production boom. Sooner or later, according to the theory, the investors realize the production is unsustainable and try to re-adjust the production and capital to other productions. At this moment, the economy is in a recessionary period.

When the interest rate is lower than a natural rate of interest, savers saves less and consumes more. At the same time, businesses borrow more money to invest in their projects. Businesses fail to see an increase in the demand for their products as an aggregate increase in the demand instead they think that the relative demand for their products has increased. To respond to the increase in the demand, businesses borrow more money and produce more. With a new cheaper money, investments that wouldn't have been done without an artificially low interest rate are made. These investments are called malinvestment by Austrian economists. When the businesses realize that this higher demand wasn't relative and the inflation is higher than they expected, they try to fix the mistake they made by changing the use of the capital and labor they have already obtained through the artificially low interest rate. Unfortunately, the process to make this adjustment takes some time because not all capital and labor can be used to produce a different product than the product they had been specified for. Therefore, this adjustment results in a period of unemployment and underemployment a.k.a a recession.

Moreover, the Austrian Business Cycle Theory explains one more thing that other business cycle theories don't explain. William J. Luther and Mark Cohen states this in their recent paper:

In particular, we have argued that the Austrian view is unique in suggesting that a monetary shock will distort the structure of production. An unexpected monetary expansion encourages early and late stage production relative to middle stage production. Hence, the Austrian theory claims that prices and production will increase in early and late stages relative to middle stages when the interest rate prevailing in the market falls below the natural rate.

In other words, the artificially low interest rate changes the structure of the production process.

According to the Austrians, the recent recession was the result of the Fed's low interest rate policy that followed 2001 recession.

Moreover, the theory has a implication on today's Fed's low interest policy. According to the Austrian Theory, the recession is a self-healing process of the economy after a boom and burst. Therefore, lowering the interest rate is seen as a problem by the Austrians. Here, WSJ covers some Austrian voices on the issue of the easy money policy in 2010:

Narayana Kocherlakota, president of the Minneapolis Fed, argued that a large part of today's unemployment problem is caused by issues the Fed can't solve, such as the mismatch between the skills of jobless workers and the skills that employers wanted.

The ABCT theory hasn't been prominent theory to explain the business cycles as others, such as Keynesian economics. Economists have done researches to study the empirical evidence of the theory, but most of them shows results against the ABCT explanation. (Here and here) But it is still important to look back at the ABCT theory and its ingredients to understand economy more and fix its errors, if there is, to solve the economics problems more successfully.