It was Ludwig Von Mises, the most accomplished student of Böhm-Bawerk and arguably the most important Austrian economist of the 20th century, who used Böhm-Bawerk's capital reasoning to explain the causes and dynamics of economic cycles. Friedrich A. Hayek, Mises's protege, later extended this reasoning to its logical conclusions in works for which he was awarded the Nobel Prize in Economics in 1974.

Mises and Hayek began their analysis with an increase in savings as the starting point. As we have seen in the previous chapters, any increase in savings necessarily entails a corresponding decrease in consumption and thus lower relative prices of consumer goods. This leads to two effects: firstly, an increased demand for capital goods caused by rising real wages resulting from the relative decrease in the prices of consumer goods; and secondly, an increase in entrepreneurial profits at the stages of production farthest from consumption (lower order). As real wages rise, entrepreneurs are incentivized to economize labor by using more capital goods, which creates a stronger demand for capital goods and higher profits for entrepreneurs producing these lower order goods. Thus, in the context of increased savings, i.e. a decrease in time preferences, interest rates fall, promoting the development of additional stages of production and increased productivity. This is a classic Böhm-Bawerkian production detour, and it is a highly desirable outcome.

However, the two Austrian economists pondered what would happen if the decrease in interest rate, which serves as the starting point for this production detour, did not result from an increase in savings but instead from credit expansion.

In the context of fractional reserve banking, credit expansion does not require a corresponding increase in savings. Therefore, entrepreneurs can raise more capital and engage in production detours even as time preferences remain unchanged, i.e. without any decrease in consumption. For Hayek and Mises, such a situation should necessarily lead to significant coordination problems among economic agents. Due to the lack of free-market interest rates, these problems may not be immediately evident, but in the long run, the resulting misallocations of capital should produce tangible consequences: a recession.

To describe this phenomenon of temporal miscoordination and its consequences as clearly as possible, we will rely on a model of the production structure and observe how it is affected, first by a decrease in interest rates resulting from an increase in savings, and then by a decrease in interest rates caused by an expansion of credit.

To facilitate our explanation, we will return to Menger's classification of goods and represent the productive structure on a diagram consisting of an arbitrary number of stages:

In the above diagram, initial resources pass through various stages of production, undergoing transformations that bring them closer to the state of final consumer goods (through interaction with original factors of production: time, land, labor). The height of the right side of the triangle schematically represents GDP since it denotes the sum of all consumer goods sold in a period. The gap between each bar corresponds to the value added (in monetary terms) generated by each stage of the process. This difference can also be seen as the income associated with each stage (revenues - costs).

If, at the aggregate level, economic agents increase their savings, the quantity of final goods consumed will decrease - all else being equal, saving necessarily involves postponing part of one's consumption to a later date. As a result, interest rates will fall - because the supply of capital is increasing, allowing entrepreneurs to use this influx of capital to create new investment goods and thus lengthen the production structure.

We will then obtain an extended production structure, a change that can be qualitatively represented by the following diagram:

Here, the monetary value of demanded consumer goods has decreased, freeing up resources for the creation of an additional stage of production. In this scenario where the decrease in interest rates is a consequence of decreased consumption, i.e., increased savings, the area of the triangle, representing the quantity of money in circulation, remains unchanged. The transformation of the production structure (lengthening) simply results from a transfer of purchasing power from one part of the structure to another.

It is also noteworthy that the reduction in demand for consumer goods will cause, in the medium term, a decrease in consumer prices rather than a decrease in the quantity of final goods offered. This is because the final part of the production structure will not adjust immediately after the drop in demand for consumer goods occurs; entrepreneurs will take some time to alter their plans and investments. As they hold inventories, the decrease in demand will force them to sell these inventories at a discount, and, consequently, the surplus of savings will initially result in lower prices for consumer goods (i.e., an increase in real wages).

Conversely, investment goods will see their prices rise because the transfer of purchasing power to entrepreneurs enables them to increase their investment expenditures. Once this savings, transferred by savers to entrepreneurs, is spent by the latter, interest rates will tend to rise again (due to a reduced supply of capital), which in turn will lead to lower prices for investment goods. In fact, at the end of this production detour, relative prices will remain roughly the same as before. But economic agents overall benefited: increased productivity resulting from the lengthening of the production structure will offer consumers more products at lower unit prices; the purchasing power of savers will increase, partly through interest earnings and partly due to lower consumer prices; meanwhile, entrepreneurs, considered as a whole, will experience neither gains nor losses. Those engaged in activities closest to consumption will lose income, while those involved in creating new stages of production will gain proportionally. In such a situation, no new monetary income is created; it is production that increases, and thus the real value of incomes rises.

Now, if we consider a decrease in interest rates resulting from an expansion of credit offered by banks, we obtain a very different picture of the production structure.

With lower interest rates, entrepreneurs can borrow more resources and thus create higher order production stages. In this case, such an extension of the production structure will not result in decreased consumption because there has been no consumer postponement of present consumption. In other words, GDP grows. Consequently, our triangle will lengthen while maintaining a similar height, meaning its area will increase.

Note that this is a completely logical consequence of the credit expansion. Insofar as banks produce fiduciary media by granting loans, one should naturally expect overall purchasing power to increase.

As credit enters the economy through loans to entrepreneurs, we should observe an increase in profits in the production sectors distant from consumption, and a decrease in relative profits in sectors closer to consumption. This higher profitability then supports a reallocation of capital towards these new, more capital-intensive stages (shipbuilding, automotive, construction, advanced technologies, etc.), and a decrease in investments in sectors closer to consumption.

Now, the entrepreneurs involved in these higher stages of production earn higher monetary incomes, and, as time preference remained the same, we should also see increased demand for consumer products. But as, during this boom, the relative profitability of invested capital has been higher in sectors far from consumption, there has been a transfer of resources from activities close to consumption to more distant activities. Consequently, the entrepreneurs in lower stages of production lack the resources to meet the increased demand. This creates tension between these two parts of the production structure: each tries to obtain capital at the expense of the other, and since the demand for consumption represents more urgent needs, at some point, entrepreneurs engaged in activities distant from consumption will run short of the resources needed to complete their investments. The profit rate in these sectors then starts to decline, businesses go bankrupt, and the relative increase in consumer prices motivates a rapid reallocation of capital toward the production of lower-order goods. When this sudden resource reallocation manifests, the economy enters a recession: asset prices fall, real wages decline, consumer prices fall, and inventory piles up.

For Friedrich Hayek and Ludwig von Mises, the recession is the manifestation of the misallocation of capital from the expansion phase. As prices for savings and capital were manipulated, entrepreneurs developed projects which could not be finished by lack of resources, and/or build productive capacity planning for a future level of consumption which could not be sustained due to a lack of savings.

Only through deflation, i.e. decline in asset prices and wage prices, higher interest rates, and the liquidation of unfinished projects can the economy readjust and develop toward a sustainable path. So, the recession is the dissipation of this illusion of prosperity triggering a violent readjustment process.

In general, the recession is triggered by the banking sector itself. As long as credit is increasing at an accelerating pace, prices continue to rise, and entrepreneurs compete for productive resources. However, as noted by Hyman Minsky, there comes a point where the banking sector decides to reduce its risk, therefore diminishes the flow of credit. The depression, therefore, results in many bankruptcies, credit tightening, a decrease in available purchasing power, and financial meltdowns.

Such an adjustment can be viewed as a period during which underconsumption, and underinvestment are enforced to rebuild the missing savings. For Hayek, this depressive stage, although painful, is highly necessary as it allows for a recovery of economic activity based on a structure of relative prices reflecting the actual scarcity of production factors. If this depression is interrupted, the economy cannot return to a desirable path because, in the absence of an information system allowing economic agents to rationalize their decisions, the misallocation of resources will only continue.

Unfortunately, this depressive mechanism is often interrupted by political power and central banks seeking to “boost” the economy through deficit spending and easy monetary policy.

For both monetarists and Keynesians, the cause of the depression is insufficient aggregate demand, so neither pays attention to the evolution of relative prices, which, as we have seen, is the core of the problem. Thus, they believe that providing an incentive for credit expansion (lowering interest rates) and using the state's deficit capacity to boost demand will kickstart a recovery. In the short term, such measures may seem to produce the desired effects: the deficit supports spending, while the reduction in interest rates leads to higher asset prices, which, in turn, encourages asset holders to increase their spending. However, such boost eventually wanes off, while the structural problem remains, or even worsen as capital misallocation continues thanks to artificially low interest rates.

In the modern era, central banks and governments have been so zealous in preventing the manifestation of this adjustment process that we end up with mass structural unemployment and perpetual debt accumulation. Japan serves as an example in this regard. After the burst of an asset bubble in 1989-90, the Bank of Japan (BoJ) and the various governments in office used all the methods described here to try to "restart the Japanese economy." Apart from brief surges following spending programs and interest rate cuts, Japan has remained in a state of neurasthenic growth and over-indebtedness for 30 years.

By emphasizing the sequential nature of human action and paying particular attention to the impact of interest rate fluctuations on the intertemporal coordination of economic agents, Ludwig Von Mises and Friedrich Hayek explained economic cycles as endogenous dynamics of the fractional reserve banking system. The difference between the Austrian analysis and that of monetarists and Keynesians largely lies in the fact that the former pays particular attention to the various stages of production and the structure of relative prices, whereas the latter stops at aggregated variables such as employment levels, GDP, or the consumer price index. Indeed, as they lack a capital theory, mainstream economists tend to attribute the causes of the recession to “animal spirits” or “external events”.

More than any other school of economics, the Austrian School insists on the importance of relative prices to coordinate economic agents. Members of the Austrian School have been dragged into debates on the matter for more than a century, especially so since Mises published his work on the impossibility of economic calculation in socialist economies in 1919.

This will be the subject of the next and last chapter of this course.