I. Introduction

II. History

III. Business cycle theory

Entrepreneurs make money by forecasting demand. Whether this takes place in the area of consumer goods like shoes or in that of capital goods like land, this concept remains. To understand how Austrian economists like Mises could predict the Great Depression, we need to first examine how entrepreneurs decide whether to invest in consumer or capital goods.
Entrepreneurs attempt to predict consumer demand by accurately responding to signals given off by the market, which is composed of every individual consumer. One crucial way in which consumers signify their intentions is by how much money they save. When a consumer saves money, this indicates that they either value future goods over present goods or are accumulating capital for a future purchase.

Entrepreneurs are not completely certain about what people are going to spend their money on in the future, so when people save more money, these entrepreneurs invest in capital goods. Regardless of what the consumer intends to spend money on, certain capital goods will be required to produce new products — capital goods like steel, oil, factory machinery, or, above all, land. The more consumers save by putting money in banks, the less scarce money becomes for these banks, who make their money via lending. Thus the natural interest rate (the “price” of money) goes down. The lower the interest rate, the more entrepreneurs will want to borrow money to invest in capital goods, and the more banks will want to lend.

When the government sticks its central banking hands into the picture, things get distorted. To supposedly stimulate the economy, the Federal Reserve creates new currency and gives it to banks via a process called fractional reserve banking . The result is that the banks suddenly have a great deal more money to lend, money becomes less scarce, and interest rates go down. This is what happens when the Federal Reserve lowers interest rates. In short, it is a false claim to wealth because no production accompanied the rise in the monetary base.

To entrepreneurs, these lower interest rates are a false signal that people are saving more money when they actually are not. Thus, they invest in capital goods, believing themselves to be accurately forecasting demand. Every entrepreneur makes a mistake sometimes, but this situation causes a large amount of entrepreneurs to all make a giant mistake at the exact same moment, called the “cluster of errors.” When the time comes for consumers somewhere along the production line to demand capital goods, there is no consumer demand; consumers never actually saved any more money, and thus never really placed any more value on future goods than present goods.

The result is what Austrian economists call malinvestment. Malinvestment represents an overinvestment in capital goods and an underinvestment in consumer goods, each cancelling out the other and thus not stimulating anything at all. So, the prices of oversupplied capital goods plummet, while the prices of oversupplied consumer goods skyrocket. In reality, all that happened was a diversion, not a stimulation, of production.

In the economic collapse of 2008, the major capital good in which entrepreneurs overinvested was real estate. As the Austrian theory predicts, the bubble eventually popped, and housing prices plummeted.