The Austrian business cycle theory offers a sound explanation of what happens with the economy if and when the central banks, in close cooperation with commercial banks, create new money balances through credit expansion.

Said credit expansion causes the market interest rate to drop below its “natural level,” tempting people to save less and consume more. Credit expansion also drives firms to increase investment spending. The economy enters into a boom phase.

However, the boom is unsustainable. After the effect of the injection of new money balances has worked itself through the economy, consumers and entrepreneurs realize that the economic expansion has been a one-off affair. They return to their previously preferred savings-consumption-investment affinity: once again, they save more, consume, and invest less. This manifests itself in a rising market interest rate and the boom subsequently turns into bust.

Read more…