Knowledge Shifts and the Business Cycle: When Boom Turns to Bust

Informational cascades can be used to augment the existing Austrian business cycle theory. As first-order users of knowledge know the direct causes of a price change, they transmit this knowledge to second-order users through the price system. Banks with direct knowledge of the sources of the fresh liquidity during a credit induced boom have knowledge of the boom's artificial and unsustainable nature. Higher-order users lack this direct knowledge, and hence continue investing largely ignorant of underlying developments. When first-order users of knowledge sense the boom has run its course, they exit the market, sending a strong signal to higher-order knowledge users that the boom has ended – a fragile situation built upon an informational cascade begins collapsing. Simultaneously, the boom is characterized by an influx of capital and knowledge into the financial sector owing to increased profits relative to the real economy stemming from Cantillon effects surrounding the credit injection. As knowledge pertaining to real production has also exited, the bust commences with a misallocated productive structure requiring equilibration to become consistent with consumers' wants. Actions which inhibit this knowledge from returning to the productive structure will unnecessarily lengthen the time to recovery.