Hayek identified two scenarios for the business cycle: one where the central bank independently cheapens credit and drives interest rates down igniting an investment boom, and a subtler one where investors become optimistic about new technology and demand more credit, and the central bank accommodates by injecting credit to keep the interest rate from rising rather than letting demand bid it up.

Artificially low interest rates drive the market rate below the natural/equilibrium rate, creating a disequilibrium between savers' and investors' plans: investors try to invest more resources than are actually available while consumers don't want to delay consumption enough to free them up.

The investment projects most sensitive to interest rates are those with long time horizons between investment and reward, because discounted cash flow analysis means future cash flows are heavily affected by the discount rate; therefore cheap credit makes long-term, roundabout production projects particularly attractive and they take off disproportionately in a low-rate environment.

Because resources (workers, machinery, raw materials) are finite, cheap credit draws them away from sustainable short-payoff projects into time-consuming roundabout projects, making the economy top-heavy; as resources are continually expended to keep long projects going, they bid up the prices of labor and inputs, raising other businesses' costs until it becomes clear there aren't enough genuine savings to complete all projects, forcing some to be abandoned and causing unemployment in those industries.

The 2002-2004 housing boom and bust fits the Hayekian pattern: John Taylor's account holds that artificially low interest rates of that period encouraged excessive borrowing and housing construction, and when Greenspan quickly raised rates around 2004-2005 those projects became unprofitable and many were abandoned.

Genuine entrepreneurial innovation (e.g., the early auto industry or the internet boom) draws resources toward new projects just like a credit-induced boom, but it is healthy when the rising interest rate acts as a 'brake' rationing resources to what savers voluntarily provide; the danger arises only in Hayek's second scenario where the central bank refuses to let rates rise and pumps in credit, encouraging too many such projects.

An over-investment/malinvestment boom typically piggybacks on a genuine investment boom and is allowed to go too far because the central bank is too accommodating.

The 'time to build' modeling approach of Kydland and Prescott helps resolve an empirical puzzle for the Austrian theory—why elevated investment persists even after a policy change becomes evident—because projects require continual investment to reach fruition rather than a single up-front outlay; Mike Montgomery has applied this technique to show the Austrian story fits better and addresses the objection that investment doesn't look as interest-sensitive as the theory requires.

The Hayekian cycle does not require everyone to misjudge the future path of interest rates—it only requires that too many people guess wrong; malinvestments piggyback on sustainable investments precisely because people are convinced 'this time is different' (a new era), an idea central banks like Greenspan sometimes actively encouraged.

A large spread between short-term and long-term interest rates tempts investors to borrow short and roll over the debt rather than locking in long-term funding, and this maturity mismatch is when people 'get caught out'—and the government is doing the same thing by borrowing short.

Hayek opposed stabilizing consumer prices throughout his career because in an environment of rising productivity it requires injecting credit to keep prices from falling, distorting the interest rate; instead he proposed (in The Constitution of Liberty) stabilizing an index of wholesale/input prices so that output prices could fall relative to input prices without triggering credit injections.

Hayek's explanation for the onset of the Great Depression was that the Federal Reserve and Bank of England injected credit during the 1920s in an environment of rising productivity to keep the price level from falling; inspired by stabilizationist ideas, this credit injection distorted the interest rate and caused the eventual downturn—so a flat price level was not a reliable indicator of health, and one had to look at relative prices and the structure of production.

Hayek and Schumpeter's macroeconomic business cycle theories fell out of favor while their microeconomic work remained respected, largely because Keynes came along; Hayek had a good explanation for the downturn but no good explanation for why the economy kept deteriorating and stayed down so long after 1931.

In Prices and Production Hayek actually prescribed that the central bank should stabilize the 'money stream' (in modern terms nominal GDP, or M times V), offsetting a shrinking money supply or rising hoarding—the same advice as Milton Friedman—but Hayek did not follow his own prescription during the Depression, instead harboring a 'fond wish' that a little deflation would break wage/price rigidity, an error he later apologized for and called a pipe dream.

Keynes succeeded over Hayek because, as Milton Friedman noted, Hayek's view was seen as gloomy—that you just have to let the economy purge malinvestments painfully—while Keynes offered a message of hope that active intervention could end the depression; this same hopeful appeal explains why the 2009 stimulus message kept selling despite the economy not improving.

Stabilizing nominal GDP cannot eliminate real recessions because genuine malinvestments must be written down and real income must fall as resources are temporarily unemployed until they find sustainable uses; but it can prevent the recession from being more punishing than necessary by avoiding making debts hard to repay due to shrinking nominal income.

In the 1970s Hayek turned to institutional reform, proposing in 'Choice in Currency' (1976) that people be free to use whatever currency from anywhere in the world they find most stable to damper any one central bank's inflationary proclivities, and then in 'The Denationalization of Money' arguing that private firms could issue fiat-type money and would be more reliable than central banks because it is easier to hold private firms to their promises than central banks.

There is a tension in Hayek's Denationalization of Money: he suggests private money issuers would most appeal to the public by promising stable consumer prices, which contradicts his lifelong argument that stabilizing the consumer price index caused the 1920s bubble and 1929 crash—a tension White finds hard to resolve, though Hayek footnotes that he no longer regards it as a problem of much practical relevance.

The length and depth of the Great Depression is not explained by Hayek's theory alone; it requires adding Bob Higgs's regime uncertainty and Milton Friedman's money-supply collapse, plus the actual interventions of the National Industrial Recovery Act and Agricultural Adjustment Act, which organized industry and agriculture to restrict output to raise prices—a non-sequitur because cartelizing one industry yields monopoly profit but cannot work for all industries simultaneously, since universal output restriction shrinks total output and reduces hiring.

Once policymakers have dug a deep hole, there is no magic bullet to climb out; the single most important thing government can do is create confidence about the future, but confidence is the one thing economists, psychologists, and policymakers understand very little about—and issuing a new plan every week undermines the ability to plan, as does tax-environment uncertainty.