Fear the AI boom and bust

Economists have been trying to understand stock market bubbles for over 300 years. They’re as old as stock markets themselves. But investors still get caught out by the boom and bust cycle every time.

100 years ago, a theory known as the Austrian Business Cycle was developed to explain the booms and busts. It perfectly explains today’s AI bubble. How it was inflated, how it’ll pop and what happens next…

The best explanation of the ABC Theory can be found in rap music, strangely enough.

The godfather of podcasting, Russ ‘The Podfather’ Roberts combined with the creative genius of John Papola to write a song called Fear the Boom and Bust. It has over 8 million views.

The song features the reincarnated economists F.A. Hayek and John Maynard Keynes in a rap battle.

Their topic was the 2008 crisis. But the song could just as easily be about 2021’s green energy bubble, Japan’s 1980s bubble, today’s AI bubble or any other bubble since the Mississippi Bubble of 1720.

If you had been aware of the ABC Theory in 1980, 2007, 2021 or 1720, you would’ve seen the writing on the wall. Indeed, many of those who predicted the 2008 bust were followers of the ABC Theory.

So, let’s take a closer look. And then apply it to AI in 2025…

Hangover economics

As faux-Hayek explains in the rap battle music video, Keynes’ theory about what causes crises like 2008 is badly flawed for a simple reason. It ignores the bubble that precedes them…

The place you should study isn’t the bust
It’s the boom that should make you feel leery, that’s the thrust
Of my theory, the capital structure is key
Malinvestments wreck the economy

The first idea here is fairly intuitive. A boom must be followed by a bust. So, if you want to figure out the bust, the place you should start is the boom. You need to explain what causes it.

Of course, this makes Austrian Business Cycle Theory immensely unpopular. People love a boom. They don’t like to be told it will end in tears. And so nobody listens to ‘the Austrians’ during the boom. Indeed, one follower of the Austrian school was warning the US Congress about the coming housing bubble and bust as far back as 2003, before even the boom had begun!

A ‘malinvestment’ is the sort of investment an economist talks about. This is very different to an investor buying stocks and bonds. Economists mean an investment in capital. Something like buying a machine, hiring more people or building a factory. It’s about an investment to increase production.

Malinvestments are investments that are doomed to failure for a particular reason. They relied on an artificially upbeat economy to succeed. They are mistakes made because of the artificial boom.

But who goosed the economy into thinking we are in a boom? Keynes blames ‘animal spirits’. But Hayek has a better explanation…

The boom gets started with an expansion of credit
The Fed sets rates low, are you starting to get it?
That new money is confused for real loanable funds
But it’s just inflation that’s driving the ones…

Who invest in new projects like housing construction
The boom plants the seeds for its future destruction
The savings aren’t real, consumption’s up too
And the grasping for resources reveals there’s too few

The key point here is that, when central banks create new money, it initially tricks the economy into thinking that people are saving more. That’s because there’s suddenly more money in the system.

Real savings are money that’s available for investment instead of being spent on consumption. They also represent future consumption, because people save in order to use the money to buy things later.

This is an optimal partnership. Savings lead to both more money available for investment in production and more future consumption. Those two link up perfectly because it’s the increase in future consumption that justifies the increased investment. The system is in balance.

But when the new savings were just printed money, the future consumption never shows up. It was just inflation – the devaluation of money by creating more of it.

And so the investments that businesses made in expanding production don’t meet an increase in demand.

The obvious example of this was the 2006 housing bubble, as mentioned in the song. Countless houses across Spain and Ireland stood empty, for example.

Today, vast numbers of renewable energy projects stand idle, waiting to connect to a grid that is oversupplied with electricity during optimal weather.

Japan still hasn’t worked through its vast supply of zombie companies.

And I’m sure you can guess what I’m going to say about all those AI data centres under construction below…

But let’s finish the ABC Theory explanation first.

Eventually, the higher inflation and lack of consumption combine to expose the investments as malinvestments…

So the boom turns to bust as the interest rates rise
With the costs of production, price signals were lies
The boom was a binge that’s a matter of fact
Now its devalued capital that makes up the slack

What made people build vast housing estates in places nobody would ever buy a house? Price signals – the hope of future capital gains. But, as the ABC Theory explains, these were lies. It was just inflation that was driving those investments.

The ABC Theory is often called the ‘hangover theory’ because it resembles an explanation for consequences of binge drinking. You get a boom…and then a bust.

What’s the economic alcohol that misleads people? Freshly created money:

Whether it’s the late twenties or two thousand and five
Booming bad investments, seems like they’d thrive
You must save to invest, don’t use the printing press
Or a bust will surely follow, an economy depressed

That was the warning of the Austrian School of Economics. Central bank fiddling with the money supply doesn’t mitigate the business cycle. It creates it.

This should be very intuitive after the last few years of inflation, a green energy bubble and a bubble in bond prices.

Now let’s apply all this to the AI bubble…

Is AI just another Austrian Business Cycle?

The AI bubble is a textbook example of the ABC Theory in action. Inflation is high, but interest rates are coming down. This misleads the economy into malinvestment. Based on price signals, we think we’re in a boom. But it’s fake.

Like the housing bubble, green bubble and Japan bubble, the AI bubble is extraordinarily capital intensive. The size of investments being made are truly mind blowing – measured in the trillions.

A key part of ABC Theory is that capital intensive industries tend to exhibit the boom and bust cycle most. That’s because they are most influenced by cheap interest rates. Housing being the obvious example again, with mortgage rates influencing demand.

Will companies ever get a return on all that AI investment?

In our video series on the topic, our technology analyst Charlie Ormond digs into some rather worrying revenue projections for the AI data centre buildout…

And stock market analysts have been busy warning about what the profits would have to look like to justify the current share prices of AI data centre developing companies.

At some point, ‘devalued capital’ will take up the slack. Companies will have to write down the value of their capital intensive investments.

That’s happening in the green energy space right now. Huge write downs for companies like Orsted, Equinor and BP.

Japan struggled to deal with the end of its bubble for decades because it attempted to avoid this devaluation. Instead, it played out in a multi-decade period of poor economic growth.

We’re all familiar with the write-downs which banks and investors suffered in 2008…

My point is that the AI bubble is exhibiting all the same signs as so many bubbles before it. After 300 years of examples, you’d think we’d know better by now.

Of course, this just leaves you stuck with a different problem. If the AI bubble is doomed, what should you invest in instead?

Our editorial summit After AI aims to answer precisely that.

After so many years of AI dominance, investors need something new to drive their wealth creation. Dodging the AI bust won’t be enough…