The Austrian Business Cycle : A Vector Error-Correction Model with Commercial and Industrial Loans

A vector error-correction model (VECM) of output, consumption, investment, and credit is identified and estimated, employing the Johansen-Juselius (1990) test for cointegration. Because the Austrian school views economic activity as a disequilibrium process, VECM estimates offer an empirical methodology especially amenable to interpretation through Austrian business cycle theory. Austrian business cycle (ABC) theory was pioneered by Ludwig von Mises (1912, 1949) and Friedrich Hayek (1933, 1935, 1941). Harwood's (1932) account of the business cycle is very similar. ABC theory focuses on credit expansion, which artificially lowers interest rates creating an investment boom and unsustainable business expansion. ABC theory is presented prominently by Haberler (1937) as a leading modern theory of the business cycle, and yet has largely fallen out of favor with orthodox economists. This is especially surprising because only ABC theory can claim much success in providing coherent and plausible explanations of historic business cycles. Rothbard (1963) explains the Great Depression in terms of ABC theory, concluding that overexpansion of the money supply in the late 1920s caused the stock market crash, and exceptionally unskilled policy responses created the prolonged secondary contraction by preventing the economy from liquidating the accumulated malinvestment and unemployment. Although their explanation of the dynamics of the depression differs and is distinctly non-Austrian, Friedman and Schwartz (1963) agree that bad policy greatly exacerbated what would have been an unexceptional recession. Garrison's (2001) restatement of ABC theory and his applications to historical cycles should lead to renewed interest in Austrian capital theory. According to ABC theory, recession constitutes the process of liquidating resources and production plans misallocated during the unsustainable boom. This paper finds compelling evidence of such cycles of malinvestment and liquidation in 1959-2003 U.S. data