The Austrian Business Cycle: a Vector Error-correction Model with Commercial and Industrial Loans*



Western Carolina University


Victor. I know what you're talking about.  But it's not a dream -- it's that you've got to make decisions before you know what's involved, but you're stuck with the results anyway.

Arthur Miller (1968) The Price Act II.


Key words:  Austrian business cycle theory, Hayekian triangle, Vector error-correction model


JEL classification: B53, C32, E23, E32, E43.


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.


1.  Introduction


Austrian capital theory (Mises 1912, 1949; Hayek 1931; subsequently developed by Hayek 1933, 1939, 1941) is used to construct and interpret a vector error-correction model estimated with U.S. macroeconomic data.  Using 1959-2003 monthly data, the relationship between real output, consumption, investment, and real commercial and industrial loans is examined.  When additional fiduciary media are injected into the fractional reserve banking system, the interest rate is depressed, and commercial banks increase commercial and industrial loans above and beyond aggregate savings.  The Hayekian production structure becomes more roundabout and more time and capital intensive as entrepreneurial managers reallocate resources away from consumers' goods toward producers' goods. 

Whenever credit is tightened, interest rates rise, and higher rates of return in production are necessary to compete with financial instruments, such as relatively higher-yielding government bonds.  This is manifested in a shifting of resources away from early stages of production to later stages, and can be shown as a shortening of the base of the Hayekian triangle (Figure 1) (Hayek 1931:39).  This paper explicitly tests the main assertion of Austrian business cycle theory, that increasing available credit beyond actual saving lowers, rather than increases real output and real investment expenditure.


The rest of the paper is organized as follows.  The theoretical basis for the paper is briefly developed in section 2.  Section 3 discusses some applications of Austrian business cycle theory in the economics literature.  Data sources are documented in section 4.  Section 5 develops the methodological approach applied in section 6.  Section 6 presents and interprets the empirical work, consisting of an error-correction model of real output as measured by real consumption expenditures. This section presents tests for cointegration followed by estimates of the error-correction model.  Concluding comments are presented in section 7.

<<Figure 1 about here.>>


2.  The Austrian Theory of the Business Cycle


Consider the problem faced by a capitalist with idle savings to invest, who engages in a specific productive activity.  One use of these idle savings is to purchase intermediate inputs or goods-in-process, adding complementary resources such as labor and capital services to raise the sale value to another capitalist who engages in the next stage of production.  The capitalist's decision focuses on their opportunity cost, the prevailing interest rate which could be realized by lending the savings to someone else.  Capitalists opt for their own productive activity if the return is higher than could be realized through lending, and lend out the savings if the market interest rate exceeds the return to their own production.  Thus, if the interest rate falls, less money will be lent out and more will be used to finance productive activities, and vice versa.


At the same time, however, the interest rate influences consumers' decision on how to divide their income between consumption and saving.  The lower the interest rate, consumers save less and consume more.  Any lowering of the interest rate must simultaneously increase consumption spending, lowering saving, as well as increase investment in productive activities.  This process would work in reverse when the interest rate rises, if productive activities could be liquidated rapidly and at low cost.


When the interest rate rises, capitalists should liquidate their own productive activities to the extent possible, and lend the money out to take advantage of the higher return.  Ideally, the opposite should occur when interest rates fall.  However, physical capital comprises illiquid assets, and once savings is invested in productive activities, it cannot be extracted without delay and loss of value.  Once a capitalist invests in productive equipment, a higher interest rate may make it desirable to lend out the money that could be raised by selling the equipment.  The sale may involve a delay, however, and as long as the capitalist enjoys a comparative advantage in the productive activity, the equipment's selling price must be below what the equipment was worth to the capitalist.


This cost asymmetry in converting between financial and physical capital is the basis for Bischoff's (1970) "putty-clay" model of investment.  Uninvested "putty" capital, also called financial capital, is highly liquid, and can easily be moved from loan markets into productive activities.  Once savings is tied up in installed physical or "clay" capital, it cannot be moved costlessly from productive activities back into loan markets, or even into alternative productive activities.  The Austrian school emphasizes these costs associated with adjusting the capital structure – also called the structure of production – when interest rates rise, though it should be kept in mind that similar adjustment costs are incurred whenever labor, human capital, and raw materials are reallocated.  Installed capital equipment can be thought of as the least adaptable input and the one that most often constitutes a binding constraint on the process of reallocating production in response to increases in the interest rate.


In the Austrian view, the prosperity which precedes a recession is marked by overexpansion of the money supply above what could be justified by any increase in real consumable output or productive activities.  This could be seen through a growth of the money supply greater than the growth of real output, particularly of real consumable output, which unlike investment spending, is used directly to satisfy individuals' wants.  It can also be seen through a lowering of the nominal interest rate below an appropriate, sustainable, equilibrium interest rate which would prevail in the absence of monetary overexpansion.  While the interest rate is artificially depressed during the expansion phase, firms invest intensively in physical capital.  Since the interest rate is so low, the production process can take more time to produce the same amount of real consumable output, so the production process becomes more drawn out, or more roundabout, and the slope of the hypotenuse of the Hayekian triangle becomes flatter, as its base becomes longer.


At the same time, however, the lower interest rate means consumers save less of their income and consume more.  The below-equilibrium interest rate results in an economy which takes longer to produce real consumable output, but also ensures consumers are less willing to wait for their wants to be satisfied.  This production structure is unsustainable, and must result in abandonment of much capital installed in early stages of production, and many entrepreneurial plans, as well as high labor unemployment, even if the interest rate is kept low.  Entrepreneurial plans of both producers and consumers are disrupted because they were predicated on a lower interest rate and a longer production structure.


In Austrian business cycle theory, the onset of a recession can occur in any of three ways:


(1)  Deflation:  Often, following overexpansion of the money supply, the monetary authorities will recognize the dangers of the low interest rate and will intervene to effect adjustment by tightening the money supply.  This is signaled by higher interest rates toward the end of the expansion and the early stages of the recession.  This policy response results in a shorter-lived, though usually more severe, recession, which is the process of the economy bringing the production process back in line with the sustainable interest rates and actual time preference.  Contractionary policy can be observed most notably preceding the onset of the Great Depression, the Volker recession of 1981-82 and the 2001 recession.

(2)  Steady inflation: The monetary authorities continue to inflate the money supply at approximately the same rate as during the expansion.  This would normally occur whenever the monetary authorities remain unaware of the ill-advised aspects of their policy-induced credit expansion, or are otherwise innocent of economic theory.  As low interest rates persuade entrepreneurial managers to invest more in early stages of production and lower-yielding productive activities, and simultaneously persuade consumers to save less and consume more, the need for complementary resources required to simultaneously increase the resource allocation in both early and late stages of production becomes critical.[1]  Demand for credit finally outstrips the monetary authority's intended oversupply, driving interest rates up, leading to massive abandonment of production plans and lower-yielding capital equipment, precipitating higher unemployment.  Most postwar recessions have started this way, including the first Gulf crisis recession of 1990-91.

(3)  Accelerating inflation:  Finally, the monetary authorities may foresee the recession, or perceive the increased demand for credit, and attempt to forestall the collapse by increasing the money supply even faster.  The economic collapse can be postponed as long as the monetary expansion proceeds faster than rational individuals can revise their expectations.  This course of policy is inevitably rendered fruitless as market participants must eventually learn to anticipate future inflation.  This strategy of accelerating inflation may delay the onset of a recession, but guarantees a more severe and protracted one.  This experience characterized the oil-shock recessions of 1969-70 and 1973-74.


Productive resources have differing degrees of substitutability and complementarity (Garrison 1985:168; 2001:49).  ABC theory emphasizes the inflexibility imposed by the high cost of adjusting the production structure by reallocating installed physical capital.  It is important to realize that similar kinds of inflexibility and high adjustment costs can come from other resources, particularly labor.  Workers often resist seeking employment outside preferred venues.  Because this source of high unemployment results from high adjustment costs which frustrate resource allocation and adjustment of the production structure, rather than from real or nominal wage or price stickiness, this potential cause of recession, though labor based, should be recognized as Austrian rather than Keynesian.   Mulligan (2002) presents evidence that labor employment is reallocated over the business cycle in a manner similar to that predicted by ABC theory for the physical capital it complements.  Hayek (1935:136-139) and Garrison (1986:440; 1988; 2001:71-73) draw a fundamental distinction between ordinary changes in time preference and policy-induced changes in interest rates.  Only a decrease in interest rates caused by credit expansion can drive the business cycle.  According to ABC theory, there should be no cycle if the decrease in interest rates is due to a general lowering of time preference.  Mises (1949:550-566) develops a similar argument. 


3.  Qualitative Applications and Earlier Empirics


Austrian business cycle theory is unmatched in offering persuasive qualitative explanations of historic business cycles.  This fact by itself makes a powerful case for the Austrian school, which should be accepted as the dominant macroeconomic policy paradigm. Curiously, the Austrian business cycle was once the leading theory (Haberler 1937).  More recently the Austrian theory is often dismissed (e.g., Friedman 1969:261-284, 1993; Hummel 1979; Yeager 1986:378; Tullock 1987, 1989; Cowen 1997; Wagner 2000) or simply ignored.  In response, an Austrian literature of defense, apology, and counterattack has developed (Salerno 1989; Garrison 1996, 2001; Cwik 1998; Block 2001).  Although their analysis of investment as a driver of recession owes little to the Austrian school, Chari, Kehoe, and McGrattan (2002) conclude the Great Depression was caused by labor market rigidities, and that investment frictions played a minor role. Holcombe (2001) discusses some reasons why Austrian macroeconomics is undervalued by the neoclassical and Keynesian mainstream.


Rothbard's (1963) monumental study of the inflationary roots of the Great Depression persuasively argues that credit expansion created an unsustainable boom in the 1920s, and that government policy frustrated the efforts of economic agents to liquidate inefficient capital, resulting in a protracted secondary contraction, thus transforming what would have been a routine recession into the Great Depression by preventing prompt liquidation of overinvestment.  Valuable resources which could have been used for more productive purposes, and for output more urgently desired by consumers, instead were tied up in fruitless and counterproductive attempts to maintain labor employment in the same industries which had already overexpanded through the malinvestment boom.  Focusing on unorthodox and rarely examined monetary aggregates, Rothbard shows that inflation and credit expansion continued sporadically well into the 1930s, effectively preventing any general liquidation of malinvested capital.  Rather than facilitate liquidating malinvestment, easy credit policies generated further opportunities for malinvestment.  The misallocation of productive resources was further exacerbated by governmental efforts to restore and maintain artificially high prices through cartelization and price controls. 


This view contrasts markedly with Friedman and Schwartz's (1963) conclusion that the secondary contraction was caused by the Federal Reserve System's failure to provide enough liquidity (Table 1).  Using the standard monetary aggregate that ultimately emerged as M1, Friedman and Schwartz find that the main problem during the depression was that the money supply shrank, even though the monetary base grew.  Table 1 summarizes some of the evidence cited by Keynesian, monetarist, and Austrian authors.  It is difficult to avoid the conclusion that the Austrian explanation is the most encompassing, even though Austrian business cycle theory focuses on the unsustainable expansion which precedes a recession[2].  The monetarists are simultaneously to be applauded for introducing the first evidence of contractionary policy over three decades after the start of the recession, as well as to be scolded for selectively ignoring very real evidence of expansionary policy, which remains irrefutable.


<<Table 1 about here.>>


The Austrian perspective can be interpreted as intermediate between the Keynesian, emphasizing a liquidity trap which made expansionary monetary policy ineffective, and the monetarist, which criticizes the Fed for unwittingly implementing a contractionary policy.  The Austrian school blames the expansionary policy of the 1920s for the onset of the Depression, and active government and central bank policy for transforming what would have been a routine recession into a decade-long ordeal.  The Austrian school goes beyond the monetarist school in emphasizing the real discoordination and resource misallocation forced by government and central bank activism, resulting in persistent and abnormally high unemployment. 


Because he was not an academic, Harwood (1932) focused only on the unsustainable aspects of inflation, not on how it created an overextended production structure.  Economic historian William Graham Sumner (1891) also recognized that inflation precipitated economic downturns.  Harwood's theory of the business cycle was that the root cause was any excess of investment spending over saving.  Such an imbalance can only be introduced through systematic expansion of the money supply, which allows banks to lend funds for business investment in excess of the savings they hold on deposit.  He argued that the amount might be small initially, but would necessarily grow over time, as producers' goods face increased demand, bidding up their price. 


Harwood agreed with Mises and Hayek that unsustainable expansion comes about primarily because the interest rate is kept artificially low due to the oversupply of cheap credit, and businesses take advantage of the attractive low borrowing rate to finance expansion of production facilities. He largely disregarded the impact of localized distortions, recognizing that they occur, but arguing that their impact distorting the allocation of productive resources must be negligible.  This is a major difference between Harwood and Mises and Hayek. 


In Harwood's view, as soon as investment spending exceeds saving, businesses that sell producer's goods start expanding to satisfy increased demand for productive assets.  The increased spending results in increased income to households and workers, meaning that the increased demand is for consumption goods as well as investment goods.  Harwood's point is that this leads to a general increase in business activity to satisfy what businesspeople perceive as increased demand for goods and services.  Though he accepted the Mises and Hayek's views that investment and employment expand fastest and farthest in the industries most directly affected by the additional investment spending, he felt this was generally less important than the fact the increase in spending is quickly diffused throughout the consumption-goods-producing sector. 


O'Driscoll and Shenoy (1976) present an account of the stagflation of the 1970s.  They note that credit expansion increases nominal demand at the point the newly-created money is injected, distorting the price vector and the allocation of resources, especially of capital which cannot be easily reallocated.  Credit expansion always increases consumption expenditures because any new money results in increased nominal income to some households.  Firms engaging in production most remote from consumption find resource prices bid up, and resources bid away, by firms selling directly to consumers.  Unemployment starts in these firms remote from final consumption even as prices continue to be bid up by continued injections of cheap credit.  Garrison (2001: 145-164), in the most important contribution to Austrian macroeconomics since 1949, also provides convincing accounts of both the Great Depression and the stagflation of the 1970s using the Austrian model.


Cwik (1998) uses the Austrian theory to analyze the Gulf crisis recession of 1990.  Carilli and Dempster (2001) argue that Austrian business cycle theory places undue reliance on economic agents misperceiving credit expansion as a real increase in loanable funds.  They suggest that even if rational agents correctly anticipate inflation, agents maximize profits under uncertainty by taking advantage of the market interest rate whenever it falls below the underlying rate of time preference.  Keeler (2001) used standardized quarterly data for eight U.S. business cycles, finding monetary shocks did cause cycles which were propagated through relative price changes, including nominal interest rates. 


Powell's (2002) account of the Japanese recession of the 1990s is especially noteworthy because he focuses on exactly how expansionary monetary and fiscal policy recommended to spur recovery, actually lengthened and deepened Japan's recession.  His conclusion is that monetarist policy prescriptions proved only marginally less ineffective than Keynesian ones.  As with the Great Depression, poor policy prescriptions transformed what should have been a routine recession into a decade-long ordeal.  Mulligan (2002) used sectoral labor data as indicators of resource allocation among industrial sectors.  Resources are reallocated among early, middle, and late stages of production in response to changes in nominal interest rates, as Austrian business cycle theory predicts.  Callahan and Garrison (2003) explain the 1990 technology boom and subsequent recession of 2001-2002 in terms of Austrian business cycle theory.  They are able to point to specific Cantillon effects created when excess liquidity was injected into localized markets, showing how markets temporarily inflated prices for computer programmers and web developers, real estate in certain cities, and technology stocks. Cochrane, Call, and Glahe (2003) argue that the location and timing of credit injection are especially critical in determining where and how far the production structure will overexpand, and what will be the nature and timing of the inevitable collapse.


In marked contrast to orthodox neoclassical and Keynesian accounts of the business cycle, Austrian business cycle theory presents a consistent and coherent explanation of the causes and propagation mechanisms of the business cycle.  Though more typically qualitative than quantitative, the explanatory successes of Austrian business cycle theory have proved robust over an impressive time period and range of specific applications.  This remarkable success makes it even more puzzling that Austrian business cycle theory has not been enthusiastically embraced by non-Austrians, and that it has yet to emerge as the dominant macroeconomic policy paradigm.


4.  Data


This section documents the data used for econometric estimation and motivates the choice of data.  All data are from the Federal Reserve Bank of St. Louis Federal Reserve Economic Data (FRED-II) website.


a.  Output Index:  The industrial production index (FRED-II variable INDPRO) is used, reinitialized at January 1959 = 100.


b.  Consumption Index:  Annualized real personal consumption expenditures is observed monthly for January 1959 to March 2003 and reported by the U.S. Department of Commerce Bureau of Economic Analysis (FRED-II variable PCEC96).  This was converted to an index with January 1959 = 100.


c.  Investment Index:  An investment index is imputed based on the difference between total real output and real consumption.  Monthly percent growth rates are computed for the industrial production index and the consumption index.  It is assumed that any real output produced which is not consumer goods is producer goods.  The percent growth rate of the consumption index is subtracted from the percent growth rate of the industrial production index.  The resulting difference is taken as the imputed percent growth rate for real investment.  Starting with January 1959 = 100, the imputed real investment index for period t + 1 is constructed by multiplying the index for period t times one plus the imputed percent growth rate.


d.  Credit Index:  Commercial and industrial loans at all commercial banks is observed monthly and reported by the Board of Governors of the Federal Reserve System (FRED-II variable BUSLOANS).  This nominal value has to be adjusted for changes in the price level.  The producer price index (PPI) for all commodities is used as a deflator, which is observed monthly and reported by the U.S. Department of Labor Bureau of Labor Statistics (FRED-II variable PPIACO).  The deflated series is converted to an index with January 1959 = 100.


One difficulty with empirical work which cannot be avoided is that in the Austrian view, the real value of consumable output is not the objective and observable exchange value captured in real consumption expenditures, but the subjective use value extracted by each consumer.  This value is inherently unobservable and disaggregated.   Such fundamental issues of methodology and philosophy help explain why there have been so few econometric analyses of Austrian theories.


5.  The Error-correction Methodology


This paper proposes the error-correction model as an econometric methodology especially amenable to interpretation by the Austrian school.  Error-correction models provide estimates of both a structural or equilibrium process toward which adjustment is generally effected, and the error-correction or disequilibrium adjustment process through which adjustment is made toward the hypothesized equilibrium.  Even if one rejects the reality of any hypothesized equilibrium, estimates of the disequilibrium adjustment process still warrant interest.


The error correction model consists of two parts, a structural equation which defines the equilibrium process, and a disequilibrium adjustment process.  If this equation were estimated by ordinary least squares or any other econometric technique, the residual of the structural equation would define the extent of disequilibrium in any given time period. 


The structural relationships among the four macroeconomic variables will be normalized with respect to the first three: output, consumption, and investment.  These three variables will each be expressed in terms of the fourth, commercial and industrial loans.  The resulting vector of structural equations is:

Yt = a1 + b1Lt + e1t

Ct = a2 + b2Lt + e2t

It = a3 + b3Lt + e3t

where a is the intercept, indicating average output, consumption, and investment in the absence of any commercial and industrial lending, b is the slope indicating the extent to which increases in commercial and industrial lending increase output, consumption, and investment, and e is an additive regression residual or error.  Because the data are dimensionless constants, the coefficients and residuals are also dimensionless.  The vector error correction model is:

DYt = Q1(Yt-1 - a1 - b1Lt-1) + Y1(Ct-1 - a2 - b2Lt-1) + X1(It-1 - a3 - b3Lt-1)

+a11DYt-1 +b11DYt-2 + …+a12DCt-1 +b12DCt-2 + …+a13DIt-1 +b13DIt-2 + …+a14DLt-1 +b14DLt-2 + …+u1t

DCt = Q2(Yt-1 - a1 - b1Lt-1) + Y2(Ct-1 - a2 - b2Lt-1) + X2(It-1 - a3 - b3Lt-1)

+a21DYt-1 +b21DYt-2 + …+a22DCt-1 +b22DCt-2 + …+a23DIt-1 +b23DIt-2 + …+a24DLt-1 +b24DLt-2 + …+u2t

DIt = Q3(Yt-1 - a1 - b1Lt-1) + Y3(Ct-1 - a2 - b2Lt-1) + X3(It-1 - a3 - b3Lt-1)

+a31DYt-1 +b31DYt-2 + …+a32DCt-1 +b32DCt-2 + …+a33DIt-1 +b33DIt-2 + …+a34DLt-1 +b34DLt-2 + …+u3t

DLt = Q4(Yt-1 - a1 - b1Lt-1) + Y4(Ct-1 - a2 - b2Lt-1) + X4(It-1 - a3 - b3Lt-1)

+a41DYt-1 +b41DYt-2 + …+a42DCt-1 +b42DCt-2 + …+a43DIt-1 +b43DIt-2 + …+a44DLt-1 +b44DLt-2 + …+u4t

Note the expressions in parentheses are lagged residuals from the structural equations, and thus could be represented simply by (et-1)s.   These are the errors which the disequilibrium adjustment process of the error correction model attempts to explain.  The upper-case Greek letters are the structural adjustment or disequilibrium adjustment terms, which weight the error-correction processes and so indicate the importance of the past changes in the explanatory variables in effecting adjustment toward the hypothesized equilibrium.  The equilibrium represented by the structural equations is generally never realized, and if realized, is not persistent.  If equilibrium is ever reached, that is represented by zero residuals in the structural equations for those observations.  Whenever residuals are non-zero, that is, whenever the system is in disequilibrium, which generally will be for virtually every observation, the non-zero residual in period t results in an adjustment back toward equilibrium in period t+1, represented by the error-correction processes.  The error-correction processes can be thought of as indicating how the data processes can best be represented as adjusting to maintain the long-run equilibrium.


Conventional inference is valid in an error-correction model even when the structural variables are nonstationary, provided the residuals are white-noise processes with no serial correlation.  It is generally assumed that adding a sufficient number of lagged difference terms in the disequilibrium adjustment process is always sufficient to guarantee white-noise errors.


6.  The Vector Error-correction Model


This section presents and interprets empirical estimates based on a simple parameterization of Austrian business cycle theory.  In the subjectivist theory of a capital-using economy, entrepreneurial planners act as the subjects of productive activities, creating real consumable output as the object (Garrison 1985:164-165; 2001:15). Interest rates facilitate intertemporal coordination of productive resources by clearing the loanable funds market (Garrison 1986:440; 2001:39).  In this regard disequilibrium interest rates play the same role as prices in signaling opportunities for entrepreneurial discovery (Kirzner 1984a:146; 1984b:160-161; 1997), and individual entrepreneurs respond by maintaining the production structure, that is, they adjust it by reallocating resources.

a.  Unit Root and Cointegration Tests

Most macroeconomic time series display an increasing trend, and unit root tests were developed to identify this characteristic.  Stationary time series are said to have zero roots or be integrated of order zero [I(0)].  Non-stationary series may have a unit root or be first-order integrated [I(1)].  Unit root series become I(0) when first-differenced.  Regressions estimated with non-stationary data will not have the white-noise residuals needed for valid inference.  The regression could be estimated in first-differences, but then any long-term information carried by the levels of the variables is lost.  Error-correction models overcome this difficulty by estimating a regression in first-differences augmented by error-correction terms, the lagged differences between the actual and estimated value of the left-hand-side variable, collectively referred to as the error-correction process, also called the disequilibrium adjustment process.  The coefficients on the first-differenced variables constitute the cointegrating vector or structural relationship.  A sufficient number of lagged error-correction terms are added to guarantee white-noise errors and valid inference (Davidson and McKinnon 1993:720-730, Kennedy 1998:266-270). 


The Johansen-Juselius (1990) procedure was used to identify stable, long-term relationships between real consumable output and the interest rate term spread.  Table 2 reports augmented Dickey-Fuller (1979) and Phillips-Perron (1988) unit-root tests for each variable.  The augmented Dickey-Fuller results with 48 lags indicate output, investment, and commercial and industrial loans are all I(1), but that consumption may be I(2) or integrated of higher order.  Phillips-Perron tests indicate all variables are I(1).

<<Table 2 about here.>>

Table 3 reports Johansen-Juselius tests for cointegration.  Results of the trace test, a likelihood ratio, indicate a stable, cointegrated relationship among the system of four macroeconomic variables with three cointegrating vectors.

<<Table 3 about here.>>

Because the four variables in the model are cointegrated, ordinary least squares estimates of the structural relationships have the property of superconsistency. 


b.  The Cointegration Space

The estimate of the vector error correction model (VECM) is reported in table 4.   To facilitate interpretation, the VECM is normalized with respect to and solved for output, consumption, and investment.  Coefficients on the forty-eight lagged difference terms are not reported, partly due to space limitations, and also because individual coefficient estimates hold limited interest.  The implications of the disequilibrium adjustment process can be inferred from the variance decomposition and impulse response graphs (Figures 2-4).

<<Table 4 about here.>>

The slope coefficient in the structural equation for the industrial production index is not significant, indicating that credit expansion as measured by commercial and industrial loans, does not significantly affect real output either positively or negatively.  The slope coefficient in the structural equation for consumption is positive and significant, indicating that credit expansion leads to higher consumption expenditures.  This result is consistent with Austrian business cycle theory, which suggests consumers save less in response to the lower interest rate.  The slope coefficient in the structural equation for investment is negative and significant, suggesting that credit expansion lowers investment expenditure.  Austrian business cycle theory suggests that credit expansion shifts resource allocation away from middle stages of production toward early and late stages (consumption).   


Adjusted R-square for the disequilibrium adjustment processes are very low.  In spite of the low R-squares, both  disequilibrium adjustment terms [Q, Y, and X] are positive and significant, only in the disequilibrium adjustment process for consumption.  This is an especially interesting result, which is easy to account for according to Austrian business cycle theory.  Apparently any market disequilibria, measured by non-zero residuals in any of the three structural equations, effects correction chiefly through changes in consumption spending.  Little or no adjustment occurs through total output or through investment.  Consumer behavior is highly responsive to market disequilibria, but producer behavior exhibits much more inertia, likely due to the fixed capital embodied in the production structure.


The specification of the disequilibrium adjustment process includes only lagged first-differences of output, consumption, investment, and commercial and industrial loans, one through forty-eight, four years of lagged differences.  The median length of a recession is somewhat less than two years, but the median length of an expansion may be as long as ten years.  One approach would be to average the two figures to ensure capturing most of the dynamics in the disequilibrium adjustment process.  However, the average expansion generally cannot last so long if it is characterized by policy-induced credit expansion.  The complete dynamics of the business cycle may be captured with four to five years of lagged differences.  This would be the case if a recession always results after so many years of credit expansion, and if the recessions are always shorter than the expansions.


Validity of the error-correction specification depends on cointegration among the variables in the model and white-noise characteristics of the residuals.  Jarque-Bera (1980) tests of normality of the residuals are reported in Table 5.   Results strongly suggest the residual series are not multivariate normal.  It should be emphasized, however, that normality is a sufficient, rather than a necessary, condition for valid VECM estimates.  The Johansen-Juselius procedure estimates the VECM by maximum likelihood, imposing the most nearly normal character possible on the residuals. 

<<Table 5 about here.>>

Non-normal residuals can be interpreted as evidence of specification error, and from the perspective of the Austrian school, specification error is necessarily present in all econometric models.  The measures of real output, real consumable output, and real investment are not the subjective use value extracted by users, and the real interest rate measure is not the idealized interest rate hypothesized by Hayek and Mises (Garrison 1985:169-170; 2001:50; Rothbard 1970:321-323).  Thus, Austrian methodological arguments suggest an a priori expectation of unavoidable misspecification and measurement error in any econometric empirical work.


c.  Granger Causality Tests

Granger causality tests (Granger 1969) are presented in table 6, indicating rejection of the null hypotheses that the forty-eight lagged differences of the four macroeconomic indices can be deleted from the disequilibrium adjustment processes for output, investment, or commercial and industrial loans, but failing to reject the hypothesis that the lagged differences can be deleted from the disequilibrium adjustment process for consumption.  Thus consumption is endogenous with respect to the remaining three exogenous variables.  This test is strongly dependent on the VECM estimate and the maintained hypothesis that all relevant variables have been included in the VECM (Davidson and MacKinnon 1993:686). 


Although ABC theory asserts that real consumable output depends on the stability of the money supply and the maintenance of an appropriate, sustainable interest rate, it might reasonably be questioned whether all relevant variables have been included, especially in light of the Austrian school’s methodological criticisms of output and interest rate measures.  Orthodox neoclassical and Keynesian economists could contribute additional reasons to suspect omitted variables.  The Granger causality tests should be viewed as inherently context dependent.


This outcome supports the interpretation that most adjustment to disequilibrium occurs through consumption, rather than investment, due to the high costs of adjusting the production structure characterized by multispecific capital.  The lagged difference terms play little role in adjusting consumption spending toward equilibrium.

<<Table 6 about here.>>


d.  Impulse Response Functions

Graphs of the impulse response functions are presented in figures 2 and 3.  In each figure, the right-hand graphs in each row are the ones of interest for Austrian business cycle theory.  It indicates that over the period studied, a one standard-deviation increase in real commercial and industrial lending has resulted, on average, in a two standard-deviation decrease in total industrial production, a one standard-deviation decrease in real consumption, and approximately a 0.6 standard-deviation decrease in investment, after four years.  Impulse response functions measure the strength of the disequilibrium adjustment processes working through each variable.  The fact that disequilibrium adjustment is effected downward on output, consumption, and investment, whenever there is a positive shock to commercial and industrial loans, is strong support for Austrian business cycle theory. 

<<Figure 2 about here.>>

Figure 3 shows cumulative impulse response functions.  Again, focusing on the right-hand graphs in each row, these illustrate that increases in commercial and industrial loans, force a large downward adjustment on output (40 standard deviations after four years), consumption (25 standard deviations after four years), and investment (12 standard deviations after four years).  The interpretation suggested by Austrian business cycle theory is that credit expansion, manifested by exogenous shocks to commercial and industrial loans, causes scarce capital resources to be misallocated over an unsustainably long and low-yielding production structure.  Too much capital is allocated to early and late stages, with too little allocated to the critical middle stages which are necessary to transform early stage goods-in-process into late-stage consumable output.  This culture of waste and misallocation permanently shifts the economy into a lower growth trajectory.


e.  Variance Decomposition Functions

Graphs of the variance decomposition functions are presented in figure 4.  Again, the right-hand graph in each row is the one of interest for Austrian business cycle theory.  These graphs indicates that after four years or 48 months, approximately 20% of the variance in industrial production, consumption, investment, and commercial and industrial loans has been attributable to variation in business and commercial loans, over the period studied.  Interestingly, while significant variation seems to transfer from industrial production to commercial and industrial loans, very little variation seems to be transmitted from consumption or investment to commercial and industrial loans.

<<Figure 3 about here.>>


7.  Conclusion


This paper presents evidence of cointegration among real output, consumption, investment, and commercial and industrial loans.  This finding implies a close, stable relationship among these four macroeconomic variables.  Austrian business cycle theory is applied to interpret these empirical regularities.  A simple vector error-correction model is specified and presented, and demonstrated to have a great deal of explanatory power over 1959-2003 historical data. 


Cointegration analysis identifies a stable long-term relationship or cointegrating vector, which constitutes a dynamic equilibrium entrepreneurial planners have generally effected adjustment toward during the 1959-2003 observation period.  This equilibrium is not necessarily ever realized.  The market process consists of entrepreneurial planners effecting adjustment toward a dynamic equilibrium they continuously redefine.  The prevailing term structure of interest rates determines resource allocation among early, middle, or late stages of production, allocating resources and production in accordance with consumers' time preference and available investment alternatives.  Estimates of a stable long-run relationship using U.S. data provide convincing support for Austrian business cycle theory as an encompassing explanation of intertemporal resource allocation, production, and employment.


ABC theory is founded on the concept of a sustainable, market-determined interest rate, and predicts negative consequences when that equilibrium is persistently disturbed.  Economists and laypeople are well aware of these consequences: the periodic high unemployment associated with the business cycle.  The policy prescriptions of the Austrian school are unmistakable: first, never disturb the interest rate with credit expansion or monetary inflation, and second, after the first policy prescription has been violated, never interfere with entrepreneurial planners' efforts to liquidate suboptimal production plans as rapidly as possible.  As long as economists and policy makers believe the business cycle can be avoided through the activism of charismatic central bankers, recessions will be inevitable.





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Table 1

Competing Views of the Great Depression




Liquidity trap created once nominal interest rates became low enough; bank demand for excess reserves became perfectly elastic.  Monetary base doubled between 1929-38: monetary policy was expansionary, but excess reserves accumulated in banks.  Demand for loans depressed due to unfavorable business outlook.  Banks did not buy short-term securities because nominal yields were so low.

Real interest rates extremely high due to price deflation: e.g., CPI fell 10% in 1931 and 1932.  Indicates contractionary policy.  Growth in monetary base mostly attributable to currency held by public, unavailable to be loaned out, rather than bank reserves.  "Flight to quality" greatly increased demand for short-term Treasury securities, depressing their yield.  Fed tightened discount lending policy in 1931, and doubled reserve requirement between 1936-37, triggering a secondary recession.

Expansionary monetary policy depressed interest rates and created unsustainable investment boom throughout late 1920s.  Monetary policy was intermittently both expansionary and contractionary throughout the 1930s.  Government intervention initiated under the Hoover administration between 1930-32 delayed liquidation of malinvested capital.  Price fixing, fiscal stimulus, and inconsistent monetary activism, continued and extended under the Roosevelt administration, prevented liquidation of malinvested capital, prolonging the contraction.

Keynes 1936, Hicks 1939, Modigliani 1944

Friedman and Schwartz 1963: 411-419

Rothbard 1962, Garrison 2001


Table 2

Unit Root Tests

January 1959 – December 2003

Augmented Dickey-Fuller Tests

48 lags



First differences


Intercept + trend


Intercept + trend

Industrial Prod Index



 *** -3.5254

** -3.6559

Consumption Index





Investment Index



*** -3.5876

** -3.6919

Credit Index



** -3.2375

* -3.3631

Critical values2

1%   -3.4459

5%   -2.8677

10% -2.5700

1%   -3.9810

5%   -3.4209

10% -3.1329

1%   -3.4460

5%   -2.8677

10% -2.5701

1%   -3.9796

5%   -3.4202

10% -3.1325

Phillips-Perron Tests

5 lag truncation for Bartlett kernel (Newley and West 1987)

Industrial Prod Index



*** -16.9202

*** -16.9411

Consumption Index



*** -27.8791

*** -29.8532

Investment Index



*** -19.6074

*** -19.6153

Credit Index



*** -19.8052

*** -19.8242

Critical values

1%   -3.4448

5%   -2.8672

10% -2.5698

1%   -3.9795

5%   -3.4202

10% -3.1324

1%   -3.4448

5%   -2.8672

10% -2.5698

1%   -3.9795

5%   -3.4202

10% -3.1324


  1. Rejection of the null hypothesis of a unit root [H0: x ~ I(1); HA: x ~ I(0)] at the 10%, 5%, and 1% significance levels indicated by *, **, and ***.
  2. ADF critical values from MacKinnon ().
  3. Results of the Phillips-Perron tests suggest all four index series are I(1) processes. 




Table 3

Tests for Cointegration among Indexes of Industrial Production, Consumption,

Investment, and Commerical and Industrial Loans

December 1959 – December 2003

(491 observations after adjusting endpoints with 48 lag intervals)

Hypothesized # CE(s)

Maximum Eigenvalue

Trace Statistic

5% Critical Value

1% Critical Value

None **





At most 1 *





At most 2 *





At most 3






  1. Critical values from Osterwald-Lenum (1992). 
  2. *(**) denotes rejection of the null hypothesis at the 5% (1%) level.  
  3. Trace test indicates three cointegrating equations at 5% significance level. 
  4. 48 lag intervals in disequilibrium adjustment process (48 lagged first-differences).
  5. Trend assumption: No deterministic trend (restricted constant).



Table 4

Vector Error Correction Model

Industrial Production, Consumption, and Investment

 explained by Commercial and Industrial Loans

December 1959 – December 2003 (491 observations after adjusting endpoints)

Cointegrating equations


Industrial Production Index

Consumption Index

Investment Index








[ 1.42262]

[ 2.41236]


Index of Commercial & Industrial Loans









[ 41.9390]

Error correction process

Summary Statistics





D(C & I Loans)

 Cointegrating Equation 1 coefficients











[ 0.85652]


 Cointegrating Equation 2 coefficients









[ 1.66411]

[ 4.54981]


[ 1.55538]

 Cointegrating Equation 3 coefficients











[ 1.19730]







 Adjusted R-square





 Sum of squared residuals





 Standard error of equation





 F-statistic (zero slopes)





 Logarithm of likelihood function





 Akaike information criteria AIC





 Schwarz criteria SC





 Mean of dependent variables





 Standard deviation of dependent variables





 Determinant of residual covariance matrix


 Logarithm of likelihood function


 Logarithm of likelihood function adjusted for degrees of freedom


 Akaike information criterion AIC


 Schwarz criterion



  1. Standard errors in (); t-statistics in [ ].
  2. 10%, 5%, and 1% significance indicated by *, **, and ***.



Table 5

Vector Error Correction Model

Jarque-Bera Test for Multivariate Normality of Residuals











Consumption Index





Investment Index





C&I Loans Index





Joint Test















Consumption Index





Investment Index





C&I Loans Index





Joint Test















Consumption Index





Investment Index





C&I Loans Index





Joint Test






  1. H0: residuals are multivariate normal. 
  2. 491 included observations. 

3.      Cholesky orhogonalization (Lütkepohl 1991). 



Table 6

Wald Tests for VECM Pairwise Granger Causality/Block Exogeneity

Dependent variable: D(IIP)





















Dependent variable: D(ICON)





















Dependent variable: D(ICAP)





















Dependent variable: D(ILOAN)






















  1. d.f. indicates degrees of freedom. 
  2. ** and *** indicate 5% and 1% significance. 
  3. The context-dependent test indicates C&I Loans may be removed from the VECM, but Real Consumable Output may not. 
  4. Pairwise tests are consistent with Real Consumable Output causing Real C&I Loans.  The null hypothesis that Real C&I Loans do not cause Real Consumable Output cannot be rejected. 

Granger causality tests are sensitive to changes in model specification, including but not limited to, lag structure, intercepts, and variables included (Davidson and MacKinnon 1993: 629-31).

Figure 11

The Hayekian Triangle: Production and Capital Structure

Text Box: Output Delivered to Consumers
    (Real Consumable Output)


















Production Time



            1 Garrison 2001, p. 47.

Figure 2

Vector Error Correction Model

Impulse Response Functions





Figure 3

Vector Error Correction Model

Cumulative Impulse Response









Figure 4

Vector Error Correction Model

Variance Decomposition


* Financial support of the John William Pope Foundation is gratefully acknowledged.  This paper was initially presented at the meeting of the Association of Private Enterprise Education, April 4-6, 2004.  Thanks are also due to Roy A. Cordato for encouragement and a kind invitation.  The author remains responsible for any errors or omissions.

[1] As a rule more illustrative than actually descriptive, the need for additional complementary resources for production is approximately proportional to the amount already in use, for example, the amount of physical capital already installed.  Thus more capital installed means more additional resources required, so the demand for additional credit accelerates.   If the supply of additional credit remains steady as the demand for it increases, the interest rate must rise.


[2] The author is much indebted to Sudha Shenoy for a highly enlightening conversation on the state of understanding of the causes of the Great Depression prior to the publication of Friedman and Schwartz's Monetary History of the United States (1963).  It simply was not clear whether monetary policy had been expansionary or contractionary during the thirties until this definitive study was published with its huge volume of previously unavailable monetary data.  Until then, armchair Keynesians were free to presume facts supported their conclusions.  Rothbard's (1963) reliance on subsequently ignored monetary aggregates and proxies was largely necessitated by the unavailability of more widely accepted data prior to the publication of the Monetary History.  Rothbard (1978) explains and justifies his choice of data, but see also Anderson (1949: 125-502) for a contemporary account of the Great Depression.  Responding to Keynesian assertions largely unsupported by data that monetary policy had been unambiguously and ineffectively expansionary, Friedman and Schwartz concluded that policy had been almost unambiguously contractionary.  Their conclusion does not square entirely with the facts, many of which Friedman and Schwartz were the first to document.  Policy was inconsistent, as Rothbard shows, providing some support for Keynesian claims, and this inconsistent expansionary-contractionary policy provided an especially difficulty environment for entrepreneurs' liquidation of malinvested capital, delaying recovery for nearly ten years.  In an important sense, both Keynesians and monetarists failed to see the forest for the trees.