The central bank is on the Gold Standard. The discovery of new gold increases the supply of gold, which causes an inflationary boom. People blame the inflationary boom on the gold discoveries. It can't have been a monetary shock, because the central bank wasn't doing anything different from what it always does. The central bank "did nothing". Gold mining needs to be a regulated industry to prevent this happening again.
Or a sudden fashion for gold jewelry increases the demand for gold, which causes a deflationary recession. People blame the deflationary recession on the fad for gold jewelry. It can't have been a monetary shock, because the central bank wasn't doing anything different from what it always does. Regulation is needed to control bubbles in jewelry markets.
In those two examples it's easy for us to see the fallacy. It was the gold discoveries, or fashion for gold jewelry, given the Gold Standard, that caused the monetary shock, which in turn caused the macroeconomic fluctuations. It's easy because we don't see the Gold Standard as "normal"; pegging the price of gold is not the way that we nowadays frame monetary policy. We don't use the price of gold as our measure of whether monetary policy is "tight" or "loose". And we are pretty sure that those two shocks would have had little macroeconomic effect if the central bank had a more sensible monetary policy than the Gold Standard.
But it might be a lot harder to see the same fallacy created by our own frameworks for thinking about monetary policy.
Suppose we model monetary policy as M(t) = bX(t) + e(t), where M is the money supply, X is some vector of macroeconomic variables, and e is some random shock. Or, if you prefer, as i(t) = bX(t) + e(t), where i is a nominal interest rate. We estimate (somehow) that monetary policy reaction function, and call our estimate of e(t) the "monetary shock".
Let us suppose, heroically, that our estimate of the monetary policy reaction function is correct. The econometrician, by sheer luck, gets it exactly right. Whatever that means. And then we use that estimate of monetary shocks to see what percentage of macroeconomic fluctuations (somehow defined) was caused by those "monetary shocks", and what percentage was caused by other shocks. And suppose, again heroically, we get it right.
This is nonsense. We are making exactly the same mistake that the people were making in my Gold Standard examples above. If the central bank had been following the monetary policy reaction function exactly (or if the econometrician had a complete data set and correct model of the central bank's behaviour so the estimated reaction function fitted exactly) then by definition there would have been no "monetary shocks". And so "monetary shocks" would explain 0% of anything, because there weren't any. 100% of macroeconomic fluctuations were caused by other, non-monetary shocks. Any deterministic monetary policy will have zero "monetary shocks", by that definition, and any organisation's behaviour is deterministic, if we understand it fully enough. That is not a useful definition of "monetary shocks".
Monetary shocks are not the e(t). Monetary shocks mean the central bank chose the wrong monetary policy reaction function. It's the choice of parameter b, and the choice of which variables belong in the vector X.
This post is not really about econometrics. It's about all of us. The financial crisis "caused" the recession in the same sense that the fad for gold jewelry did.
[I'm not sure it's directly related, but this had been at the back of my mind before I read Paul Romer's post, which brought it to the front of my mind. Update: my old post on "Identifying monetary policy shocks". And you could say I'm just saying what Scott Sumner's been saying as well, in a slightly different way.]