Good shocks, bad shocks, and shocks that cause a monetary coordination failure

Just because a shock is a bad shock doesn't mean it should cause a recession. A recession is a monetary coordination failure. Monetary coordination failures are caused by monetary policy.

Start with a Robinson Crusoe economy. By assumption, Robinson Crusoe always allocates his resources perfectly to maximise his expected utility given his information about the constraints he faces. There are "good" shocks that raise his (expected) utility, and "bad" shocks, that lower his (expected) utility. But there are no shocks that cause a coordination failure in this economy, because Robinson Crusoe doesn't have anyone else to coordinate with. And he doesn't use money, so a "monetary coordination failure" is doubly nonsensical in a Robinson Crusoe economy.

Recessions are a bad thing, but they are not bad in the same way as a bad shock in Robinson Crusoe's economy.

Every Saturday Canadian output and employment drop. And they drop again every Sunday. Every weekend, output and employment drop for two successive quarters days. Are weekends mini recessions? I would say "no". In those things we call "recessions", we don't just see a reduction in the volume of trade, output, and employment; we see something peculiar happening in many markets where goods are traded for money. In recessions, it becomes harder to sell goods (including labour) for money, and easier to buy goods for money, relative to normal times. And the economy just doesn't seem to be working as well as it normally works, to do the best it can to satisfy our wants, given available resources and technology. The increase in the number of unemployed workers is one symptom of this.

Recessions are a coordination failure, and a specifically monetary coordination failure. Weekends don't look like a monetary coordination failure. They don't look like a coordination failure at all; they look like a coordination success, where we all take time off work at the same time so we can work together and do other things together.

A recession is a monetary coordination failure with a reduction in the volume of monetary trade. A monetary coordination failure probably means that output and employment will be lower than they would have been without that monetary coordination failure. It does not necessarily mean they will be lower than they were in the previous period.

Whether a given shock causes a monetary coordination failure depends on monetary policy. And it is perfectly possible that a shock that would be a "good' shock otherwise could cause a monetary coordination failure, for some monetary policies. For example, discovering that gold cures cancer would normally be a good shock, but if the world is on the gold standard the increased non-monetary demand for gold would mean that all other prices would have to fall to prevent monetary disequilibrium, and if prices are sticky this won't happen quickly, so we get an excess demand for money, and a recession. The net result might (or might not) be worse for human welfare than if the discovery had been suppressed.

We should not blame the shock for the monetary coordination failure it causes under some monetary policies. We should blame monetary policy instead. And I can think of no obvious reason why there should be any correlation between the goodness/badness of shocks in a hypothetical perfectly coordinated Robinson Crusoe economy and whether or not those shocks are likely to cause a monetary coordination failure.

In 1996 the Canadian economy was hit by a big shock, when the federal government tightened fiscal policy, turning a fiscal deficit into a surplus. We can argue about whether that was a good shock or a bad shock. But it did not cause a recession. It did not cause a monetary coordination failure. But there are good reasons for believing that if monetary policy had been different, if the Bank of Canada had targeted a fixed exchange rate rather than 2% inflation, that same fiscal shock would have caused a monetary coordination failure. Because the Bank of Canada allowed nominal interest rates and the exchange rate to fall, so private spending and net exports could rise, and that could not have happened with a fixed exchange rate.

In 2008 the Canadian economy was also hit by a big shock. That shock was probably a bad shock for Canada. If the customers for your goods get into difficulties, that will lower your expected utility even if you respond perfectly to that shock. But there is no reason why a bad shock should necessarily cause a monetary disequilibrium. It depends on monetary policy. The monetary policy in 2008 was the same as monetary policy in 1996. The Bank of Canada targeted 2% inflation in both cases. But the 2008 shock did cause monetary disequilibrium. It did cause a recession. Or, rather, the same 2% inflation target monetary policy caused a recession when faced with the 2008 shock, but did not cause a recession when faced with the 1996 shock.

Why?

[For Bob Murphy; I'm trying to clarify something about my previous post to try to prevent us arguing at cross-purposes.]

Comments

[Majromax]

> Why?

Because inflation measures are only weakly sensitive to "my trading partner didn't show up."

Imagine that Canadians produce apples to eat and wood pulp to export in exchange for cosmetics. One day, our trading partner has a flat tire and doesn't show up to the market.

The non-monetary response is for the Canadian economy to reallocate such that more people produce apples and fewer people produce wood pulp. Overall welfare decreases some, but this is a barter economy and it's the best we're going to achieve.

Now, add money and inflation targeting to the picture, defined based on personal consumption expenditures. When our trading partner doesn't show up, wood pulp starts rotting and cosmetics become scarce. This increases the observed inflation rate, as the supply of cosmetic has decreased (raising equilibrium prices) and reallocation of unsatisfied demand to apples increases prices in that market as well.

This would cause an inflation-targeting central bank to reduce the money supply, but this is precisely the opposite of what we know (from this constructed example) is necessary if there is any downward price/wage stickiness.

[Kenneth Duda]

If gold turned out to cure cancer... I love it. Your posts are so great, thanks for writing.

-Ken

p.s. I still think sectorial inflation (due to sector-specific negative supply shocks/constraints) plus downward nominal rigidity in other markets can really mislead an inflation targeting central bank, enabling it to hit its inflation target even when aggregate demand is insufficient due to exactly the sort of monetary coordination failure you discuss in this post, and that could explain Canada's 2008-2009 "success" of hitting its inflation target even as NGDP plunged.

[Nick Rowe]

My guess is somewhere along the same lines as Majro and Ken (who are saying something similar in different ways).

[Jeff]

I think you hit on it with the gold/cancer hypo shock. And price stickiness. It's when money myths become too prevalent in the economy in question and the particular shock plays against those myths. The basic myth being I suppose that money itself is a good. Because you can't eat it, live in it, nor (really) heat with it. Another myth I suppose is "I should be able to get a fixed 10% return when I invest my money and I will shop, cajole, and/or manipulate until I get it". (Let alone the Krugman policy myths: confidence fairy, bond vigilante.)

[jonathan]

Surely there are other alternatives besides frictionless optimum and monetary coordination failures? For instance, maybe information problems cause labor/goods/credit markets to fail to function optimally, and these market failures worsen during recessions. So there is a coordination failure, but it is not monetary in nature, or correctable through conventional monetary policy.

[Nick Rowe]

Jeff: well, money is a good, but not in the same way as all the other goods. It's a good that helps us coordinate our trade in all the other goods. And sometimes it coordinates well, and at other times it coordinates less well.

jonathan: yes. But it looks to me like recessions are a specifically *monetary* coordination failure. Because it is *money* that gets harder to buy and easier to sell in recessions. Plus (AFAICT) barter trade actually expands in recessions.

[Market Fiscalist]

In the Austrian model it seems that people come to the realization at some point in the trade cycle that they have been busy producing the wrong kind of things.

All the factoriess producing the useless stuff shutdown and the workers want to go back to their old jobs as wheat farmers. But they can't becasue the factories producing farming equipment all switched to producing useless stuff as well. They restart farm equipment production but it will take a while to get the equipment ready. In the mean time there is unemployment and a drop in RGDP. This would happen even if prices were perfectly flexible.

The Austrian model may be flawed - but why would they be wrong to see this as an example of a recession caused by non-monetary reasons ?

[jonathan]

Nick: It is true that during a recession it becomes harder to sell labor and goods (for money), and harder to obtain loans (of money). But it's not clear to me that this is essential to the failure, or just reflects that in an economy that uses money as a medium of exchange, every transaction involves money.

This is especially true in a liquidity trap in which money and T-bills are equivalent at the margin. You could equally well say that the problem is that it's hard to get T-bills, since under current conditions one can immediately swap one piece of government paper for another.

(I've also never heard that barter increases during a recession. Are you thinking of unemployed people exchanging favors?)

[Tom Brown]

Nick, I love the bold face you often use: it amounts to a handy tl;dr version.

[Miguel]

Nick, I think the answer is quite clear if you introduce the level of debt. Higher level of debt make monetary policy less efficient, independently that you change inflation for GDP level objective.

[Miguel]

See http://www.miguelnavascues.com/2015/08/1996-y-2008-por-que-no-funciono-la.html

[Majromax]

@Fiscalist:

In the Austrian view, why would a recession be consistent with falling prices? In the 2008 recession, the Bank of Canada did what it described as monetary easing in order to increase inflation and inflation expectations. In the counterfactual of "no change in the monetary instrument," we would have experienced a collective fall in the price level and very arguably worse real output.

The Austrian view of recessions makes a lot of sense for "stafglation" recessions like that of the 1970s oil shock, where there really is a factor of production that becomes scarce. What happened in 2008 in Canada that would have been comparable?

@Miguel:

> Nick, I think the answer is quite clear if you introduce the level of debt. Higher level of debt make monetary policy less efficient, independently that you change inflation for GDP level objective.

Your story is precisely opposite what is supported in Canada's experience. The Canadian federal government of 1996 had a relatively high level of debt -- in fact the austerity measures were brought about in response to a looming debt crisis. On the other hand, the Canadian federal government of 2008 had a very low level of debt, having come off many years of either surplus or budgetary balance with economic growth.

[Majromax]

> The Austrian view of recessions makes a lot of sense for "stafglation"

*stagflation, of course.

[Market Fiscalist]

'In the Austrian view, why would a recession be consistent with falling prices?'

Good question. I suppose the easy answer is "Hayek's secondary deflation" - a recession caused by an Austrian supply shock turns into a recession worsened by monetary dis-equilibrium.

[Nick Rowe]

jonathan: "(I've also never heard that barter increases during a recession. Are you thinking of unemployed people exchanging favors?)"

To my mind, this is a crucial bit of evidence that supports the monetary disequilibrium theory, and is rather hard to explain otherwise. Unemployed people exchanging favours would be one example. I wish I had more data on this. Here is one old post I did linking to some anecdata (with links to more posts in that post).

Tom: I stole the bold face idea from blogger Razib Khan (who is a brilliant blogger BTW, even if a lot of stuff he writes goes way over my head).

[Nick Rowe]

jonathan: another old post on empirical evidence for countercyclical barter. Plus, see the post by Alex Tabarrok that I link to there.

[Bob Murphy]

Thanks Nick this is awesome. I'm not being lazy, but I think this article I wrote after my debate with Karl Smith still perfectly captures how I would respond to your post here. If you get time to check it out, I'd love to hear your feedback (here in these comments). If you were willing to do that, I will try to do something at my blog reconciling our two perspectives. I think it's one of those "blind economists describing an elephant" situations.

[Nick Rowe]

Miguel: I had a read of your post. Who/what is "PP"? Did Spain do a big fiscal tightening in 1996, just like Canada? And did it also result in no recession? But Spain had its own central bank back then, right? Did it (de facto) keep inflation on target? And in 2011, with Spain in the Euro, there could be no monetary offset of fiscal tightening, of course, so it's not surprising if things got worse for a bit.

In Canada, federal government debt/GDP was lower in 2008 than 1996. Not sure about private debt.

[jonathan]

Nick: The examples of barter cited are interesting, but here is a counterpoint: if the problem is a shortage of money *as medium of exchange*, then why is the T-bill rate zero? Given that T-bills do not serve as a medium of exchange in transactions, and given that the interest rate on T-bills should equal the liquidity premium of money over T-bills, I would expect that if the economy were suffering from a medium of exchange shortage, there would be a positive interest rate. People would have to be compensated for holding T-bills instead of money.

Instead, it seems that T-bills are an asset that is in demand more than usual relative to money. This fits in well with another sort of shortage -- a shortage of assets that can serve as a safe store of value. In this case, T-bills are serving as stores of value, and at the margin are equivalent to money. I consider this strong evidence that the problem is not a shortage of money for transaction purposes, but of stores of value. Or equivalently, excessive demand for future goods relative to current goods, and the intertemporal price (real interest rate) can't fall.

[Andrew_FL]

Market Fiscalist-The Austrian theory is a monetary theory of recessions. People produced all the wrong things because of an earlier monetary expansion.

You're reducing the Austrian story to a supply shock because you're preoccupied with the bust. The Austrian story is a theory of the boom, not the bust.

In AD/AS terms, a rightward shift in the AD causes a leftward shift in LRAS but we temporarily move to the right on the SRAS curve. A demand shock causes a supply shock.

From the sound of it you may have ABCT confused with Kling's PSST.

[Nick Rowe]

jonathan: suppose we used cows as money. An increased demand for milk would cause a recession, because people would stop spending their cows as quickly. And if goats produce milk too, but are not used as money, we would not expect the price of goats to fall.

If there is expected to be an excess demand for money in future too, so NGDP is expected to rise more slowly than usual, that will cause equilibrium nominal interest rates to fall.

The IS curve slopes the "wrong" way, not because interest rates have the "wrong" sign on investment demand, but because dI/dY + dC/dY > 1.

Low nominal interest rates do not mean money is loose. They mean money is expected to be tight in future.

Andrew: "From the sound of it you may have ABCT confused with Kling's PSST."

I sometimes get them a bit confused too.

Bob: I had a read of your post Karl Smith article. And this morning I read your other old Mises post on ABCT (linked in your potpourri). You are good at explaining it. But I am still not convinced it is a coherent theory.

But assume for the sake of argument ABCT is both coherent and correct. A collapse in foreign demand for your goods will (generally) require a change in the time-structure of production. A collapse in government demand for your goods will also (generally) require a change in the time-structure of production.

[LK Beland]

If one believes in the musical chair model, it is pretty clear that nominal income, not consumer prices, are at the heart of monetary coordination failures. Negative growth in nominal income can be especially problematic.

Given that real gdp growth can, for all kinds of reasons, be smaller than -2%, I don't think that it's surprising that 2% cpi inflation (which may or may not be related to the production of a small open economy such as Canada) was observed amidst the 2008 recession.

[Andrew_FL]

Nick-The main difference is that PSST has no special role for money. Money plays the central role in the Austrian theory. Which is why I found it odd that Market Fiscalist was talking about it as if it was about recessions unrelated to money.

Something I wrote from a long, long essay I should post online at some point:

"I suggest we should consider a recession as a time when a mismatch occurs between the individual economic actors' plans for production and consumption, in such a way as to be unfavorable both to producers and consumers simultaneously.

From that definition, three sorts of recession that might hypothetically occur can be gleaned: 1. Unexpected, unfavorable reductions in the productive capacity of industry in general, such that consumers may have wanted more production, but adequate production proved physically or practically impossible. The real supply of goods is reduced 2. Producers produce an excess of goods in general, greater than the quantity consumers intend to consume. Products lie unsold on shelves. 3. The goods producers have produced are inconsistent with what consumers actually wish to consume, that is, there is not an excess supply of goods in general, but an excess supply of some goods and a shortage of others. Superficially recessions of this type resemble those of type two, as some products lie unsold on shelves. But other goods lie unproduced entirely, despite the desire of consumers to purchase them."

Type one are supply shocks, and I would say you could have a recession due to, say, an asteroid impact or something that would effect all production at once. A supply shock for a single individual good would not cause a recession. Either way these are rare to non existent in modern, diverse economies, or at least they're less important than types two and three.

Type two are General Gluts, they imply people in general desire higher real money holdings at the expense of nominal demand for goods.

Type three are the busts that follow Austrian style booms. Technically I suppose you could say PSST looks like this to. But I have a hard time understanding why a PSST style recalculation would become necessary without invoking a distortionary role for money, in which case PSST starts to become very difficult to distinguish from ABCT-but not impossible.

[Scott Sumner]

Nick, Interesting post. Suppose Canadian manufacturing produces components for US firms. The US goes into a deep recession (a la 2008). There is a big drop in demand for Canadian components, and no feasible price change for those components can maintain output, when the final goods factories in the US (say car factories) are shut down.

So it's a re-allocation problem. The empirical question is how much smaller is the loss of jobs under monetary equilibrium (say NGDP targeting) as compared to monetary disequilibrium (say inflation targeting, or interest rate pegging or exchange rate pegging)

The experience of the US from January 2006 to April 2008 suggests that re-allocation shocks are not important at the macroeconomic level. US housing construction fell by more than 50%, and yet unemployment barely budged (from 4.7% to 5.0%) And even that overstates things, as NGDP growth slowed.

On the other hand the global recession of 2008 may have hit Canada's economy harder (in a real shock sense) than the housing collapse hit the US. Housing was 6% of GDP at the peak, whereas manufacturing is much larger. So I have an open mind as to the extent to which monetary stability would have shielded Canada from recession in 2008-09. My guesstimate is that the slowdown (under NGDPLT) would have been only 1/4 to 1/3 as large as it actually was, which is of course much better.

Check out the bicycle video at moneyIllusion

[ThomasH]

@Majromax

Your example is of a supply shock. Price level targeting (with higher price levels in the future) is designed to deal with negative demand shocks and downward sticky prices. This is part of the argument for NGDP targeting.

[Market Fiscalist]

@Andrew_FL

"The Austrian theory is a monetary theory of recessions": I don't doubt it. I was deliberately focusing on the co-ordination failures that occur during the bust phase of ABCT and ignoring the cause of the initial boom to see how that fitted with Nick's views that all recessions are the result of monetary disequilibrium. I think Bob does a similar thing in his Gnome story that he links to above. Of course at heart ABCT is a special case of monetary dis-equilibrium theory but that wasn't my point.

Nick says "A monetary coordination failure probably means that output and employment will be lower than they would have been without that monetary coordination failure". I think this applies to ABCT and Bob's Gnome theory.

[Market Fiscalist]

In fact Bob's gnome story is interesting in that it has a random supply shock totally unrelated to monetary policy.

Bob then draws the conclusion "Any attempt to short-circuit this[recovery] process with a wave of fiat inflation or deficit spending would simply screw up price signals and make the adjustment process that much longer.".

So we have 2 polar views:

Nick: A monetary coordination failure probably means that output and employment will be lower than they would have been without that monetary coordination failure.
Bob: Any attempt to short-circuit this process with a wave of fiat inflation or deficit spending would simply screw up price signals and make the adjustment process that much longer.

For Nick you need monetary policy that consciously strives to avoid monetary dis-equilbrium, for Bob any attempt to do this just makes a bad situation worse!

[LK Beland]

Scott Sumner, I believe you are right.

In the case of Canada, it was not only manufacturing (cars in particular) that were hit, but also commodities. Case in point, exports crashed from 34.5% of GDP in 2008 to 28.4 % in 2009. (Imports decreased by a smaller margin 32.7% to 29.9%). That's a very sudden fall in net exports (3% of GDP). I think that the fact that Canada is an open economy played a big role. It's not impossible that the huge depreciation in the CAD in mid-2008 was enough to lift CPI inflation to the 2% trend, but was not enough to fully accommodate this huge exogenous shock.

[Miguel]

Nick, I refer to private debt. It's my fault not to have precise it. In any case, I agree with you except in you monetarist model. You say that the crisis of 2008 has change your mind, and prefer a NGDP objective rather than inflation rate. Good. But I think it is not very different, because the problem, the big problem, is that inflation or NGDP, both are ineffective when the debts have risen.

[Bob Murphy]

Market Fiscalist, the only way your contrast between Nick and me--which is clearly designed to make Nick come out as the better man--works is if you define a bunch of gnomes rearranging all the capital goods as "a monetary coordination failure." That's the whole point of my example, to show that the Keynesian (and by extension on this issue, Market Monetarist) framework forces you to diagnose drops in real output as due to bad monetary policy when, by construction, they have nothing to do with monetary policy.

[H Stede]

Robinson Crusoe can take some time to think.
"The social function of liquidity is that it gives time to think." Hicks, 1974, p.57.

[Market Fiscalist]

Bob,

My comment certainly wasn't intended to "make Nick come out as the better man" but merely to try and state the differences in your views of what is the appropriate monetary policy in the face of a supply shock

I do not think it true to say that the only way my contrast works "is if you define a bunch of gnomes rearranging all the capital goods as "a monetary coordination failure.". Rather, I think that given a random supply shock (such as your Gnome example which is clearly not a monetary shock) Nick thinks that monetary policy aimed at preventing monetary disequilibrium will optimize the recovery process, while you appear to believe that any tinkering with the money supply ("wave of fiat inflation") will mess with prices and de-optimize the recovery process.

Am I am mis-stating your views ?

[Bob Murphy]

BTW just to avoid confusion, since the casual reader might think Andrew_FL and I are contradicting each other:

In canonical Austrian business cycle theory, it is loose monetary policy that pushes interest rates below their "natural" level and misleads entrepreneurs into making unsustainable investments. This creates a temporary boom period that is an illusion.

Eventually the boom ends, typically when the central bank gets nervous about rising price inflation and so cuts back on the injection of new money. Interest rates spike and a bunch of businesses realize they are in trouble. The recession ensues.

However, the critical point is that once malinvestments occur during the boom period, the economy is now in a *physically* unsustainable configuration. The bust is inevitable at that point. So the boom is caused by monetary factors, but the bust is a "real" phenomenon. Once you are in the midst of a bust, pumping in more money isn't going to fix it. At best (worst), it will keep the illusion of the boom alive for longer, allowing even worse malinvestments to occur so that an even more severe reallocation is now going to be necessary.

[Andrew_FL]

Thanks Bob.

At the risk of actually disagreeing, can you comment on whether you think "typically when the central bank gets nervous about rising price inflation and so cuts back on the injection of new money." isn't the central bank compounding one error with another? It's too late for the central bank to undo the policy which put the economy in an unsustainable configuration, and real goods are scarcer than they appeared to be during the boom, and they're also scarcer relative to money than they appeared to be during the boom. If the central bank "does nothing,"-or more accurately, stops doing something-prices should rise as output falls. If they don't, it would make sense to say that the central bank compounded the problem, not because it tried to re-inflate (which I agree would be a mistake) but because it tried to reverse price inflation it had already caused?

That's Hayek's secondary deflation, I think.

[Tom Brown]

@Market Fiscalist, you write:

"For Nick you need monetary policy that consciously strives to avoid monetary dis-equilbrium, for Bob any attempt to do this just makes a bad situation worse!"

Now how can we go about telling how it is for reality? (I'm not into this post-modernist "everybody's reality is equally valid" nonsense) ;^)

[Bob Murphy]

Andrew_FL I'm talking about what usually makes the boom come to an end. Prices start rising too quickly, so the central bank slows down on its asset purchases, the monetary base stops rising so rapidly, and interest rates end up rising. Then the boom turns to a bust.

I think you are talking about something else, where they try to reverse the price inflation of the boom years.

[Nick Rowe]

Scott: "On the other hand the global recession of 2008 may have hit Canada's economy harder (in a real shock sense) than the housing collapse hit the US. Housing was 6% of GDP at the peak, whereas manufacturing is much larger."

In the 1990's Canada went from a 5% budget deficit to a 2% budget surplus, which is 7% of GDP. That's quite big, though it changed a little more slowly than the drop in US housing construction.

[JKH]

Nick,

I’m glossing over all this because I find the economics profession’s specific use of the term “co-ordination” to be inherently vague and mind-bogglingly amorphous. That may well be because I’ve spent little time looking at it.

I saw this post from David Glasner about one of your posts on the subject:

http://uneasymoney.com/2014/09/11/nick-rowe-on-money-and-coordination-failures/

He says:

“Thus, the condition for macroeconomic coordination is that all agents have correct expectations of all currently unobservable future prices. When they have correct expectations, Walras’s Law is satisfied, and all is well with the world… actually, Nick admits that coordination failures can be caused by factors other than an excess demand for money, but for some reason he seems to think that every coordination failure must be associated with an excess demand for money. But that is not so. I can envision a pure barter economy with incorrect price expectations in which individual plans are in a state of discoordination.”

I also skimmed Murphy’s post, and that last sentence from Glasner reminded me of it.

Question:

Can you define the term “co-ordination” and/or the term “monetary co-ordination” according to how you see them interpreted in the broad economic context?

[JKH]

comment in spam I think

[Nick Rowe]

JKH: I fished you out of spam.

Fair critique. "Coordination failure" gets used in many ways.

It can mean where you have multiple Nash equilibria, some better than others, and we get stuck in a bad equilibrium.

I'm using it in a loose sense here. If you read Hayek's essay on the use of knowledge in society (which is well worth reading quite apart from this post) you will get a sense of the fuzzy sense in which I am using it here.

Those particular coordination failure we call "recessions" seem to have a peculiarly monetary character, for reasons I state above. It's easy to buy goods *for money* and hard to sell goods *for money*. So I call them "monetary coordination failures".

[LK Beland]

I think I have a part of the answer.
Canadian Total Government Deficit started shrinking as of 1992:

http://fin.gc.ca/budget00/images/bpc3_3e.gif

1992 -8% of gdp
1997 ~0.8% of gdp

The average rate of tightening was 1.6% of gdp per year. The 1996 tightening was about 2.2% of gdp. A bit above average, but still in the same ballpark. In other words, austerity in 1996 wasn't that large, in the context of the 1992-1997 overall provincial+federal fiscal tightening.

[Miguel]

Nick, from Uneasy money, cited by JKH,
"...In a monetary economy suffering from debt deflation, one would certainly want to use monetary policy to alleviate the debt burden, but using monetary policy to alleviate the debt burden is different from using monetary policy to eliminate an excess demand for money. Where is the excess demand for money?"

So an excess of debt can make ineffective al MP guided by. Inflation objective or by a NDGP one.

[Andrew_FL]

Thanks for the clarification Bob, yeah, we are talking about slightly different things.

[Kathleen]

What was different about 2008/09? A possible hypothesis for consideration:

There was a coordination failure in the Asset Backed Commercial Paper market when that market effectively froze solid - ABCP being something of a shadow banking system member. ABCP was a popular place for firms to park short-term cash for the obvious reason - higher returns. Monetary policy that acts on banks had no impact on the ABCP market. There were signficiant funds frozen in the ABCP market in 2009 - take Nav Canada as an example where money that was targeted for capital projects was suddenly frozen causing capital projects to be delayed causing a drop in economic activity.

Companies caught in the ABCP freeze were not about to go to their bank to finance these activites as they were facing the possibility of losing their capital investment in ABCP - risk management would have said to retrench.

It tooks months for the ABCP market to get settled. Long enough to do real damage to economic activity.

Possibly there were several shocks hitting Canada at the same time: ABCP market freezing plus a recession in our largest trading partner.

[Jeff]

@Nick, Thanks for responding, and agreed money is a "meta-good", not to be confused with "goods and services" in the usual sense. More oil than gas, in an ICE metaphor.

[Nick Rowe]

Jeff: It's an older metaphor than that: “Money... is none of the wheels of trade: it is the oil which renders the motion of the wheels more smooth and easy.”
David Hume's essay is well worth reading.

[Keshav Srinivasan]

Nick, you said "But I am still not convinced it is a coherent theory." Why don't you write a post on why you think ABCT might be incoherent?

[Nick Rowe]

Keshav: it's an idea. But I'm afraid my post would just be "I can't figure out how ABCT is supposed to work", and would be followed by lots of comments telling me to read XYZ, or trying to explain it to me.

If I can figure out a more constructive post, I might do it.

[Nick Rowe]

Kathleen: "It tooks months for the ABCP market to get settled. Long enough to do real damage to economic activity."

Suppose Canada never had an ABCP market. Presumably that would be worse for Canada, but it wouldn't have put Canada in a permanent recession with higher unemployment. Maybe the sudden disappearance of the ABCP market caused search unemployment, while workers reallocated to different firms. But the same thing would have happened in 1996, as workers needed to reallocate to the export sector.

[Majromax]

> But I'm afraid my post would just be "I can't figure out how ABCT is supposed to work", and would be followed by lots of comments telling me to read XYZ, or trying to explain it to me.

From my very amateur viewpoint, what puzzles me about Austrian Business Cycle Theory is how asymmetric it is. It seems plausible that too-loose money could cause a real bubble that pops, but explanations of the theory that I have read make no mention of what would happen if money is too tight.

If too-loose money has a real-terms effect, then too-tight money should have one as well. If that effect is contractionary, then ABCT still has two "kinds" of recessions: a bubble-popping one (the canonical description) and a monetary strangulation one. Then we're still faced with an identification problem in diagnosing an observed downturn.

[JKH]

Thanks for the Hayek link, Nick.

I’ve seen it before, but its the first time I’ve read it.

A brilliant piece of thinking and writing, IMHO.

And I was struck by this:

“Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to coördinate the separate actions of different people in the same way as subjective values help the individual to coördinate the parts of his plan.”

That last part uses the term in a slightly different way than you do with respect to Robinson Crusoe. I think that’s indicative of what I meant by amorphous. The idea is so deep and powerful that you can run with it in just about any direction.

[Nick Rowe]

Majro: "but explanations of the theory that I have read make no mention of what would happen if money is too tight."

Interesting point.

JKH: It's one of my all time favourite essays in economics.

We can imagine a Robinson Crusoe who gets a bit muddled in solving his economic problem (because it's a complicated one, and he can't figure out the spreadsheet), and finds himself with unplanned spare time on his hands, and nothing to do with it. In a recession, the economy seems to get muddled in the same way, but for different reasons (having to do with prices not conveying information correctly).

[Oliver]

You seem to be saying 2 things here:

Every Saturday Canadian output and employment drop. ... Are weekends mini recessions? I would say "no".

Here you say that a drop in NGDP is not a sufficient indicator of a recession. You also need a coordination failure. But a coordination failure in this sense is a cause, not a symptom. And an invisible one, too. You do not mention the symptom. It's like the 'involuntary' in involuntary unemployment. How do you know people didn't coordinate badly on purpose?

(I'd say output and production (GDP) drop every weekend but employment doesn't. Employment contracts aren't terminated on friday and renegotiated on monday. They persist, except in a recession.)

Then, In your two real examples from 1996 and 2008, you make a different distinction. In one instance (1996), there is a policy shock that does not lead to a drop in NGDP and in the other (2008) it does. Suddenly, a drop in NGDP is the measure of a recession.

I find Scott Sumner's answer more satisfying in this respect. He basically distinguishes between good an bad recessions. There are two types of drops in NGDP, one that causes a fall in employment and one that doesn't. The latter is a product of good monetary policy. It cannot prevent the real shock but it prevents it from further causing an increase in unemployment. Employment is the measure, coordination failure is the mechanism that causes it which can be prevented with the appropriate monetary response. Importantly, one cannot measure coordination failure by itself.

Also, in re-reading the Hayek paper, I don't see how the information transfer via price signals allows for any type of coordination failure. All he is saying to me, is that decentralised decision making (I assume that includes decision within firms?) will lead to better prices and thus leaner processes because prices reflect scarcities more truly (always assuming perfect competition and normal profits). I don't see how anything can fail within that story. Prices are just more or less indicative of scarcities. In fact, Hayek seems to be saying that the existence of money means nobody actually has to coordinate anything.

Or are you saying that there was more centralised decision making in 2008 than in 1996? And is monetary policy not a centralised decision?

[Oliver]

Sorry, just reread your post and saw this. (Some law of blogging at work here where relevant passages in the blog only appear after hitting post...):

...The increase in the number of unemployed workers is one symptom of this.

So I'll take that back about the symptom. I'll stick with the rest though for the moment. Until after I hit post again, that is :-).

[Oliver]

Maybe I'm taking the word coordination too literally. In any case, I don't quite get it.

[Nick Rowe]

Oliver: Here's the main symptom: "In recessions, it becomes harder to sell goods (including labour) for money, and easier to buy goods for money, relative to normal times."

[Nick Rowe]

Oliver: "Hayek seems to be saying that the existence of money means nobody actually has to coordinate anything."

In that essay, Hayek is trying to get across the main idea, like a physiologist saying how human bodies actually work. He is setting a side the secondary question, like a doctor saying that sometimes, despite what the physiologist says, people get ill.

[Oliver]

Regarding the symptoms. How do you measure easier and harder? Which metric are you looking at?

Regarding Hayek. I understood that he was describing how he believes markets should function and not how they might not. But I din't understand how you can deduce from that that the mechanism by which markets supposedly fail is coordination failure - seeing as market success, as I understood him saying, doesn't require any coordination in the first place. I guess it comes down to a definition of the word coordination.

[Tom Brown]

Oliver, you might find this alternative (and complementary) view interesting.

[Oliver]

Thanks, Tom. The post is way too mathy for me, but I think I have a rough picture of the essence of both posts. In short, when things don't go as expected, it takes a while for people to adjust and construct (coordinate) a new, stable reality. This adjustment often, but not always, has undesired effects we call a recession.

Nick seems to be saying that buying up assets for new money helps the adjustment process along. People are stuck in old assets they want out of, because expectations about the future have changed, but haven't shaped stable new expecations yet. New money offers a temporary parking spot that allows us to keep all options open until we have decided.

As for the first paragraph, I'm not sure it is reasonable to assume to the economy operates in binary states of either equilibrium or adjustment.

As for the second, I'm not sure that covers the whole story, nor takes into account the consequences of such an intervention. It's a bit monocausal, but we are talking blogposts intended for simpletons like myself, so I guess gross simplification is justifiable. Personally, I think I'd frame recessions in terms of changes in risk assessment, not demand for money aggregates. Assuming the asset class in the diagnosis also seems a bit circular.

[Andrew_FL]

On the off chance that Majromax is still reading and interested in symmetrical ABCT:

Steve Horwitz has explicitly developed the theory along exactly those lines:

Horwitz, Steven. "Capital theory, inflation and deflation: the austrians and monetary disequilibrium theory compared." Journal of the History of Economic Thought 18.02 (1996): 287-308.

Horwitz, Steven. "12 Monetary disequilibrium theory and Austrian macroeconomics." Money and Markets (2006): 166.

I suspect the reason you've not seen many exposition of the Austrian theory that give time to the flip side sort of monetary disequilibrium, is that people judged the looseness or tightness of money based on their implicit policy norm, and Rothbard's implicit policy norm was 100% reserve banking on a gold standard. If that's your policy norm, tight money relative to the norm is a practical impossibility.

But Mises' explicit policy norm was free banking. So I think that's the more relevant norm against which to judge policy.

[Nathan W]

Why would a recession necessarily have to do with monetary coordination failure?

Aren't business cycles an agreed upon feature of the economy and creative destruction one of the benefits of not interfering too much?

[Gizzard]

How at a macro level can it be "harder to sell things for money" and "easier to buy things for money"? Aren't the people who are buying things easily buying them from sellers?

A recession is when all sales are falling so there is less buying and less selling

[Nick Rowe]

Gizzard: the quantity of apples bought is always identical to the quantity of apples sold. Yes.

But it might be easy for a buyer of apples to find a seller of apples, and at the same time hard for a seller of apples to find a buyer of apples. We might call that a "buyers' market for apples".

[Philippe]

Bob Murphy,

"Eventually the boom ends, typically when the central bank gets nervous about rising price inflation and so cuts back on the injection of new money. Interest rates spike and a bunch of businesses realize they are in trouble. The recession ensues."

Once the economy goes into recession, shouldn't the 'natural' interest rate fall?

[Nick Rowe]

Philippe: interesting question. But I think I would rephrase it like this: suppose there is an Austrian boom, caused by the central bank setting the actual rate below the natural rate, distorting the time structure of production. So at the start of the recession, we inherit a bunch of semi-finished capital goods that is different from what it would have been if there had been no boom. What does that do to the ***term-structure*** of the natural rate of interest? (It will almost certainly change it, but how? And if we simply woke up one morning, and didn't know whether that bunch of semi-finished capital goods had fallen out of the sky, why would that cause a recession?)

[Philippe]

"What does that do to the ***term-structure*** of the natural rate of interest?"

I guess that it would flatten the term structure.

What would you say?

[Philippe]

Wrong answer? I have no idea.

I'd be interested in hearing your answer to your question.

[Andrew_FL]

"And if we simply woke up one morning, and didn't know whether that bunch of semi-finished capital goods had fallen out of the sky, why would that cause a recession?"

The consumption goods produced using the assortment of capital goods have to be at odds with priori future consumption plans, so no, but only because you've assumed those plans away.

But people could have more fortunate lucky endowments of capital goods in an immaculately created economy, that happened to more closely resemble the capital goods they would tend to create to use in the production of the consumption goods they prefer. Those economies would have higher real GDPs (probably, but not always) than ones where the miraculous history-free endowment was less well fit to the ends they pursue with them.

As a caricature, imagine a nation of vegetarians wakes up with no memory of the past, except that they are vegetarians, and finds they only possess hunting rifles and no farming equipment. Obviously this is not as fortunate for the vegetarians as it would have been to wake up finding they had tractors and fertilizer plants (assuming they're not also organic nuts). Is this a "recession?" Well we have no past to compare it to in which the vegetarians were better off, so we can't really say that it is. But if we imagine that before they slept the previous night, they had an apparently thriving vegetarian economy, they were producing plenty of fruits, vegetables, and grains, then it almost certainly is because what they are capable of producing now is much less, from their perspective, than what it was in the past. And it's going to take a lot of time and effort for them to melt their guns back into plowshares. We can bring unemployment into the picture if we assume vegetarian farmers have to learn how to be smiths before they can be employed by others to melt their guns into farming implements, and we assume a lack of farming implements makes the equilibrium farm labor wage lower, and the decision whether to wait for it to rise, try to become a smith, or take an initial wage cut is not an obvious one. It would be especially obvious if the price of fruits, vegetables and grains is much higher now because the supply is so low.

Again, I'm creating a caricatured story but I think I've captured the essence of it, although I've probably done some violence to important elements by vastly over simplifying it. The obvious question is "what could cause an entire society of vegetarians to produce nothing but guns instead of farming implements." (And please don't say "a war" because that's true, but it's getting sidetracked away from the point by the analogy.) More realistically "What could cause a society to produce the wrong mix of capital goods for producing society's preferred mix of consumption goods as efficiently as possible?" (The answer is monetary coordination failure, though not quite in the sense you mean in your post)

[Andrew_FL]

Sorry it would be especially *unobvious*