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.]
Worthwhile Canadian Initiative 
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.
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).
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?
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 :-).
Maybe I’m taking the word coordination too literally. In any case, I don’t quite get it.
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.”
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.
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.
Oliver, you might find this alternative (and complementary) view interesting.
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.
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.
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?
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
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”.
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?
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?)
“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?
Wrong answer? I have no idea.
I’d be interested in hearing your answer to your question.
“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)
Sorry it would be especially unobvious