A Risk-Based Recession?

Includes: RINF
by: Scott Sumner

Tyler Cowen has a new post entitled "If we have a U.S. recession this year, it will be a risk-based recession."

Not surprisingly, I don't agree, but I'd rather focus on the question of what exactly this term means. First let's quote Tyler again, expressing views closer to mine:

2. In the more recent segment of world history, a lot of cycles have been caused by negative nominal shocks. I consider the Christina and David Romer "shock identification" paper (pdf, and note the name order) to be one of the very best pieces of research in all of macroeconomics. Sometimes central banks tighten when they shouldn't, and this leads to a recession, due mainly to nominal wage stickiness.

3. Workers are laid off because employers are often (not always) afraid to cut their nominal wages, for fear of busting workplace morale, or in Europe often for legal and union-related reasons.

So that provides some context. Tyler is saying that if there is a recession this year, it won't be the sort of demand shock recession we've often seen in recent history. Next, let's consider some hypotheses.

Perhaps the claim is that we might have a recession this year due to risk, despite 3% plus NGDP growth. If so, I very strongly disagree. (This could be viewed as a version of real business cycle theory.)

Perhaps the claim is that if there is a recession, then NGDP growth will slow, but that this will not be the cause. In other words, even in a counterfactual world where the Fed kept NGDP growing at 3% plus, there would still be a recession for non-monetary reasons. If so, I very strongly disagree. (Again, an RBC-type claim.)

Perhaps the claim is that falling NGDP growth is a necessary condition for a recession this year, but it will be caused by growing risk and there is nothing that monetary policymakers can do about it. If so, I strongly disagree. (A traditional Keynesian claim.)

Perhaps the claim is that falling NGDP growth is a necessary condition for a recession this year, but it will be caused by growing risk that monetary policymakers are too cautious to do anything about. If so, I mildly disagree. (A New Keynesian claim.)

Why do I only mildly disagree with the last option? Because it's certainly possible, but on balance, I believe that growing signs of risk in the asset markets are themselves caused by signs of excessively tight money, which is reducing expected NGDP growth. In other words, in my view growing risk is the symptom of a recession, should it occur, not the cause.

Just to be clear, I am not predicting a recession this year (nor does Tyler in the post I linked to). But I certainly think the risk of one has increased in recent months, and I'd guess he does as well.

To summarize, I view the NGDP shock/sticky wage model as being very powerful, partly because we see this pattern over and over again under all sorts of monetary regimes, and all sorts of triggers for monetary shocks. Some intentional (the Fed 1920-21, 1929-30, Volcker 1981) and some unintentional (2008-09). But always the same result. NGDP falls much faster than hourly nominal wages, and unemployment soars. Then wages adjust and unemployment falls. That's not to say real recessions are not possible - as Zimbabwe showed in 2008, and perhaps the US in 1974.

On Facebook, Don Geddis sent me a wonderful introduction to market monetarist ideas by Eliezer Yudkowsky. I probably enjoyed reading this piece more than almost anything else in the past 10 years, partly because it's very nicely done, but more because I feel gratitude that one of the smartest individuals that I have ever read finds the ideas appealing. That doesn't mean we are right, but it's certainly a good sign. On a related note, check out my newest post at Econlog, which discusses Yudkowsky, Newcomb's Paradox, and long and variable leads.