I’ve been thinking about how to teach monetary economics from the beginning. Perhaps before people start learning, they need to unlearn things they believe, that just ain’t so. We market monetarists believe that monetary shocks (or “disequilibrium” if you prefer) is the primary cause of business cycles, indeed almost the only cause of big swings in unemployment.
Most people don’t believe this; indeed it’s not even clear that most economists believe this. Instead the average person thinks recessions are caused by big real shocks, or financial shocks, of one sort or another. Asset bubbles bursting, 9/11, stock market crashes, devastating natural disasters, etc.
It’s surprisingly easy to dispose of these real theories. We know that 9/11 didn’t cause the 2001 recession, because the recovery started just 2 months later. The biggest stock market crash in my life was 1987, which was almost identical to 1929, including the subsequent stock price rebound. The biggest natural disaster to hit a rich country in my lifetime was the 2011 Japanese earthquake/tsunami/nuclear meltdown, which killed tens of thousands of people, devastated a sizable area of Japan, and caused their entire nuclear industry (25% of total electrical output) to shutdown for more than a year (causing brownouts.)
The next two graphs show the US unemployment rate from 2 years before the October 1987 crash to 2 years after, and the Japan’s unemployment since January 2009 (the tsunami was March 2011):
What do you see? Nothing!!! I’m tempted to say “real shocks don’t matter.” But that would be incredibly insensitive for 9/11, or the tsunami that killed nearly 30,000 Japanese people. One could argue that nothing mattered more to these two countries, in 2001 and 2011. The stock crash wasn’t as traumatic, but certainly impacted people’s lives and outlook.
But these real shocks don’t matter (very much) for business cycles. The tsunami did cause a temporary dip in industrial output, but nothing severe enough to constitute a recession. However when you turn your attention to the labor market you can really see how little real shocks matter. Real shocks do not cause big jumps in unemployment. Period, end of story. Even I’m surprised by this fact, but it is evidently true. Recessions are caused by unstable NGDP, which is in turn caused by unstable monetary policy (by definition, as stable NGDP growth is my definition of a stable monetary policy–and Ben Bernanke’s too.) But it’s not a tautology that the recessions themselves are caused by monetary policy, indeed it’s surprisingly difficult to explain why NGDP instability causes unemployment to fluctuate so much. Especially when the NGDP shocks are caused by rather obvious changes in monetary policy, rather than “errors of omission.”
Another example is January 2006 to April 2008, when housing construction in the US collapsed, falling by 50%. What happened to unemployment? It rose from 4.7% to 4.9%. The worst clearly non-monetary shock in my lifetime was the nationwide steel strike of 1959, which caused unemployment to rise by 0.8%. But the smallest recession in my lifetime was 1980, where unemployment rose by 2.2%. The steel strike ended quickly and unemployment fell back down to where it was before the strike. (The two 1970s oil shocks are debatable.)
We’ve seen that most people, and even some economists, grossly overestimate the importance of real shocks in the business cycle. On the other hand most people, and some economists, grossly underestimate the importance of monetary shocks. Now that we’ve disabused everyone of the notion that non-monetary shocks cause recessions, it’s time to move on the to real cause (pun intended) of business cycles—monetary policy. In a future post.