The mystery of mini-recessions: The dog that didn’t bark

[If you haven’t already, read the previous post first.]

In this post I plan to define mini-recessions and then discuss why they are so mysterious and why they might offer the key to macroeconomics.  Then I’ll offer an explanation for the mystery.

To understand mini-recessions we first need to understand the monthly unemployment data collected by the Bureau of Labor Statistics.  This data is based on large surveys of households.  It seems relatively “smooth,” rising and falling with the business cycle.  Month to month changes, however, often show movements that seem “too large” by 0.1% to 0.3%, relative to the other underlying macro data available (including the more accurate payroll survey.)  So let’s assume that once and a while the reported unemployment rate is about 0.3% below the actual rate.  And once in a great while this is followed soon after by an unemployment rate that is about 0.3% above the actual rate.  Then if the actual rate didn’t change during that period, the reported rate would rise by about 0.6%.

I searched the post war data, which starts at 1948, and covers 11 recessions.  During expansions I found only 12 occasions where the unemployment rate rose by more than 0.6%.  In 11 cases the terminal date was during a recession.  In other words, if you see the unemployment rate rise by more than 0.6%, you can be pretty sure we are entering an recession.  The exception was during 1959, when unemployment rose by 0.8% during the nationwide steel strike, and then fell right back down a few months later.  That’s not called a recession (and shouldn’t be in my view.)  Oddly, unemployment had risen by exactly 0.6% above the Bush expansion low point by December 2007 (when the current recession began) and by 0.7% by March 2008, and yet many economists didn’t predict a recession until mid-2008, or even later.

What’s my point?  That fluctuations in U of up to 0.6% are generally noise, and don’t necessarily indicate any significant movement in the business cycle.  But anything more almost certainly represents a recession.

Now here’s one of the most striking facts about US business cycles.  When the unemployment rate does rise by more than 0.6%, it keeps going up and up and up.  With the exception of the 1959 steel strike, there are no mini-recessions in the US.  The smallest recession occurred in 1980, when the unemployment rate rose 2.2% above the Carter expansion lows.  That’s a huge gap, almost nothing between 0.6% and 2.2%.

It’s often said that nature abhors a vacuum.  I’d add that nature abhors a huge donut hole in the distribution of “shocks.”  Suppose there were lots of earthquakes of zero to six magnitude.  And occasional earthquakes of more than seven.  And even fewer earthquakes of more than 8 magnitude.  But nothing between 6 and 7.  Wouldn’t that be very odd?  I can’t imagine any geological theory capable of explaining such a gap.  We normally expect shocks to become less and less common as we move to larger scales.  And to some extent that’s true of recessions.  The Great Depression is unique in US history.  Big recessions like 1893, 1982, and 2009 (roughly 10% unemployment) are rarer than common recessions.  So why no mini-recessions? (Or almost none, if we are going to count the 1959 downturn as a mini-recession.)

I don’t see why other macroeconomists are not obsessed with this issue.  Why isn’t there a Journal of Mini-Recessions?  I suppose some smart-alec commenter will say; “because there’s nothing to study, stupid.”  But he’d be missing the point; just like the dog that didn’t bark in that Sherlock Holmes tale, the lack of mini-recessions may provide the explanation to the business cycle.

(Or is there such a field, and I just don’t know about it?)

Let’s start with real theories of the cycle.  I can’t imagine any plausible real theory that didn’t predict lots more mini-recessions than actual recessions.  After all, aren’t modest size real shocks (i.e. those capable of raising the unemployment rate by 1.0% to 2.0%) much more common than really big real shocks, capable of raising unemployment by more than 2.0%?

Of course one could say the same thing about nominal shocks, wouldn’t you expect modest-sized nominal shocks to be more common than big nominal shocks?  Yes, but I still think the lack of mini-recessions points to nominal shocks (or monetary policy) as being the culprit.

Let’s try to construct a “just so story” to explain why recessions are always fairly big, and then look for evidence to support the story.  Suppose you have the following conditions:

1.  There is a data lag of a couple months.

2.  There is a recognition lag of a few months.  This is the time between when the data comes in and the Fed recognizes that a new trend is developing.

3.  When the Fed does recognize problems, it reacts in a “responsible and deliberative fashion,” it doesn’t change policy drastically, in a move that appears panicky.

4.  The Fed targets nominal interest rates.

5.  When the Wicksellian equilibrium rate is below above the market rate the economy expands at trend or above.

6.  The Fed can’t directly observe the Wicksellian equilibrium rate, and tends to gradually nudge rates higher as the economy approaches full employment, and seems in danger of overheating.  Or as inflation rises above target, and appears in danger of affecting inflation expectations.

7.  At some point the target rate is nudged above the Wicksellian equilibrium rate, but the Fed doesn’t know this initially.

8.  When the economy turns into recession the Wicksellian equilibrium rate falls fairly rapidly.  Even after the Fed begins cutting rates the market rate will be above the equilibrium rate for several months.  Hence monetary policy stays “contractionary” for several months after the Fed realizes a recession may be developing.

Put all that together and you get contractions that could easily last for 9 months to a year, even if Fed policy is attempting to be countercyclical.  BTW, you could tell a similar story with money supply targeting, as velocity tends to fall on its own accord during contractions.

OK, but is there any evidence for my just so story?  Maybe a bit.  Let’s start with the peculiar 1980 recession, the mildest in the post war period.  I recall in mid-1980 thinking that Carter was toast, and that the recession would be as bad as 1974-75.  The Fed had raised rates to about 15% in late 1979.  Unemployment soared in the spring of 1980.  But then it suddenly stopped rising, leaving the recession the mildest on record.  What explains this turnabout?  There are two possible answers.  First, this was one of the few periods where the Fed wasn’t targeting interest rates.  But I don’t think that tells the whole story.  Rather it was the Fed’s willingness to do an extraordinary about face in policy, and ignore interest rates.

We know from the Fed minutes that they generally don’t like to suddenly reverse course; it makes them look bad.  It makes the previous decision look foolish.  So during recessions they cut rates gradually, in a “responsible and deliberative fashion.”  But not in 1980.  The 3 month T-bill yield plunged from 15.2% in March to 7.07% in June.  That’s more than 800 basis points in 3 months!  And that immediately ended the recession.  The unemployment rate had ended 1979 at 6.0%, and then soared to 7.8% in July 1980.  But that was it; the rate immediately started falling, as the Fed stimulus (which pushed nominal interest rates well below the inflation rate) caused NGDP to soar at an annual rate of 19% in late 1980 and early 1981.

So that explains why the 1980 recession was so short.  But what of the longer than average recessions like 1982 and 2009?  In mid-1981 Volcker realized that the previous “tight money” policy had failed and more draconian medicine was needed.  So the Fed tightened policy and kept it tight even after it was clear we were in recession.  Volcker kept it tight until inflation fell to about 4%.  So the 1982 recession was longer and deeper than normal because it was a rare case where the Fed wanted a longer and deeper recession.

In 2009 the Fed would have preferred a milder recession, but they weren’t able to use their preferred interest rate instrument to spur the economy.  So the “liquidity trap” can explain this one.  But most contractions are about 9 to 12 months, which I think fits my model just so story pretty well.  In some cases like 1974, the first part of the recession is arguably not a recession at all, as unemployment rose only a tiny amount.  Rather it was a sluggish economy produced by the oil shocks and price controls.  The severe phase of the recession (when unemployment soared) was in late 1974 and early 1975, and was pretty short.

To summarize, I can’t even imagine a non-monetary theory that explains the lack of mini-recessions.  RBC, RIP.  Bye bye to blaming ObamaCare.  So much for the sub-prime bubble.  But I can imagine a plausible theory of how inertial central banks that target nominal rates and observe the macroeconomy with a lag might occasionally produce short contractions, typically 9 to 12 months.  I recall that in both the 1991 and 2001 recessions it wasn’t until about 6 months in that the consensus of economists even forecast a recession.  A few months later the contraction was over.  And I believe this theory can also account for the occasional recession that is slightly shorter or longer.

Also note that it’s a post-war US theory only.  I’d expect mini-recessions in small, less diversified economies, and perhaps even in the US prior to WWII, when we had a different monetary regime.  Unfortunately we lack comprehensive monthly unemployment data from before WWII.

PS.  Grad students who are interested might want to compare this theory to the Romer and Romer narrative of Fed decisions.  There might be some overlap.

PPS.  The two occasions where the U-rate rose by 0.6% with no recession were 1957 and 1960.  In both cases we were officially in recession within 2 months.  So maybe 0.5% is the limit of randomness.

PPPS.  I discussed one short recession (6 months) and three long ones (16, 18, 18 months)  in this post.  The other 8 post-WWII recessions were all within 8 to 11 months long.  There’s probably a reason for that, and I’d guess it has something to do with monetary policy.



38 Responses to “The mystery of mini-recessions: The dog that didn’t bark”

  1. Gravatar of Neal Neal
    20. December 2011 at 12:24

    So, in brief, there are no mini-recessions in the post-war US because the Fed’s inertia turns every mini-recession into a medium-sized recession?

  2. Gravatar of tom s. tom s.
    20. December 2011 at 12:33

    5. When the Wicksellian equilibrium rate is below the market rate the economy expands at trend or above.

    Don’t you mean above the market rate?

  3. Gravatar of Lorenzo from Oz Lorenzo from Oz
    20. December 2011 at 12:40

    All the unemployment [rate] movements you mention are %pts, right?

  4. Gravatar of dwb dwb
    20. December 2011 at 12:48

    very interesting set of posts. This seems to validate other stuff I’ve seen on the “threshold” for recessions – if growth falls below x% then a recession almost always ensues. This is a interesting and different perspective though: its not a threshold per se. Seems to me even now the Fed spends an awful lot of time looking in the rearview mirror, even now not looking to ease even though inflation expectations are very low, mainly because inflation has not clearly “peaked.” With a pretty long lag, waiting for inflation to peak falls smack dab in #2 and 3 except i think the lag for inflation is more than a few months.

  5. Gravatar of Lars Christensen Lars Christensen
    20. December 2011 at 13:00

    Scott, you are so very right. Recessions always and everywhere a monetary phenomenon. Something that by the way if confirmed by my recent posts on my blog on what I – inspired by David Eagle – has termed a Quasi-Real Price Index (QRPI). QRPI inflation is demand inflation – contrary to supply inflation.

    I have had a look at all the post-WWII US recession and large (large!) majority of them coincide with a sharp drop in “demand inflation”. In fact in most case recessions coincide with demand inflation turning negative.

    The only real exception is the first oil crisis around 1973.

    But have a look yourself:

  6. Gravatar of flow5 flow5
    20. December 2011 at 13:00

    Mini-drops are rare because of early recognition of the contraction (and because recessions are defined to last at least 6 months), and a quick response on the part of the FED. The economy generally can be turned on a dime. And there are a few.

    In 1980, there was an extremely sharp tightening in monetary policy in the early part of the year (along with credit controls). Both were quickly reversed and the economy reversed. The 19.1% increase in nominal gNp in the first quarter of 1981 was due both to an easy money policy & to an explosion in financial innovation (ATS, NOW, & MMMF, accounts greatly accelerated the transactions velocity of money). The protracted 82 recession was because the FED can’t forecast. The 2009 recession/depression was (contrary to FED research), a strangulation of the money market by the monetary authorities.

    Since the Great Depression, all recessions have continued to reoccur solely due to monetary policy errors (though fueled by financial innovations).

  7. Gravatar of Mikko Mikko
    20. December 2011 at 13:09

    Now this sounds like a great topic for a great PhD student. I really hope you’ll find someone with the interest to do digging on this topic. Could be big. Bigger than Milton Friedman, or Keynes…

  8. Gravatar of Jeff Jeff
    20. December 2011 at 13:18

    “We know from the Fed minutes that they generally don’t like to suddenly reverse course; it makes them look bad. It makes the previous decision look foolish.”

    Wasn’t Kotcherlakota on CNBC this morning calling himself a “consistency hawk”? My thought at the time was consistent actions? Why should should consistent actions and not consistent outcomes be the goal? Excellent timing Scott.

  9. Gravatar of Lars Christensen Lars Christensen
    20. December 2011 at 13:30

    Jeff, it is incredible that anybody would say they are a “consistent hawk”. What kind of commitment is that? Would that mean that he would consistently vote for monetary tightening? Would he have voted against monetary easing in early 2009? Would he vote for reintroducing the gold standard in the US at the 1933 parity? It is incredible that he would say this – it makes absolutely no sense at all.

    Jeff, thanks for this comment – I am getting more and more scared about how Kotcherlakota is thinking about monetary policy…ah I forgot there at not even money in his models…

  10. Gravatar of brendan brendan
    20. December 2011 at 13:57

    What a great post.

    If all post WW2 recessions are caused by nominal shocks and nominal shocks are caused by inertia from data lag and central bank stubborness, and NGDP targeting fixes both causes of inertia…are we to expect recessions to basically cease going forward in the US? (barring some sort of shock worse than the Japanese quake)

    If Prof Sumner’s preferred method of NGDP targeting were implemented, what would he put the over/under at for proportion of time spent in recession in say, the next 30 years?

  11. Gravatar of Benjamin Cole Benjamin Cole
    20. December 2011 at 14:01

    More remarkable insights by Scott Sumner. Please Fed, listen and learn.

  12. Gravatar of Peter Peter
    20. December 2011 at 14:45

    Fascinating! This one goes up on my best-of-money-illusion list.

  13. Gravatar of Nick Rowe Nick Rowe
    20. December 2011 at 15:56

    Very good post Scott.

    I think you are saying, though you don’t quite say so explicitly, that the current Wicksellian natural rate depends on the lagged gap between the natural rate and the actual rate. (If the Fed sets the actual rate above the natural rate, this causes the natural rate to fall.) And I mean the *real* rate. Correct?

    This makes sense from your “upward-sloping IS curve” perspective.

  14. Gravatar of tim tim
    20. December 2011 at 17:02

    Hi scott
    How did nominal shocks cause the 2001 recession? Also a bit off topic, but do markets react to news of fiscal stimulus in the same way they react to news of monetary stimulus?
    Just some questions which have been nagging me.
    Also off topic, but i recently realised that Australia, whose banks remained profitable through the financial crisis, “coincidently” had no deposit guarantee before the crisis unlike the banks in other countries which had to be bailed out. Moral hazard much?

  15. Gravatar of tim tim
    20. December 2011 at 17:04

    My mistake i see youve answered my question about 2001 already after re-reading it

  16. Gravatar of ssumner ssumner
    20. December 2011 at 19:24

    Neal, Yup.

    Tom, Thanks, I changed it.

    Lorenzo, Yes, percentage points.

    dwb, Good point.

    Thanks for the link Lars, I agree they are all demand side, with the possible exception of 1974. And even in that case I think the severe phase was partly a drop in aggregate demand growth.

    flow5, Nonetheless, unemployment rose 2.2% from the cyclical low, so even 1980 wasn’t a mini-recession.

    Mikko, Thanks, but I wouldn’t go that far. This is an issue people have thought some about. But I’m not quite sure whether people have thought about it from the exact angle I considered here. I’m hoping to find commenters who know the literature on this subject.

    Jeff, That’s a good find. I suppose I’ll have to refrain from jokes about “consistently wrong.”

    Lars, I think you misunderstood. Kocherlakota was saying he believes in being consistent, not necessarily hawkish. It was a bizarre way of saying it, so it’s not surprising you took it that way.

    Brendan, My gut instinct says we’d have a few very mild recessions, but I’m really not sure. Australia missed both the 2001 and 2009 recessions, hasn’t had one since 1991. I’d never say we cured the business cycle, because those predictions always precede disaster. But I think we could make it much milder.

    Thanks Ben and Peter.

    Nick, Yes, that’s right. The real rate plunged in the early 1930s, and I can’t think of any plausible cause other than the depression itself.

    Tim, Are you sure Australia has no deposit insurance? That’s impressive!

  17. Gravatar of johnleemk johnleemk
    20. December 2011 at 21:24

    Scott / Tim,

    Funnily it seems that Australia might have not had any deposit insurance until the Great Recession!

    Quoth Wikipedia,

    “The Australian Prime Minister announced on October 12, 2008 that, in response to the Economic crisis of 2008, 100% of all deposits would be protected over the subsequent three year period. This was subsequently reduced to a maximum of $1 million per customer per institution.”

    But prior to 2008, Australian depositors had zero deposit insurance. (See Wikipedia’s footnote 43, which goes to an outdated Australian Treasury page that states, in its note #10, that Australia and NZ were as of the time of writing the only OECD countries without any form of deposit insurance.)

    Unfortunately, it looks like last year the Aussie government decided to make the temporary 3-year guarantee a permanent one, although in September they dropped coverage to only Aussie $250,000 (which is less than US FDIC coverage once you convert!).

  18. Gravatar of Lars Christensen Lars Christensen
    20. December 2011 at 21:27

    Scott and Tim, It is very interesting that Australia did not have deposit insurance when the crisis hit. As far as I know only three developed economics did not have deposit insurance when the crisis hit 2008 – Australia, New Zealand and Israel. The banking system in all three crisis did very well through the crisis. All three countries also have flexible inflation targeting and floating exchange rates. Maybe it would worth studying for somebody what these institutional factors meant for the size and scope of the crisis. It is notable that both Australia and New Zealand had sizable external imbalances and what to many (including myself) looked like housing bubbles when the crisis hit. This did not trigger any serious banking distress however…somebody should have a close look at these three countries.

  19. Gravatar of Bob OBrien Bob OBrien
    20. December 2011 at 22:28

    I just read a very insightful article by Don Boudreaux on Robert Higgs and “Regime Uncertainty”. See:

    This seems to be complimentary to Scott’s NGDP targeting ideas.

    I would be interested to hear if readers of this blog agree with Don and Robert’s “Regime Uncertainty” analysis.

  20. Gravatar of W le B W le B
    21. December 2011 at 03:11

    So, the Central Bankers need a better/more sensitive thermometer?

    In the UK, the Bank of England has a number of offices out in the regions. They also have ‘agents’ working from these regional offices whose job is to keep close to business and gauge the ‘temperature’.

    The troubling fact is that these agents are establishment types who only talk to establishment businessmen in mature businesses – not entrepreneurs and not those entrepreneurs who cut their teeth in what the establishment regarded as the less legitimate part of the economy.

    But it was these entrepreneurs, who were moving into cash as early as 2005/6, who should have been (to mix metaphors) the weather vanes for the economy. Their flight to cash could have been an early warning to the CBs both to counteract the effects on the money supply and look very carefully at who commercial banks were then deciding to lend to.

    As the effective entrepreneurs made for the bunker, the commercial bankers were left selling their loans to weaker and weaker propositions.

  21. Gravatar of ssumner ssumner
    21. December 2011 at 07:12

    Johnleemk, Thanks, that’s sad to hear. Canada didn’t have deposit insurance until 1966.

    Bob, I agree that monetary policy cannot explain the slow recovery from the Depression. I’d put more weight on FDR’s wage policy, than regime uncertainty, although I don’t doubt that regime uncertainty was part of the problem.

    W le B, I’d prefer to see central banks stop trying to fine tune the economy, and let the market determine the money supply and interest rates (using NGDP futures targeting.)

  22. Gravatar of o. nate o. nate
    21. December 2011 at 09:53

    It seems to me that the key part of this story is this: “When the economy turns into recession the Wicksellian equilibrium rate falls fairly rapidly.” If this assumption didn’t hold, then we could have mini-recessions that were still monetary in nature. But it’s hard to see how there could be a monetary explanation of that assumption. So it seems that RBC-type effects haven’t been completely eliminated, but just pushed back by one remove.

  23. Gravatar of Brito Brito
    21. December 2011 at 14:56

    Scott, not relevant to the topic, but FT did a video interview with Jan Hatzius of Goldman Sachs, they discuss NGDP targeting and he defends it against some criticisms, worth a look:

  24. Gravatar of dwb dwb
    21. December 2011 at 18:00

    … at 6:40. interesting – they have NGDP simulations. hehe. of course, its Goldman! damn i wish i could see those.

  25. Gravatar of Declan Trott Declan Trott
    21. December 2011 at 18:34

    John, Lars, Scott,

    Australia didn’t have explicit FEDERAL government deposit insurance until 2008, but it wasn’t quite as hands off as it sounds. More like LTCM, Bear, Lehman etc: no formal guarantee, but “Government responses . . . have generally sought to mitigate the impact of failure for certain customers. . . . community expectations of government support appear widespread”. (I guess to make depositors feel protected but keep the banks scared they weren’t!)

    Also, state governments historically guaranteed a lot of deposits – State banks, building societies (e.g. Pyramid) and credit unions.

    More here if anyone cares:

  26. Gravatar of ssumner ssumner
    22. December 2011 at 07:01

    o. nate, That raises a very complex question; how should one characterize recessions that are caused by real shocks pushing monetary policy off course. I still see those as monetary recessions, although others might disagree. For me the bottom line is that a real recession is a recession that would occur even if NGDP grew steadily.

    But I would also contest your argument that recession expectations don’t cause the Wicksellian equilibrium rate to fall sharply. I think we know that it does, just look at 1929-30 when that rate plunged. There was no plausible real shock that could explain that.

    Brito, Thanks, that’s a good interview.

    Declan, Thanks, that sounds very plausible to me.

  27. Gravatar of W le B W le B
    22. December 2011 at 09:23

    Scott, you’d prefer to see central banks stop trying to fine tune the economy, and let the market determine the money supply and interest rates (using NGDP futures targeting.)
    Does that mean we could have general elections where parties/candidates would campaign on the NGDP target and do away with committees like the MPC?

  28. Gravatar of o. nate o. nate
    22. December 2011 at 11:24

    I agree that whether to label a recession as monetary or real is somewhat a matter of semantics. I understand your position on it. However, it’s hard to test historically the proposition of whether a recession would have occurred even if NGDP had continued to grow steadily, since we have never operated under a regime of NGDP targeting. There seems to be a consensus that the recession would not occur, or would at least be greatly reduced, but it’s not simply a matter of historical observation.

    I wasn’t trying to argue that the Wicksellian equilibrium rate doesn’t fall sharply in a recession, but merely saying that to understand why seems to require something other than a purely monetary explanation. It may not be due to a real shock – like you said it could be expectations, or there could be other factors, such as credit, leverage, firm equity, etc.

  29. Gravatar of ssumner ssumner
    23. December 2011 at 07:20

    W. le B.

    I’d prefer we stick with one number for a fairly long period of time, but I have no trouble with it being determined democratically.

    O. nate; You said;

    “There seems to be a consensus that the recession would not occur, or would at least be greatly reduced, but it’s not simply a matter of historical observation.”

    I’d like to agree, but I think the real business cycle types might question this.

    I agree these affects are hard to disentangle.

  30. Gravatar of Eric Morey Eric Morey
    23. December 2011 at 11:39

    Arnold Kling has chimed in. His two sentence conclusion:

    “In short, I suspect that the absence of mini-recessions is not informative about our macroeconomic theories. It is informative about the way in which our use of zero rather than trend growth as a baseline affects the statistical properties of recessions.”

    Read Kling’s entire post:

  31. Gravatar of Scott Sumner Scott Sumner
    25. December 2011 at 09:22

    Eric, He’s wrong, I left a comment over there showing how he misunderstood my argument. It has nothing to do with how one defines recessions.

  32. Gravatar of Nick F Nick F
    3. January 2012 at 19:51

    Practically every person taking part in the economy has a mobile phone (quite possibly a smart phone), a computer and an internet connection. I would have thought that in the modern world some better economic data could flow to the Fed and the government. Why does everything have to be revised months and months later, at which point we find out that what we thought we knew wasn’t quite right?

    I’m probably being desperately naive. This is just a layman’s perspective, but aren’t there some ways to change the system so that there can be a faster monetary response to what’s going on in the economy?

  33. Gravatar of TheMoneyIllusion » Never reason from a wealth change TheMoneyIllusion » Never reason from a wealth change
    10. February 2012 at 06:08

    […] I pointed out earlier, we don’t have mini-recessions in America (since WWII.)  That’s because real shocks don’t cause recessions; we are really good […]

  34. Gravatar of jonny bakho jonny bakho
    17. February 2012 at 06:33

    Are you treating all shocks the same? There are a lot of little shocks and few big ones. Perhaps you don’t have data from a long enough period? If you look at earthquake data from a 10 year period, you might well find a similar pattern of a lot of little shocks, a gap and then a big shock. Are you observing a common statistical pattern that would correct itself with several hundred years of data?

    Recessions and inflation are part of the same spiral. Discounting commodity inflation (which the Fed mostly does in setting policy) inflation is caused by a wage-price spiral. Increasing wages- increases demand- increases price- increases wages. Recessions are a downward spiral- Decreasing demand- decreases employment- decreases demand, price and wages.

    A small shock is easily offset by Monetary and fiscal policy (automatic stabilizers). Larger shocks get ahead of monetary policy (as you note, it lags) and it overwhelms the fiscal automatic stabilizers. In the US economy, most states must balance budgets and are forced into pro-cyclical fiscal policies rather than countercyclical policies. A big enough shock will start a cascade of shocks that reinforce the downward spiral. Eventually, the economy stabilizes, but at a lower level of employment. Intervention is needed to start an upward spiral. Often the relaxation of monetary policy decreases interest rates to expand the investments that meet the risk profile for delivering returns. In a severe recession, the high unemployment lowers the level of demand, increasing the risk premium such that investment is not made because of inability to get return on investment.

    For example, the Carter energy conservation measures, once fully implemented in the early 1980s, reduced US demand for oil by over 20 percent. For the next two decades, we saw no new oil refineries built because there was too much capacity. Building a new refinery would not produce enough return on investment. The risk premium for building new refineries increased because demand decreased.

    In a severe economic downturn, demand tanks in many sectors at once. This drives up the risk premium for most investments. Reducing the risk premium requires an increase in demand. Fed policy at the zero bound cannot produce negative interest rates that would match the risk premium. The solution is to boost demand by fiscal policy until monetary policy can once again gain traction. Risk is dynamic and must be modeled as such to make economic sense. Velocity is dynamic and must be modeled as dynamic to make economic sense.

    During the Great Moderation, Velocity and Risk were relatively stable, so models that treated them as non-variable could match conditions. When the Great Recession hit, Velocity tanked and Risk skyrocketed. Models that treated these as non-variable failed for obvious reasons.

  35. Gravatar of G G
    17. February 2012 at 07:49

    I just came across this (very interesting) post via Noahpinion. Your point is related to a disconnect between theoretical and empirical macroeconomics. While the vast majority of DSGE models characterizes the economy as fluctuations around an equilibrium, where the frequency and depth of recessions should be largely driven by the size and persistence of the shocks, one of the favored ways to characterize recessions empirically is through regime-shifting models inspired by James Hamilton’s work, where a recession is viewed as an alternative state. The lack of mini-recessions is documented by successfully regime-shifting estimations, but ignored by DSGE models with a unique equilibrium.
    There is hope, however. Recent work on recession driven by credit market crises (Markus Brunnermeier and Yuliy Sannikov, deflation traps (George Evans and Seppo Honkapohja), fiscal stimulus in a liquidity trap (Lawrence Christiano, Martin Eichenbaum and Sergio Rebelo) can be interpreted as having multiple steady states or persistent deviations from a single equilibrium. Naturally, the above list is not exhaustive.
    Interestingly, the interpretation in the post seems related to the liquidity trap. In a liquidity trap, recessions are deeper and more persistent since the equilibrium interest rate is negative and but zero lower bound prevents the market for savings and investment from clearing. The story in the post is more about the timing of the monetary policy reaction, but the result, the real interest rate being too high, is the same.
    Though these approaches are quite sophisticated and the barriers to entry are high, hopefully, the will get increasing attention from researchers.

  36. Gravatar of ssumner ssumner
    18. February 2012 at 06:36

    jonny, Almost all your comments seem to support my argument that the lack of mini-recessions points to AD as being the cause.

    Especially this comment:

    “A small shock is easily offset by Monetary and fiscal policy (automatic stabilizers). Larger shocks get ahead of monetary policy (as you note, it lags) and it overwhelms the fiscal automatic stabilizers.”

    It’s very unlikely that you’d see lots of big earthquakes and no middle-sized ones.

    G, Thanks for that info.

  37. Gravatar of Skepticlawyer » Broken by the fix Skepticlawyer » Broken by the fix
    29. July 2012 at 20:02

    […] is an excellent mechanism for turning an economic shock into economic downturn. Indeed, that may be the most common reason for economic downturns in societies with central banks as monopoly suppliers of money.[ix] A drop […]

  38. Gravatar of Reviving the Knife-Edge: Aggregate Demand in the Long Run | J. W. Mason Reviving the Knife-Edge: Aggregate Demand in the Long Run | J. W. Mason
    14. May 2015 at 08:54

    […] almost always in a clear expansion or clear recession with nothing in between, is a sign that the business cycle must be the Fed’s fault. To me, it’s more natural to think that the nonexistence of “mini-recessions” is […]

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