Kinds of Recessions

(cc photo by LateNightTaskForce)

Are recessions caused by asset price busts fundamentally different from recessions caused by central bank efforts to curb inflation? A lot of commentary suggests that they are. Hence talk about “balance sheet recessions,” etc. I don’t really buy it. And Ryan Avent has some doubts as well:

I need to go catch a flight, so I don’t have a lot of time to dig into this, but let me just offer one thought on this view (which is one I’ve long shared). What if the difference in the outcomes isn’t directly due to the differences in causes? What if the difference in outcomes is due to the fact that because the Fed creates a recession through high interest rate, it—by definition—has plenty of room to loosen policy by cutting rates? And when another shock generates the recession, the Fed, often as not, can’t drop rates much before hitting the psychological barrier of the zero lower bound? Just a thought.

I would put this a bit differently. The issue in all cases is one of expectations and credibility. If the Fed causes a recession by raising interest rates, people believe the Fed can and will end the recession by cutting interest rates when it decides that the time has come to do so. Consequently, the decision to change the trajectory of policy from “raise rates” to “lower rates” serves as a powerful coordination point. The rate cut means everyone knows that the magicians behind the curtain have decided that they’re not worried about inflation anymore and instead they’re worried about increasing real output. That means it’s time to start preparing for a climate of elevated demand which, itself, creates a climate of elevated demand.

The problem of the asset price bust is that people don’t necessarily believe in the magic. You suddenly have different central bankers running around the planet giving interviews to journalists in which they offer their take on things and they all disagree. Everyone agrees that unorthodox methods are available, but there’s no consensus on exactly which methods should be used or to what extent. And since the recession itself is a huge failure of macroeconomic stabilization policy, everyone’s losing faith in the wizards behind the curtain. There’s no coordination point, just a lot of hiccups. Circular reasoning like “bad macro data will prompt expansionary macro policy and drive asset prices up” becomes temptings. You stop and start and essentially find yourself sitting around in limbo waiting for positive shocks on the real side to turn things around.

Under the circumstances, policy will be most effective if you do what FDR did in 1933—point fingers, throw the bums out, and do something dramatic and “crazy” (abandon the gold standard) to signal your fanatical determination to reflate the economy. Reappointing the incumbent central bank chief who then spends the next two years trying to reassure everyone that nothing too unorthodox is happening seems like exactly the wrong way to go.