Causality is Socially Constructed

I’m no philosopher or physicist, but if I’m not mistaken the best minds in those fields haven’t yet decided precisely what the term “causality” actually means.  If I am wrong, please correct me in the comment section.  I’d like you to consider two scenarios, and in each case think about what would have caused the recession:

Scenario 1: A financial crisis leads to a 10% increase in the demand for base money.  The Fed either refuses to increase the monetary base, or else allows some increase, but ties up the extra base money with an interest on reserves program.  The Fed’s passivity does not cause higher nominal interest rates (although real rates may rise) because the financial crisis leads to a lower Wicksellian equilibrium interest rate.  (The Wicksellian equilibrium rate is the interest rate consistent with macro stability.)   Because the Fed did not accommodate the increase in demand for base money, AD falls and we go into a normal recession.

Scenario 2: A huge upsurge in drug gang activity in Mexico leads to a 10% increase in the real demand for US currency.  The Fed fails to accommodate this increase in currency demand.  Because the drug activity did not affect the Wicksellian equilibrium rate in the US, the Fed’s passivity in the face of higher currency demand leads to higher nominal rates.  Because the Fed did not accommodate the increase in demand for base money, AD falls and we go into a normal recession.

Note that both scenarios have identical final sentences.  To me, it is obvious that both recessions have the exact same cause, an increase in the demand for base money that was not accommodated by the Fed.  But I may be the only person on the planet that looks at things this way.  Here’s what I think most people would say:

Scenario 1: A financial crisis led to a drop in AD, which caused a recession, despite low interest rates.

Scenario 2: The Fed raised interest rates for no apparent reason, and tipped the economy into a recession.

Note that in scenario 2, there is no mention of drug gangs, even though during normal times they might well hold a larger share of the monetary base than banks.  (It’s estimated that prior to 2008, currency holdings in the underground economy were 5 to 10 times larger than total bank holdings of base money.)  We have no idea of who is holding all this illicit cash, or even if it is in the US.  Then why doesn’t it have a big impact on monetary policy?  The answer has to do with interest rate targeting.  One of the few good things about interest rate targeting is that it leads central banks to automatically accommodate shifts in currency demand due to shocks that don’t affect the Wicksellian equilibrium rate of interest.

A financial crisis is different.  It will also lead to more demand for base money, but will simultaneously reduce the Wicksellian equilibrium rate of interest.  If, as in April to October 2008, the Fed remains passive in the face of this sort of crisis and leaves interest rates unchanged, it will have effectively tightened monetary policy.

How a person interprets causality depends on how they think about plausible policy options.  Most people instinctively feel the Fed should accommodate changes in currency demand due to Mexican drug wars.  Indeed they implicitly think this even if they have never consciously thought about the issue.  If the Fed suddenly let rates rise sharply during a period of Mexican hoarding of US dollars, all sorts of people would be complaining that the Fed was “causing” tight money, as well as any of the macroeconomic effects of tight money.  This is because people think of monetary policy in terms of interest rates.  In one case the Fed appears to be “doing something,” in the other it appears to be doing nothing.

If you look at policy from a narrow monetarist perspective, where the monetary base is your policy indicator, then you won’t see a shock in either case.  Both will look like drops in base velocity.  (A sophisticated monetarist who looked at the broader indices would notice tight money in the Mexican hoarding case.  The other case is unclear.)

If, like me, you favor targeting the forecast of the price level or NGDP, then both recessions would appear to have the same cause—a tight money policy by the Fed.

There may be some sort of rigorous philosophical definition of causality in philosophy or physics.  If so, I’d very much like to see it, so we can quickly clear up this post-modern mess.  Until then, we’ll all be talking past each other.  Get used to it.

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