The Great Moderation

What caused the Great Moderation?:

Welcome to 'the Great Moderation', by Gerard Baker Commentary, Times Online: Great political and cultural events tend to announce themselves with suitable fanfare. They are often highly visible moments in history: the signing of the Declaration of Independence, the assassination of Archduke Franz Ferdinand...

Great economic events are usually different. They take time to become recognised, unfolding over a decade or even a generation. The Industrial Revolution was never reported in a newspaper headline. ...

So it should not, but it probably will, come as a surprise to know that we are living through one of the great transformations of modern history. Almost unnoticed, most of the industrialised world, especially the Anglo-Saxon part of it, has enjoyed a period of unprecedented economic stability.

Recessions were once as frequent and as regular as World Cups or general elections. Now, ... they hardly happen. The classic business cycle has worked for centuries in a simple, recognisable way. ... Between 1950 and 1982 the US had seven recessions, one every 4.6 years. The UK had the same number and frequency. In between those recessions, inflation rose, reaching a higher peak in each cycle.

But something historic has happened in the past quarter of a century. The business cycle has not been abolished, but in the US and the UK, it has been stretched, to improbably great lengths. In the process, the wild fluctuations of employment, output, inflation and interest rates have been firmly damped. The peaks of inflation have been lower, and the troughs of output shallower...

Economists have coined a term for this remarkable period of stability. Taking their cue from the Great Depression of the 1930s and the Great Inflation of the 1970s and 1980s, they have called the current era the Great Moderation.

It doesn’t quite compete with the previous two for drama, does it? “What was it like in the Great Moderation, grandad?” “Ee, lad it were amazing! One year unemployment would be 6 per cent the next year it would be 5.9 per cent! You’d go to the shop for a pint of milk, and three years later it would cost exactly the same.” ...

And yet, as dull as it all may seem, the Great Moderation has been ... consequential... It is surely the main reason that political volatility has declined in much of the West. ...

The economic implications are much larger. In the absence of wild swings in activity, businesses and households can plan much more easily. The most obvious benefit can be seen in interest rates. Longer-term rates ... have what is called a “term premium”, an extra amount of interest that lenders require to protect them against the risks that big fluctuations in the economy and interest rates will undermine the value of their investment. But since those swings have been eliminated largely, interest rates can stay much lower.

Economists are debating the causes of the Great Moderation enthusiastically and, unusually, they are in broad agreement. Good policy has played a part: central banks have got much better at timing interest rate moves to smoothe out the curves of economic progress. But the really important reason tells us much more about the best way to manage economies.

It is the liberation of markets and the opening-up of choice that lie at the root of the transformation. The deregulation of financial markets over the Anglo-Saxon world in the 1980s had a damping effect on the fluctuations of the business cycle. These changes gave consumers a vast range of financial instruments (credit cards, home equity loans) that enabled them to match their spending with changes in their incomes over long periods. ... The economies that took the most aggressive measures to free their markets reaped the biggest rewards.

The Great Moderation offers another precious lesson in an old truth of economics: the power of creative destruction. The turmoil of free markets is the surest way to economic stability and prosperity.

While I agree the Great Moderation is worthy of attention, the author oversells the amount of agreement in the profession about the reasons for the decline in aggregate volatility since 1984 (e.g. the variance of GDP growth has fallen by about 50% since 1984, here's a graph showing the decline). The main competing hypotheses for the Great Moderation are better technology (e.g. information processing allowing better inventory control and management), better policy (e.g. inflation targeting), a run of good luck where no big shocks hit the economy, and financial innovation. Repeating from the paper in the link to the graph above:

Assessing the Sources of Changes in the Volatility of Real Growth, Stephen G. Cecchetti, Alfonso Flores-Lagunes, and Stefan Krause, NBER WP 11946, January 2006: Abstract In much of the world, growth is more stable than it once was. Looking at a sample of twenty five countries, we find that in sixteen, real GDP growth is less volatile today than it was twenty years ago. And these declines are large, averaging more than fifty per cent. What accounts for the fact that real growth has been more stable in recent years? We survey the evidence and competing explanations and find support for the view that improved inventory management policies, coupled with financial innovation, adopting an inflation targeting scheme and increased central bank independence have all been associated with more stable real growth. Furthermore, we find weak evidence suggesting that increased commercial openness has coincided with increased output volatility. [Open link to paper]

This paper does find the financial innovation may have played a role in the 64% of the countries where stability has increased, but to portray it as an area where there is wide agreement misstates the evidence. For example, this is from the conclusion to the paper:

While everyone who has looked agrees ... that the volatility of real growth in the US fell by more than one-third in the mid 1980s, there is substantial disagreement over the causes of the decline. Is it inventory policy, monetary policy, or just luck? Could it be changes in financial development or possibly commercial openness? ... Our results show that financial development, as measured by the importance of bank lending, is linked to real economic stability. Beyond the importance of financial development, we also provide evidence in favour of the view that improved inventory control policies played a role in the more stable growth that we have observed. ...

Finally, we should note that what we have done is established a set of correlations... What we have not done is show causal links. It is surely possible, for example, that financial systems are more prone to develop in countries that are more stable and that less stable countries may trade more. Determining the ultimate causes of these changes must be high on the agenda for future research.

So while I share the author's faith in the ability of markets to allocate resources efficiently and to act as effective shock absorbers, I cannot endorse the idea the economists are in broad agreement that the Great Moderation is due primarily to the liberation of markets. That conclusion seems to be based more upon an attempt to sell an ideological point about free markets than an honest presentation of the evidence.

Comments

[Barry]

Lessee now: the first time I noticed such articles was in 1989; the second time was 1999/2000.

These 'the business cycle is dead' articles are a dead giveaway that we're in for a recession.

[ken melvin]

Borrowed money = Borrowed time.

[Richard]

Ahh, those who would measure history in mere years or decades! Thirty years is suggestive, and certainly we must make the best decisions we can in our lifetime with the information available. But the human hear has not changed, nor the desires of greed and the reactions of fear. And given the weakening of all manner of institutions in the last thirty years, I'd be cautious in suggesting that this moderation was due to CB reforms or better institutional understandings. Moderation there may be, but it might also be simply fortuitous.

[unemployed observer]

One of my friends told me that the pay method in the US has been changing over the last decade. In the past, salary is the major portion of income, while bonus is just a small complement. Nowadays, bonus is getting more imporatnt as the source of income. This is particularly true. One survey shows that 2006 average bonus for a hedge fund portfolio manager is $2.5 million.

So, there are two questions in mind.

1. Since corporation now has a lower fixed cost relative to the past, does it mean that corporation is less likely to shut down, or getting easier to start up? If so, more competition is expected and a closer competitive outcome will be forseen.

2. Since bonus is a function of the company's profit, which to some extent, a function of the economy as a while. Good ecoomic year leads to a good bonus year, which leads to higher consumption? Do we have a life income hypothesis? or a Keynesian marginal propensity to consume?

Is lower business cycle volatilites in the past years an evidence of life income hypothesis?

[Meh]

What worries me, late at night (as it were), is that the financial instruments (e.g. hedge funds) produced by the deregulated market might be less stable than we think.

[Morgan]

Two additional thoughts for your consideration or peremptory ridicule, as the case may be:

1) Some moderation may be due to demographic factors. As the population has aged worldwide, and the proportion of people with significant savings and stable employment prospects has expanded, the ability of consumers (in the aggregate) to absorb shocks has increased. The proposed mechanism is similar to that of credit availability.

2) The rapid development of large new economic actors (e.g. China, India, Russia and the former Soviet Bloc) has caused international economic cycles to become less closely linked, which feeds back to reduce the size and duration of swings.

I don't have a shred of evidence for either idea, but then, what else are comments sections for?

[reason]

Could it be the way we measure things has something to do with it? Maybe there are big swings, but not in the things we are measuring any more. We are counting more in GDP than we used to as many services that used to done for free in the home are now in the market.

And there have been (as have frequently been pointed out) huge swings in average indebtedness and in relative prices. Some countries have indeed suffered great volatility (Argentina) while others have suffered from long term relative decline (Germany, Japan).

Part of the answer of course is to be found in the fall of socialism.

[Callahan]

Obviously, the author, and other such GREAT thinkers have not yet been to MICHIGAN!

Don't come here and talk about how G.D. great the economy is.

[John J. Xenakis]

The "Great Moderation" concept is even broader than this article implies. A number of organizations have noticed that the number of wars has decreased sharply since the 1980s. It seems that all the world's problems have been solved, for both economics and war.

Unfortunately, once you understand the flow of generations, the picture is very different.

Start with the amazing things that the survivors of World War II did in the 1940s. They carefully set up worldwide organizations -- the United Nations, the World Bank, the World Health Organization, the Food and Agriculture Organization, etc. -- whose purpose was, most of all, to prevent another world war or another Great Depression. They accomplished huge things. They set up country boundaries, set up world monetary policies, as well as trade and commerce policies. They made sure everyone would be fed. They attacked all of the miseries of the World Wars -- poverty, famine, disease and war -- so that nothing like World War II would ever happen to their children or grandchildren.

But now those people are gone, and today's leaders are from the Baby Boomer generation that followed the war. This generation had no personal experience with the Great Depression or WW II, and they have no political skills except to argue with each other, as I've been tracking on my web site, http://GenerationalDynamics.com .

As soon as the generation of people who lived through the 1930s was gone, replaced by people with no memories of its horrors, the Great Bubble of the 1990s occurred -- and that's the term we should be using, rather than Great Moderation.

And to see what's happening in the war arena, just look at the Gaza strip, where the median age is 15.8. Gaza is run by children -- children with guns and missiles -- children who absolutely couldn't care less about the diplomatic niceties of people like Palestinian President Mahmoud Abbas. This region has been deteriorating rapidly since Yasser Arafat's death, and all-out war cannot be very far off.

Similar things can be said for other regions -- Kashmir, the Caucasus, Korea, and so forth. And let's not forget China's anti-satellite weapon test that came to light yesterday.

New communications technologies have indeed created a much more flexible world, a world that can absorb shocks more easily and remain stable.

But it's a funny thing: Stability creates instability. New generations take the stability for granted, push the margins much harder, cross lines more often. That's why we have an exponentially growing hedge fund industry, an exponentially growing global account imbalance, and exponentially growing hostility between Western and Muslim civilizations.

Everyone says that these imbalances can't continue, but they keep growing, and get worse each day. Each day, the number of possible shocks that can upset the system increases, and one of these shocks is bound to occur -- next week, next month, next year -- the time can't be predicted. But what can be predicted with absolute certainty is that we're headed for a new Great Depression, and a new Clash of Civilizations World War.

John J. Xenakis
GenerationalDynamics.com

[Lafayette]

JJX: "But what can be predicted with absolute certainty is that we're headed for a new Great Depression, and a new Clash of Civilizations World War."

Bollocks.

Your "absolute certainty" is shaky. With global economic growth on a roll and most of it going to countries outside the polar axis of the US and Europe, there is every reason to believe it will continue. It will pull America and Europe along with it, though both might not see all that much growth due to different internal obstacles in each area.

As for the clash of civilization, it is nowhere to be seen except at your cinema ... right out of Hollywood, Grade C. Open your perspective beyond America's three-mile limit if you want to understand the direction the world is going in. Because it is not America holding the best cards - for the first time in over a century.

Al Qaeda was a one-shot affair and has peaked. The Muslims are getting tired of its killing machine, sucking in stupid adolescents to do their murderous affair. The Muslims of this world hate Al Qaeda almost as much as the Judeo-Christians. Just because television reports focus inanely on the sensational gory bits doesn't mean that the world is aflame from religious conflict.

[Real Person from the Real World]

Hey Lafayette, How do you know what Muslims are fed up with? last I heard, the killing sprees are happening more and more, with more people being killed. While most people are fed up with it (mostly the non-multims), the new generations of muslims are younger and younger, and the younger msulim generations are bing brought up in Madrassas in Pakistan, and an even more restrictive Saudi Arabia that used to send students to study abroad, but has bought and paid for new educational infrastructure to avoid that.

[Real Person from the Real World]

Instead of opening the world to becoming a new global village, technology has only allowed hate groups to find each other more easily, and support each other.

[Lafayette]

RP: "How do you know what Muslims are fed up with?"

Turn off Fox News and have a look at moderate Muslim web-sites.

How many Muslims do you know personally? Give a number.

[Bill Conerly]

I would have expected the list of reasons for The Great Moderation to include the shift of consumption expenditures to servics from goods. Given how destabilizing inventory swings have been in the past, the shift in consumption patterns should be moderating, independently of the technological changes in inventory management.

[cm]

Morgan: "The proposed mechanism is similar to that of credit availability."

How about he mechanism is credit availability? Unfortunately, when handing out printed-money credit without backing by "hard" goods/services, before long it gets priced in, and you need more (aggregate) credit to stay "ahead of the curve".

I agree with 'reason' in contending that many indicators have been "managed" and outright manipulated so as no longer reflect reality and specifically deterioration, which is why it is not apparent how precarious things are unless you look closely. The problem is that anecdotes and non-mainstream indicators are not necessarily more reliable.

Much (though not quite all) of what people call income, and savings, comes out of somebody else's credit, past or present.

Should credit ever become substantially tightened, many may rudely wake up to suddenly disappearing demand for their previously successful goods and services, and concurrently tanking equity and bond savings via declining stock prices and bond defaults. Cash "savings" (i.e. bank accounts) are also only somewhat safe, as you don't have the money in your hand, and FDIC can take its time to fully pay you back, subject to their own ability to raise funds.

[Lafayette]

cm: "Should credit ever become substantially tightened, many may rudely wake up to suddenly disappearing demand for their previously successful goods and services"

Quite right.

So, what do you think will happen should the Chinese decide that they have better things to do with their money than lend it to Americans at the rhythm of $1B a day in T-note acquisitions (as they have been doing for a good many years).

America may be living on borrowed time.

[Morgan]

cm: Credit availability was one of the possible causes given in the article. I was simply clarifying that the mechanism by which demographically-driven changes in savings and income stability might exert an effect is similar - they increase the ability to weather shocks on the individual level.

[cm]

Morgan: My point was that much of income is actually derived from credit. When that credit goes poof, then so goes the portion of incomes corresponding to it. E.g. when the money available to buy (more) tech widgets stalls or disappears, what do you think this will mean for tech industry incomes and jobs? And the "multiplier" jobs in service business catering to tech? Similarly in all industries whose end products are bought on credit, i.e. pretty much all as far I can see.

I'm working in a place catering to producers of tech widgets, with a growing emphasis on consumer products with ever more revisions and shortened life cycles. Already for a while my industry as well as our customers are apparently refusing to hire domestic workers and keep inadequate staffing levels, all the while complaining they cannot find "qualified candidates", and these are supposedly "good times". Industry stock prices broadly perform so-so, having come down from dotcom heights. What do you think will happen when tech widget (paying) demand slumps?

Perhaps you are talking about social security supplemented by IRA investments. Social security's COLA is based on a discredited CPI, and "investment" performance depends on credit too. As corporate revenue goes, so go stock prices and bond yields.

[cm]

Lafayette: The jury is still out I think. For the time being, they still need the US to continue building up their own industry, a help that is willingly extended by offshorers. Afterwards, they will still want trade partners I suppose.

[Morgan]

cm:

I'm talking about the fact that people with a variety of high-level skills established over the course of a career tend to have more stable incomes and the fact that savings generally increase over the course of the lifespan.

So if you have a higher proportion of 40-60 year olds and a lower proportion of 20-30 year olds as active consumers, you might expect some evening of consumption and a flattening of economic swings. I don't think "more available credit" is the sole reason that people become more steadily employed or have increased savings as they age.

I'm not denying the influence that readily available credit has on economic activity, nor do I think that a credit crisis would be benign. I don't think we're on the verge of a credit crisis, but then my record as an economic forecaster is, er, spotty.

I do believe that if you're looking for causes of the (observed) moderation, there are additional factors that should be considered.

[Lafayette]

M: "I don't think "more available credit" is the sole reason that people become more steadily employed or have increased savings as they age."

But, that may indeed be the case.

Credit is a prime motivator of demand and demand stimulates not only jobs (when it grows) but their maintenance.

Having lived in a country (France) where credit is difficult to obtain, I note that it has had high unemployment (>8%) since 1980. This is quite possible not THE "smoking gun" and there probably is not just one factor to blame. Regulatory controls on labor in France as well as hours worked are also probable factors.

I'd add ease of and cost of credit to the list of major factors that sustain an economy. Of course, if the i-rate skyrockets, credit dries up and the economy must retract.