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Friday, January 19, 2007

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.

    Posted by on Friday, January 19, 2007 at 12:06 AM in Economics, Financial System, Inflation, Monetary Policy | Permalink  TrackBack (0)  Comments (23)


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