Refuted economic doctrines #3: The Great Moderation
The “Great Moderation” is a phrase coined by Ben Bernanke in 2004 to describe one particular interpretation of evidence showing that the volatility of output has declined over time in the US and other developed countries (though not, by then, Japan). Bernanke starts by citing the work of Blanchard and Simon, who offer both a different view of the evidence and a different explanation. Blanchard and Simon say that output volatility has been declining since the 1950s (fn: reliable national accounts don’t go back before WWII, but obviously output volatility was very high in the 1920s and 1930s), with an interruption in the 1970s and 1980s. However, they note that the data could also be interpreted as having a single structural break in the mid-1980s, and this is the view of the evidence taken by Bernanke.
A variety of explanations have been put forward for the Great Moderation. To the extent that the Moderation has been seen as more than a run of good luck, it has typically been explained either by a combination of improvements in macroeconomic management associated with central bank independence and reliance on monetary rather than fiscal policy and the benefits of economic liberalism, as in this piece by Gerard Baker
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 Great Moderation has vanished with surprising rapidity, though in retrospect its unsustainability has been evident since the late 1990s. It is clear that the global economy is undergoing a severe recession, which will generate a substantial increase in the volatility of output. But even if the recession ends by mid-2009, as is suggested by some optimistic forecasters, crucial elements of the Great Moderation hypothesis have already been refuted. Over the period of the Great moderation, all the major components of aggregate output (consumption, investment and public spending) became more stable. By contrast, if a deep recession is avoided in 2009, this will be the result of a massive fiscal stimulus, with a huge increase in public expenditure (net of taxes) offsetting large reductions in private sector demand.
Just as the failure of the efficient markets hypothesis has destroyed much of the theoretical basis of the policy framework dominant in recent decades, the collapse of the Great Moderation has destroyed the pragmatic justification that, whatever the inequities and inefficiencies involved in the process, the shift to economic liberalism since the 1970s delivered sustained prosperity. If anything can be salvaged from the current mess, it will be in spite of the policies of recent decades and not because of them.