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.

20 thoughts on “Refuted economic doctrines #3: The Great Moderation

  1. I’m looking for a recent link to a posting by John Taylor (of the Taylor Rule) on the policy divergence from the Great Moderation period during the last few years or so under the Great Greenspan! But can’t find it ….. a very interssting graph in there is my recollection!

    JQ, you may be correct on that initial Telstra tranche but I keep having this fantasy that we had flogged all of it to Worldcom in 2000 and ended up with a bucket of cash and a world beating telecoms market to boot …..

  2. “Just as the failure of the efficient markets hypothesis has destroyed much of the theoretical basis of the policy framework dominant in recent decades,…”

    a) ‘efficient markets hypothesis’ refers to the Efficient Capital Market Hypothesis [EMH) (Fama, Jensen, Beaver, Latham) and
    b) ‘failure’ means rejection of the EMH on empirical grounds and
    c) the EMH was the policy framework dominant in recent decades,

    then I say the problem is much deeper then having policy based on a hypothesis which turned out to be invalid on empirical grounds. The problem is that there is apparently still an attempt to refute the EMH even though it is a non-refutable (macro-economic) hypothesis by construction (eg Gross, 1986, “On the testability of Fama’s efficient market hypothesis”, Working Papers in Economics, The University of Sydney).

    The EMH was ‘sold’ on the basis of empirical evidence. ‘Evidence based decision making’ is popular again. Hopefully, this time ‘evidence’ is to be treated as inseperable from methodology.

    This morning I read in the SMH an article by Paul Sheehan. This article also refers to the ‘efficient market hypothesis’, although he gives a slightly different slant to the meaning of the EMH to that given in JQ’s earlier post. Sheehan writes: “Behind the efficient market idea lay the intellectual failure of mainstream economics. It could neither predict nor explain the meltdown because nearly all economists believed that markets were selfcorrecting. As a consequence, economics itself was marginalised.”

    I beg to differ. Mainstream economists, as I understand the term, have never taken the EMH seriously because it is a methodologically flawed hypothesis. Indeed, some of the earliest and most severe criticisms of the EMH came from general equilibrium theorists (see the literature on fully revealing rational expectations equilibria, particularly Figlewski, 1978, Rubinstein, 1975, Le Roy, 1976, Radner, 1979, Grossman and Stiglitz, 1980, Hellwig, 1980)

    The interesting question in my mind is why did politicians and opinion makers take the EMH as a policy framework?

  3. Ill tell you what certainly has been Refuted….economics as any sort of science,not even a social one.

    Try understanding that money is more than a means of exchange and you might make some progress. Trust is a human quality not an economic one.

  4. ‘The interesting question in my mind is why did politicians and opinion makers take the EMH as a policy framework?’

    Because in the 1980s Reagan, Thatcher, Hawke/Keating, etc were baby boomers of their times and as others have noted this was a demographic bulge in its prime, in their 20s and 30s. This was a generation fast in need of credit to fund an internet startup or simply takover the reins of old capital and run with it. The alphabet soup of financial derivatives to achieve that would start off as urgent and necessary to achieve that, before it turned into the indecipherable monster of today. The Great Moderation was really a demographic bulge in its prime, fuelled by central bank easy money and lastly Asian savers but that leverage could not last with a demographic on the wane.

    The first of the baby boomers is at the threshold of official retirement age 65 while the last of them is now 47 and with them goes the need for leverage and consumption that goes with household formation, child rearing and education, as well as investment in their businesses. They are winding down now and with it goes that Great Moderation. More importantly the vast amounts of central bank liquidity that they poured into assets for retirement have proven illusory as they could never sell them all at once to amortise such historically high gains. Asset prices have slumped along with returns to savings as demographic supply outstrips demand and it can only worsen or at best stagnate until the passing of a generation.

    In their 20s and 30s baby boomers couldn’t get enough of those ‘free markets’ to fulfil their youthful enthusiasm, entrepreneurship and dreams and they voted accordingly. Not so today with the sudden realisation that much of their saving was nominal and illusory. So much for early retirement and carrying on in the manner to which central banks and Asian savers had accustomed them. Naturally they want Govts to kiss it and make it all better for them, but that’s an impossible fallacy of composition problem. Nevertheless they are all devout Keynesians now. EMH? What dreadful people would ever adhere to that horrid, outdated theory? Their offspring naturally, if they can muster the numbers.

  5. “but I keep having this fantasy that we had flogged all of it to Worldcom in 2000 and ended up with a bucket of cash and a world beating telecoms market to boot …..”

    Well if they’d listened to me back then, we could have had the bucket of cash and a world beating publicly owned telecomms system.

  6. The greater stability induced higher leverage and more risky behaviour. It wasn’t just sub-prime mortgages which got the US into trouble but high rates of default across the high mortage market.

    A moderate recession every now and then is needed to limit optimism biases and to encourage greater risk aversion particularly with respect to debt. The success of capitalism itself meant that the crisis – when it did come – had to be a big one.

  7. #3: I have no trust in your statements. I am a human. I have no reason to have trust in your statements.

    #4: The age of Thatcher, Reagan, Hawke, Keating is public information. These people were not in their 20s or 30s in the 1980s. (v.Hayek, M. Friedman were also not Baby Boomers).

    #6: Why did “greater stability induce higher leverage and more risky behaviour”? Are you saying in your second paragraph that education is useless? What is your criteria for “success”?

  8. The Great Moderation is a funny phrase for a rolling series of white collar crime waves. A string of bubbles is not what I would call a regression to the mean (or “mode”).

    Of course the Great Moderators were talking up the sedative effects of financial volatility, as the counter part to industrial stability. As if the money trail lead to. Nowhere Land.

    The real industrial stability that was achieved over the past decade or so was mostly taken out of the hides of manual and material resource owners. These increasingly casualised and commodified sectors of the market were turned into Just-In-Time servants of the capitalist machine.

    Capitalists were able to turn the real providers of wealth into gigantic covenience store through the agency of high tech inventory control software ala Wal Mart. This stabilized the accountable part of the industrial system at the cost of much imconvenience and instability on the part of everyone else.

    In short the Great Moderation was an elaborate exercise in cost and benefit shifting like so many other much touted liberal reforms.

  9. ‘The age of Thatcher, Reagan, Hawke, Keating is public information. These people were not in their 20s or 30s in the 1980s. (v.Hayek, M. Friedman were also not Baby Boomers).’

    No they weren’t but that political leadership was no doubt a product of its times and electoral demographics.(ie it read the tea leaves correctly) Generally 20-30 somethings don’t run economies and nations, just as GenX-Z don’t just yet. The latter will have their moment soon, but will be saddled electorally and financially with a bunch of geriatric, bailout Keynesians when they would no doubt be better off enjoying the free market sins of their parents. No easy credit for them in future but OTOH asset prices and interest rates will be cheap. More peer to peer lending from mum and dad most likely.

  10. Seven years is the normal duration of a business cycle, from boom to bust. But the current cycle went for about twice that length.

    I, like Pr Q, expected the Great Reckoning to occur in the early part of the noughties. around seven or so years after the mid-nineties beginning of the technology and Chinese booms.

    Then 911 happened. Oh fateful day!

    This gave Bush-Greenspan all the cover the needed to launche their “debtquity, derivative and diversity” housing bubble, to give finance capital another spin of the wheel and to prop up the GOP.

    So, relative to norm, the cycle got doubled in length. I predict a corresponding increase in depth relative to the early nineties recession. That means double digit unemployment and a good year or more of negative growth.

    It almost looks like the quantum of economic volatility is conserved, at least when considering one full business cycle from peak to peak.

  11. The ‘Great Moderation’ = cheap oil, cheap Chinese goods and a lot of debt.

    The first 2, along with low wage growth (negative in some places like the US) kept inflation down (nothing to do with central banks).

    The 3rd made up for the slow wage growth. Hard to sustain any growth in an economy dominated by consumption with slow growing or (in some cases) even shrinking average wages.

    There is a weaker 4th I suppose, each of the most idiological ‘neo-liberal’ dominated states (US, UK, Oz, etc) all ran high immigration policies as well, as an additional factor in attempting to ‘square the circle’.

    A key political point was that the UK got lucky. Just as Thatcher came into power, North Sea oil and gas came onstream. Arguably, if this had never happened, the UK would have gone under in a screaming heap in the mid-late 80’s, probably killing the whole ‘neo-liberal’ economics stone dead.

  12. JQ says, “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.”

    The predictions of people like JQ, Steve Keen, Micheal Pusey and John Ralston Saul (about where the disastrous policies of the neoliberal era would lead) have been proven correct. It really is time for the neolibs and the neocons to… well they tried to put up and failed so now they must take the other option.


  13. Yes. I mentioned above that the Great Moderation was mostly
    “taken out of the hides of manual and material reource owners” from the nineties through naughties. Namely Chinese labourers and Arabian oil sellers. Interesting to check on changes to the factoral distribution of income over this period.

    Another factor was the generosity of “mental” reource owners in the communalist economy, eg html, google, open source, wikipedia, blogs etc Greatly reducing information processing costs.

    Much of these cost savings were appropriated by “mechanical”
    resource owners ie capitalists.

    The dramatic reduction in interest rates was partly due to the massive increase in the supply of loanable funds from Asian savers. Moreso due to the fiat money pumped out by western central bankers to validate massive leverage by financial institutions.

    In short the Great Moderation was a function of the victory of the capitalists in the class war. Most of the spoils of this victory were reaped by financial capitalists which lately degenerated into kleptocracy.

    oldskeptic’s point is that there is no magic in the New Economy. Bourgeois victory in the Class and Culture War dampened social conflict and made managements job easier.

  14. Massive immigration of Southern cheap labour into Northern indusfrial states is a huge factor in the capitalists overwhelming victory in the Class War. It crushes the living standards of the less institutionalised native born workers. And it keeps ratcheting up rent, which has become another source of capitalist profit since the financialisation of real property.

    No wonder everyone started putting in 10-12 hr days to “ease the squeeze” as Latham put it.

    These guys are not interested in fair and reasonable give and take. They won’t stop till they’ve got the lot. Only bloody minded ideologues like Norm Gallagher and Pauline Hanson stop them in their tracks.

  15. John, even if Obama can deliver next month it will not stop the USA from entering a severe recession this year. This factor alone refutes the ‘great moderation’ argument which many have aspired to. But even if Obama can deliver the goods it will be donkeys years before the ‘great moderation’ theorists may present another plausible argument for their case of ‘a large reduction in business cycles volatility’.

  16. Funny, that, because I’ve heard, again and again, that the cause of the Great Moderation was that economic liberalism had been rejected and that central bankers were managing the economy so well — so it’s odd how refuting the Great Moderation argues against economic liberalism just like the Great Moderation itself argued against it — you’d almost think that, whatever happens, some people will conclude “liberalism failed”!

  17. #16 I don’t think I’ve ever seen this claim and a search for “economic liberalism” + “great moderation” doesn’t help. Can you provide a link or two?

  18. I heard a rhumour that back in the 70s economics students at Sydney Uni or NSW uni went around wearing black Tshirts with white MV=PY printed on them. Anyone here who can confirm? Just gives me an image of monetarism as being somewhat faddish at the time.

  19. John, I’ve really got to thank you for refuting this “Great Moderation” nonsense. Austrian economists have been pointing this out for years. Good to see the mainstream is finally catching up.*

    From a free-market point of view, the current crisis shows that the government monopoly on money and its control over the banking system is fundamentally unstable, despite the move towards central bank “independence”.** It supports the Austrian case for abolishing the central bank, and implementing a free-market in money.

    The only way you can say refuting the Great Moderation supports your ideological case for big government (and it is an ideological case, since economics is not a science, and you are disguising your political values), is if the developed world was following anything resembling free-market monetary policies. Unfortunately for you, the central bank is an inherently statist institution, so there is no way that refuting the Great Moderation supports your position. The central bank could not engineer stability in the financial system, as the panic of 2008 shows. If we had no central bank, and this massive recession still occurred, then that would support your case.

    Of course, since you are an inflationist, you will draw a different conclusion. You probably see central bank “independence” as a free-market reform, whereas I see abolishing the central bank as a free-market reform. “Independence” is merely window-dressing.

    * I don’t believe such a thing exists. Obviously, since Keynesian economists assume that politicians and bureaucrats act selflessly and always in the public interest, it makes it easier to believe that there is such a thing as independence in government agencies, but the evidence in relation to the Fed (which cannot be detailed here) suggests otherwise.

    ** It’s funny how mainstream academia always seems to get head of things that libertarian academics have known for years. Yesterday’s Australian had a piece by two mainstream economists arguing that the New Deal prolonged the Great Depression, but Murray Rothbard argued pretty much the same thing back in the 1960s. Even if libertarian thinkers aren’t given credit, at least the ideas are finally making their way into the mainstream.

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