Bookblogging: The end of the Great Moderation, What next?

In any book on policy thinking, the easy bit (not all that easy!) is to write about what’s wrong with existing ideas, in my case the zombie ideas I’m writing about. The chapter plan for my book includes, in each chapter, a section on “What next”. As regards the Great Moderation, which was essentially an interpretative claim about the data, it’s not really clear what to include. I’m leaving the details of macroeconomic thinking and policy for another chapter and writing about how society should handle risk. Comments and criticism appreciated as always.

I’m in the process of setting up a site at where the whole draft will be presented in wiki format. But I’ve been travelling and haven’t managed to get it going yet.

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The failure of the Great Moderation, like that of the Efficient Markets Hypothesis, has major implications for a wide range of government policies. The implications for the financial sector have already been discussed and we will look in detail at implications for fiscal and monetary policies in Chapter 3. But the central implications of the end of the Great Moderation relate to the need to reverse the Great Risk Shift, and reinvigorate the social and collective risk management institutions that constitute the social-democratic welfare state.

The end of the Great Moderation has already produced a massive increase in the economic risk faced by individuals, families and businesses. In the US, as many as 10 million households are expected to face foreclosure by 2012. Over the same period, and despite laws designed to make bankruptcy less accessible, it is likely that between 5 and 10 million households will face bankruptcy (of course, the two groups will overlap).

The collapse of stock markets has wiped out, or drastically reduced, the life savings of many workers. More fundamentally, it has undermined the idea of a shareholding democracy, in which most households have sufficient financial wealth, earning good returns, to be at least partially independent of wage income during their working years, and reliably capable of financing their own retirement thereafter. (More on for retirement income in Chapter)

Around the world, tens of millions of workers have lost their jobs, and tens of millions more will do so before the crisis is over. And even after economic growth has resumed, the impacts will be felt for a long time to come. In the absence of positive government action, unemployment will remain high for years after the economy hits bottom. The unstable state of the global financial system, and the lack of any significant movement towards more effective regulation, suggests there will be more shocks to come.

The increase in inequality that produced this increase in risk is most evident in the United States, but it has occurred, with a shorter or longer time lag, in many other countries, both developed and developing. Where the social democratic welfare state has remained strong, growth in inequality has been less marked. But it is no longer possible to suppose that simply slowing the pace of market liberalisation will prevent growth in inequality, and the growth in risk and insecurity it implies.

All of these changes mean that risk can no longer be ignored, or wished out of existence through financial market conjuring tricks. Only a renewed social-democratic analysis provides any coherent basis for a response.

Social democrats have long stressed the idea that we have the capacity to share and manage risks more effectively as a society than as individuals. The set of policies traditionally associated with social democracy or (in the US, political liberalism) may be regarded as responses to a range of risks facing individuals, from health risks to uncertain life chances.

In his pathbreaking book, When All Else Fails, Robert Moss surveys two centuries of American history, in which he presents the state as ‘the ultimate risk manager’. Moss distinguishes three phases of public risk management in the United States. Although the United States is atypical in important respects, Moss’s three-phase model provides a useful framework for discussion.

Moss’ first phase, ‘security for business’, encompasses innovations such as limited liability and bankruptcy laws, introduced in the period before 1900. Many of these risk management policies are taken for granted now, but they were vigorously debated at the time. Adam Smith, the father of mainstream economics, denounced limited liability companies as providing an open invitation to managers to enrich themselves at the expense of shareholders. His critique sounds strikingly familiar, but he did not foresee the development of businesses on a scale so massive that a vast number of shareholders was a necessity rather than an option. As for bankruptcy, the US Constitution adopted 1789 allowed Congress to legislate on the topic, but it took more than 100 years to reach agreement. In the intervening century, bankruptcy laws were adopted, and later repealed, on three separate occasions.

Moss’s second phase, ‘security for workers’, was produced by the shift from an economy dominated by agricultural smallholdings to a manufacturing-based economy in which most households depended on wage employment. Historically the phase includes Progressive initiatives such as workers’ compensation and the core programs of the New Deal like unemployment insurance and social security.

The third phase, ‘security for all’, began after World War II and includes such diverse initiatives as consumer protection laws, environmental protection and public disaster relief. These may be seen as responses to the ‘risk society’ (Beck 1992). Risks of environmental degradation and natural disaster are inherently social in their nature, and the success or failure of a society in responding to these risks is a measure of the capacity and responsiveness of its government.

The Great Risk shift in economic policy was part of a bigger backlash against social risk management, which was even more ferocious in the case of environmental risks. It’s hard to believe, looking at today’s debates, that the Clean Air Act of 1970 and Clean Water Act of 1972 were passed with overwhelming bipartisan support. Any proposal to protect the environment now produces automatic, and vitriolic, rejection from the political right.

Risk and inequality are closely linked. On the one hand, the greater the risks faced by individuals in the course of their life, including the risk associated with differences in initial opportunities, the more unequal society is likely to be. On the other hand, as the financial crisis has shown, radical inequality in outcomes, such as that associated with massive rewards to financial traders, encourages risky behavior and particularly encourages a search for opportunities to capture the benefits of risky actions while shifting the costs onto others, or onto society as a whole.

A social democratic response to the crisis must begin by reasserting the crucial role of the state in risk management. If individuals are to have security of employment, income and wealth, governments must act to establish and enforce the necessary legal and economic framework. The fact that government is the ultimate risk manager both justifies and necessitates action to mitigate the grotesque inequalities in both opportunities and outcomes that characterise unrestrained capitalism and were increasingly resurgent in the era of economic liberalism.

The interpretation of the welfare state in terms of risk and uncertainty may be illustrated by considering some of its core functions. For some of these functions, such as various forms of social insurance, the risk management function has always been emphasised. However, concern with risk has traditionally been a subsidiary theme.

For instance, the public provision of retirement income and of services like health or education have commonly been justified with reference to notions of redistribution, public goods and the provision of basic needs. However, these interventions may equally be supported in terms of risk management.

A risk-based analysis may be extended to encompass more general programs of income redistribution. In a risk-based view, redistribution may be seen as providing insurance against a particular kind of risk, namely the risk of being born poor, socially dislocated and without access to human and social capital. These ideas have been explored by a number of policy analysts in recent years, notably including Nicholas Barr, Ulirch Beck, Anthony Giddens, Jacob Hacker and Robert Moss/

As Giddens observed in his 1999 Reith lectures

the welfare state, whose development can be traced back to the Elizabethan poor laws in England, is essentially a risk management system. It is designed to protect against hazards that were once treated as at the disposition of the gods – sickness, disablement, job loss and old age.

Pursuing the same theme, Nicholas Barr offers the metaphor of the welfare state as ‘piggy bank’ as against the traditional view of the welfare state as ‘Robin Hood’. The Robin Hood interpretation implies a zero sum view of the world in which the state acts to help the poor at the expense of the rich, or, more generally, the well-ff. At any given point in time, this is exactly what happens. But, over the course of a lifetime, everyone faces the risks to which Giddens refers, to some degree or another. And, taking a longer perspective, even those who are unlikely to suffer from these risks are just winners in the bigger lottery of life chances, consisting, to a very large extent, of having the right parents.

Collective risk management through the welfare state helps to stabilize the aggregate economy. When incomes decline as a result of a recession, the design of a progessive tax system means that government tax revenues decline more than proportionally. This helps to cushion the impact on private demand and offsets the downward multiplier effects of an initial shock to the economy. Similarly, when unemployment rises, this produces an automatic increase in spending on unemployment benefits which is commonly amplified by expansion of benefits and the creation of

The mechanisms by the welfare state softens the impact of demand shocks are called ‘automatic stabilizers’, and, given robust welfare state institutions, the name is appropriate. But there is nothing automatic or guaranteed about those institutions. A balanced budget requirement such as exists in most US states, will force governments to cut expenditure precisely when it is most needed, producing, in Paul Krugman’s phrase ‘50 Herbert Hoovers’.

Similarly, if a government is so indebted that it can’t borrow money, or print money without the risk of inflation, an economic crisis will force retrenchment. That’s why its important to stress the ‘hard’ side shared by social democratic risk management and Keynesian demand management. Abandoning short term budget balance doesn’t mean that bills don’t have to be paid. Help when we face unemployment or health risks, or for those who are unlucky in their life chances, must be paid for by tax contributions made those who are, at least for the moment, healthy and well-off. Budget deficits to soften the impact of recessions must be matched by surpluses in good times. The ‘golden rule’ is to balance the budget over the course of the cycle.

No one can predict the future path of the economy with any accuracy. But at the aggregate level, we will almost certainly see more instability, with more frequent and sharper shocks, than during the false calm of the Great Moderation. And the end of the Great Moderation has not reversed the Great Risk Shift or, except partially and temporarily, the growth in inequality produced by the decades of market liberalism. The social-democratic response must combine better social provision to help people deal with risk at the individual and family level with a return to active use of fiscal as well as monetary policy to stabilise the aggregate economy. The two should be designed to work together, with social risk management policies that act as automatic stabilisers in the Keynesian sense and fiscal policies focused on helping those most directly affected by recession.

50 thoughts on “Bookblogging: The end of the Great Moderation, What next?

  1. For some reason I don’t believe you Sebastian, a good Christian would help his fellow ACTU comrades.

  2. @Sebastian
    I will say that you are correct in one way: Keynesianism, be it Stealth Keynesianism, military Keynesianism or any other variety, is blatant theft. Whether you like it or not, it’s what Howard practised, it’s what Reagan practised (he may have cut taxes, but government expenditure was massive under his administration), it’s what Bush and Obama have been doing. It doesn’t turn out the way you like, so you just cover your ears and go “na, na, na, not listening” but that doesn’t change a thing.

  3. Michael of Summer Hill :Sorry Sebastian, but I’m a bit thick and slow these days but are you one of the true believers in the Protestant ethic?

    “… I’m a bit thick and slow these days…”

    Can’t say that’s the sort of thing I’d own up to…

  4. Hic Sebastian, you should look on the bright side of things. As a good Christian, your taxes have gone to help all those in need and in line with ACTU policy. Forget about the tripe the Libertarians put out, it’s all nonsense. I’m stuffed and going to bed. Sweet dreams.

  5. @Michael of Summer Hill
    As the good Christian that I (allegedly) am, you can rest assured that I will be praying for your soul. I too shall go to bed, so that I can exercise my Protestant work ethic bright and early tomorrow morning

  6. Sebastian, you’ve commented at length without saying anything beyond the tritest of libertarian talking points (that the failed financial system wasn’t really deregulated), that have been discussed to death here, and without any indication that you are going to make any useful contribution to improving the book. Can I request that you put future comments in one of the open threads, rather than here?

  7. @Sebastian
    What I dont like Sebastian is thieves masquerading as having the best economic policy solution …then practising a twisted form of Keynesianism (so twisted it could no longer even be called Keynesianism) that redirects resources from the less well off to the wealthier. That is not Keynesianism at all..and Id go so far as to say the very principles of Keynesianism have been not only ignored but debased by a succession of neo liberal governments. Whether you get a smaller government or not…I really couldnt care less. I would like to see Keynesianism restored and the thieves thrown out of their temple with their false ideologies like “trickle down” and market fundamentalism. Im sure you are a good christian and some of those, like the Brethren, were handsomely rewarded under Howards government – but sadly he went too far with workchoices because it stopped all those good christians going to church on Sundays (too busy working). Now that really upset Hillsong didnt it?

  8. Sebastian, it is good to hear that you believe in the basic tenets and doctrine of predestination to save your soul, for those don’t follow the Protestant ethic and exploits of Schmidt in Taylor’s Scientific Management will never get to heaven and see God. I knew you were one smart cookie.

  9. @jquiggin

    John, a number of points:

    i) You should note that I only brought up the idea of regulation vis-a-vis the financial crisis once. Other than that, I made a conscious effort to restrict my posts to those which concern the Welfare State and your beloved Omniscient Government. Any superfluous comments were a result of your drooling lackeys making suppositions about my (largely non-existant) religious tendencies.

    ii) Given that most of what you have been saying amounts to what I would consider “trite Keynesian talking points” (ooohh, free markets and inequality is teh evils!), it is somewhat ironic and more than a tad hypocritical to accuse me of doing the same from a “libertarian” (I say pragmatic) viewpoint.

    iii) Seriously, don’t ever mention a “right” to medical care in front of my mother. She would give you an earful, about the ferals who come into her family general practice, putting their feet all over the seats and stinking of booze (provided by the Almighty Welfare State), invoking their “‘human roights’ (sic., intentional) to see the doctor”. Yes, I realise that you are probably safe on this point, given that I can’t see you two running into each other.

    iv) As for your book, as you can guess it’s highly unlikely that I will read it (although I have read a fair bit of Krugman, so pigs may yet fly). I would actually be interested in finding out how you plan to facilitate generous economic transfers to your favoured social groups, while not completely suppressing their urge to maintain a certain level of self-sufficiency. For whose benefit are we going to ration medical care? How are we going to determine who are the genuine low-income earners, and who are those whose preferences are heavily skewed in favour of leisure? Or are we going to emulate the Europeans, supposedly the healthiest people in the world that, for some unknown reason, take the largest amount of sick leave?

    v) It might also be good to know how you measure inequality. While simply mentioning the word will throw Alice into a fit of indignation, I would like to know why this is such an evil and not just some value judgement. Of course, actually quantifying inequality is fraught with statistical difficulties – how do you plan to circumnavigate these pitfalls?

    Despite the fact that we obviously have fundamental differences in opinion, I am nonetheless fairly impressed that you take the time to reply to your readers, and will desist from posting to this thread.

  10. @Alice
    To which sarcasm do you refer? If it was complimenting Comrade Quiggin on not being too aloof to respond to those who post on his blog, well that, I’m afraid, was actually genuine.

    If, as I suspect, you refer to my comments on your propensity for self-righteous indignation and emotional outbursts (riddled with references to ‘working families’, ‘ordinary Australians’ and the other mainstays of Ruddspeak), that WAS sarcasm.

    Not sure if it’s nature or nurture (I only did one semester of sociology, and that was enough pseudo-science for me – although economics as it’s currently taught in universities is hardly any better). Perhaps you can help me? What is it called when your sarcasm stems from having to sit through the verborrhea of your fellow students, endlessly moralising about this sorry state of affairs over a lukewarm latte, and about how the world would be perfect if only they could organise everything for the masses?

  11. Sebastian my mate, are you OK? I suggest you go and see a doctor if you are not feeling well and take a sickie like the Europeans.

  12. @Michael of Summer Hill
    Fool, one does not take “a” sickie like the Europeans; one takes at least 20-30 if one hopes to emulate the “progressive” and “enlightened” people of Europe.

    I guess 3 hours lunch break simply isn’t enough for the poor dears…

  13. @Sebastian
    For someone who is relatively new here Sebastian – you seem to know a lot about me. Are you a sock puppet Sebastian? have you got any other names you spread your rampantly anti social democracy views under?
    I am entitled to my views Sebastian and you can give me Rudd any day (even though he isnt going as far as I would like with government investment and government job creation) over that creature Howard who brought down workchoices on to Australian workers and “working families”. Yes, thank goodness our society woke up to attitudes like yours (everyone who is disdvantaged can eat dirt as long as I dont have to pay higher taxes…) at the last election. Why dont youb take your prosetylising back where it belongs Seabastian – to the beaten minority where you can whinge all day long about “big governments and the need for lower taxes” with your equally small petty minded associates.
    Oh and stick with short sharp black – I wouldnt give your types milk or sugar for your lattes.

  14. @Alice
    Yes, you are entitled to your views. That doesn’t mean that they shouldn’t be based on some realistic assumptions, rather than assuming something is “right” simply because it gives you a nice, warm, fuzzy feeling, as I suspect they are.

  15. Prof Q As I read this I wondered if there was going to be any comment in this or a future chapter about the capitalist version of risk management ie the insurance industry which has created any number of products for income protection and for other risks. Wasn’t the insurance industry a central component of the pack of cards which led to the GFC?

  16. @Sebastian
    Better my views than your narrow libertarian views which are more a quasi religion, not any form of realism, have only proved harmful to the extent they have been tried, didnt result in trickle down, are now accompanied by acute denial of the inherent failures of this view, and which leave me feeling stone cold…just like the block headed republicans in the US who are attempting to stymie Obama’s reforms of their broken health system.

  17. @Alice
    It’s spelt RepubliKKKan, by the way. Oh those evil RepubliKKKans! How dare they object to the plans of God-Emperor Obama, the Immortal Light! Everybody knows that Obama’s health plan was so perfect that nobody would ever get sick again, and yet these fools resisted it – it’s obvious that they are the cronies of the tobacco industry! Dissent shall not be tolerated…

    By the way, I’m deeply sorry that nobody trickled on you.

  18. Sorry Prof Q, but I’ve lost track of what issues you are covering in 6/7 myths of the title, so apologies if I’m covering something already dealt with.

    I agree with Jill Rush that a good long look at modern insurance (AIG and other behemoths) practices for financial innovations and the vanilla financial products. As the GFC has amply demonstrated (and the 1982 recession too) the insurance itself creates a risk category all of its own, namely the risk of belief that insurance is certain when in fact the success of a call on insurance is dependent upon the state of the financial system at the time of the call. If the US government and other governments hadn’t arranged a line of credit for AIG to draw upon, it would have been game over in 2008.

    The particularly dangerous period is near the peak of a boom market, where the current success of financial innovations puts downward pressure on insurance premiums, partly due to the fact that the relatively low failure rate of finanical products seemingly makes insurance unnecessary. Of course, near the peak of a boom is the period where insurance is warranted. This plays out over time to create insurance claim discounting and the insurer rationalises this by reducing their assessment of risk in a boom market. As the great philosopher Homer would say, “Doh!”

    The real question is how can we avoid or at least compensate for the uncertainty of a call on insurance? Is it even possible to devise a strategy to cover all relevant states of the financial system? Insuring the insurer, and reinsurance don’t work for periods such as September 2007 to mid-2008.

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