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.

This is the second in a planned series of posts assessing the implications of the global financial crisis for the economic ideas and policies that have been dominant for the past few decades. The large-scale privatisation of publicly-owned enterprises both in capitalist countries like the UK and Australia and in formerly communist countries after 1989 played a big role in promoting the kind of triumphalism that characterised much commentary about free-market capitalism in the 1990s and (to a somewhat lesser extent) in the years leading up to the crisis. How well do arguments for privatisation stand up in the light of the financial crisis.

The case for privatisation had two main elements. First, there was the fiscal argument for privatisation, namely, that governments could improve their financial position by selling government business enterprises. This argument assumed that privately owned firms would have higher levels of operating efficiency, and therefore that the value of those firms would be increased by privatisation. The second argument was a dynamic one, that the allocation of capital between alternative investments would be improved if governments were not involved in the process. Both of these arguments have been fatally undermined by the collapse of the efficient markets hypothesis.

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Microsoft Zune music players stopped working on New Years Day because of a software bug, raising the inevitable comparisons with the Y2K fiasco. The way in which the largely spurious Y2K problem was handled raises some interesting comparisons with the all too real problem of climate change. Although many billions of dollars were spent on making systems Y2K-compliant, there was no serious scientific study of the problem and its implications. The big decisions were made on the basis of anecdotal evidence, and reports from consultants with an obvious axe to grind. Even the simplest objections were never answered (for example, many organisations started their fiscal 2000 year in April or July 1999, well before remediation was completed, and none had any serious problems). There was nothing remotely resembling the Intergovernmental Panel on Climate Change, let alone the vast scientific literature that needs to be summarised and synthesised for an understanding of climate change.

Thus, anyone who took a genuinely sceptical attitude to the evidence could safely predict that 1 January 2000 would pass without any more serious incidents than usual, even for the many countries and businesses that had ignored the problem. The retrospective evaluations of the policy were even more embarrassingly skimpy. I analysed some of the factors involved in this paper in the Australian Journal of Public Administration.

A really interesting point here is the fact that, in the leadup to 1 January 2000, self-described global warming sceptics, for the most part, went along with the crowd. If any of them rallied to the support of those of us who called for a “fix on failure” approach, I didn’t notice it. By contrast, the moment that the millennium had arrived without incident, retrospective scepticism about Y2K became a staple of their rhetoric. The IPA, for example, started its commentary on 15 January 2000 and it’s been a staple ever since. Of course, I’m open to correction here. I’d be very interested if anyone could point to a piece published before 2000 taking a sceptical line both Y2K and AGW.

I’m starting my long-promised series of posts on economic doctrines and policy proposals that have been refuted or rendered obsolete by the financial crisis. There will be a bit of repetition of material I’ve already posted and I’ll probably edit the posts in response to points raised in discussion.

Number One on the list is a topic I’ve covered plenty of times before (in fact, I was writing about it fifteen years ago

), the efficient (financial) markets hypothesis. It’s going first because it is really the central microeconomic issue in a wide range of policy debates that will (I hope) be covered later in this series. Broadly speaking, the efficient markets hypothesis says that the prices generated by financial markets represent the best possible estimate of the values of the underlying assets.

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There’s been a lot of talk about the idea that the GFC (the in-group shorthand for ‘global financial crisis’) is an example of a ‘black swan’, that is, an event that would be treated as impossible on the basis of induction from past experience, and hence that could not be encompassed by formal models of the kind used by risk managers. All this talk has of course been great for Nicholas Taleb who has a book with this title. It’s good in a lot of ways, but I found it ultimately insufferable in the continuous repetition of the message that only Taleb was smart enough to see all this. ( To be fair, Taleb predicted a global financial crisis, and didn’t simply claim it in retrospect as an unpredictable Black Swan).

I spend a lot of my time working on how to think about unforeseen contingencies and I’m not at all convinced that the GFC should be described in this way. Of course, the models used by the risk managers in investment banks didn’t include this as a possibility; if they had, the implication would have been that all sorts of much-desired deals should not go ahead. But as I pointed out a while ago, very simple models based on well-established principles predicted that the bubble economy would end badly.

The crisis then, involved something more like dark matter, the ‘missing’ matter in the universe that must exist if it is to work as it does, but can’t at presented be detected. Given that risk can’t easily be made to disappear*, it was obvious that the risk associated with lending of all kinds (most obviously, mortages offered to people with no capacity to repay) was being borne by someone, and probably someone who was unaware of it.

The big problem for the Cassandras (and we were certainly both correct and disregarded) was that it was easy to see that the bubble could not continue and much harder to foresee how it would end – it’s one thing to say that dark matter must exist and another to work out what it is really like. Like Brad and Brad, I expected that the problems would emerge first in the form of a run on the US dollar, given that holders of US dollar assets were receiving very little compensation for the obvious risk of large capital losses. In fact, the US dollar actually rose in the early stages of the meltdown, though it has been falling more recently.

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