Great Moderation

US annualized real GDP growth from 1950 to 2010, showing the years of the Great Moderation.

In economics, the Great Moderation was a reduction in the volatility of business cycle fluctuations starting in the mid-1980s, believed at that time to be permanent, and to have been caused by institutional and structural changes in developed nations in the later part of the twentieth century.^[1] Sometime during the mid-1980s major economic variables such as real gross domestic product growth, industrial production, monthly payroll employment and the unemployment rate began to decline in volatility.^[2]

These reductions are claimed by Ben Bernanke and others in the Federal reserve^[2][3] to be primarily due to greater independence of the central banks from political and financial influences which has allowed them to follow macroeconomic stabilisation by measures such as following the Taylor Principle. Furthermore, mainstream economics claim that information technology and greater flexibility in working practices also contribute to stability".^[4]

Origins of the term

During the mid-1980s the U.S. macroeconomic volatility was largely reduced.^[5] This phenomenon was called a "great moderation" by James Stock and Mark Watson in their 2002 paper, "Has the Business Cycle Changed and Why?"^[6] It was brought to the attention of the wider public by Ben Bernanke (then member and now former chairman of the Board of Governors of the Federal Reserve) in a speech at the 2004 meetings of the Eastern Economic Association.^[2][7]

Causes

The Great Moderation has been attributed to various causes:

Central Bank independence

Since the Treasury-Fed Accord of 1951, the Federal Reserve was freed from the constraints of fiscal influence and gave way to the development of modern monetary policy. According to John B. Taylor, this allowed the Federal Reserve to abandon discretionary macroeconomic policy by the US Federal government to set new goals that would better benefit the economy.^[8] Through systematic monetary policy free from fiscal concerns, structured macroeconomic policy helped usher in the Great Moderation. Also, the Federal Reserve’s change in communicating its monetary policy plans contributed to the Great Moderation. The increased transparency could result in more effective monetary policy.

Government economic stabilization policy (roles of monetary policy)

"Following the Taylor Principle means less policy instability, which should reduce macroeconomic volatility."^[5] This is in line with director of research at the Federal Reserve Bank of Kansas City, Troy Davig, and Indiana University professor of macroeconomics Eric M. Leeper’s statement that the success of monetary policy to satisfy the principle can produce desirable outcomes in two ways.^[9] The resulting economic stabilization policies come in two forms: business cycle stabilization and crisis stabilization.

A business cycle refers to the economic activity, production, and trade fluctuations that occur all across the economy over time. These fluctuations occasionally reach extreme levels, as demonstrated by the Great Inflation, and to combat such fluctuations, government economic stabilization policies are enacted. Designed for "keeping the economy on an even keel", the Taylor Principle is countercyclical in nature and a "very simple rule [that] does a good job of describing Federal Reserve interest-rate decisions."^[10] Business cycle stabilization introduces more systematic monetary policies that reduce the fluctuations. According to Davig and Leeper, had the monetary policy failed to satisfy the principle, "the effects of fundamental shocks are amplified and can cause fluctuations in output and inflation that are arbitrarily large."^[10]

The US economic history is rife with unwelcomed financial crises. Frederic S. Mishkin defines a financial crisis as "a disruption to financial markets in which adverse selection and moral hazard problems become much worse, so that financial markets are unable to efficiently channel funds to those who have the most productive investment opportunities".^[11] Monetary policymakers have turned their attention to financial stability in order to mitigate the damage incurred during shocks. This is due to another outcome from failing to satisfy the principle is the existence of "a multiplicity of bounded equilibria in which output and inflation respond to nonfundamental—sunspot—disturbances".^[9] Crises are typically unpredictable and uncontrollable due to the vast number of factors involved, which prompts the necessity for improved crisis stabilization policy. The Federal Reserve essay points out a couple cases, such as the Stock Market Crash of 1987 and the September 11 terrorist attack, in which the Federal Reserve had prevented even worse crises from arising by providing the liquidity essential to keeping the markets from crashing. The Federal Reserve’s quick response to stabilizing crises was made possible due to the improvement of monetary policy.

The Great Moderation has greatly benefited from the Taylor Principle and, in "large part because it is a gross simplification of reality, the Taylor rule has been extraordinarily useful" in becoming a guideline for systematic monetary policies to follow.^[9]

Improved and stabilized economic structure

A contributing factor to the Great Moderation is an improved and stabilized economic structure. There are three primary reasons for an economic structural change that occurred right before the Great Moderation.

The first was a change in economic structure that shifted away from manufacturing, an industry considered less predictable and more volatile. The Sources of the Great Moderation by Bruno Coric supports the claim of drastic labor market changes, noting a high "increase in temporary workers, part time workers and overtime hours."^[4] In addition to a change in the labor market, there were behavioral changes in how corporations managed their inventories. With improved sales forecasting and inventory management, inventory costs became much less volatile, increasing corporation stability.

Second, advances in information technology and communications increased corporation efficiency. The improvement in technology changed the entire way corporations managed their resources as information became much more readily available to them with inventions such as the barcode.^[12]

Last, information technology introduced the adoption of the "just-in-time" inventory practices. Demand and inventory became easier to track with advancements in technology, corporations were able to reduce stocks of inventory and their carrying costs more immediately, both of which resulted in much less output volatility.^[4]

Good luck

Researchers at the US Federal Reserve and at the European Central Bank have rejected the "good luck" explanation and attribute it mainly to improved monetary policies.^[2][13][14] Research has indicated that US monetary policy contributed to the drop in the volatility of US output fluctuations and to the decoupling of household investment from the business cycle that characterized the Great Moderation.^[3] There were many large economy crises — such as the Latin American debt crisis of the 1980s, the failure of Continental Illinois Bank in 1984, the stock market crash of 1987, the Asian financial crisis in 1997, the collapse of Long-Term Capital Management in 1998, and the dot-com crash in 2000 — that happened during the Great Moderation to show that the U.S. economy was not just experiencing good luck.^[5]

However, Stock and Watson used a four variable vector autoregression model to analyze output volatility and concluded that stability increased due to economic good luck. Stock and Watson believed that it was pure luck that the economy didn’t react violently to the economic shocks during the Great Moderation. While there were numerous economic shocks, there is very little evidence that these shocks are as large as prior economic shocks.^[4]

Effects

It has been argued that the greater predictability in economic and financial performance associated with the Great Moderation caused firms to hold less capital and to be less concerned about liquidity positions. This, in turn, is thought to have been a factor in encouraging increased debt levels and a reduction in risk premia required by investors. According to Hyman Minsky the great moderation enabled a classic period of financial instability, with stable growth encouraging greater financial risk taking.

On the economics profession

An example of the over-confidence of the economic profession in this period (prior to 2008) given by Robert Lucas, in his 2003 presidential address to the American Economic Association, where he declared that the "central problem of depression-prevention [has] been solved, for all practical purposes."^[15]

Possible end

Some economists, such as John Quiggin, have argued that the late-2000s economic and financial crisis brought the Great Moderation period to an end.^[16] Richard Clarida at PIMCO considered the Great Moderation period to have been roughly between 1987 and 2007, and characterised it as having "predictable policy, low inflation, and modest business cycles".^[17]

However, the US real GDP growth rate, the real retail sales growth rate, and the inflation rate have all returned to roughly what they were before the Great Recession. Todd Clark has presented an empirical analysis which claims that volatility, in general, has returned to the same level as before the Great Recession. He concluded that while severe, the 2007 recession will in future be viewed as a temporary period with a high level of volatility in a longer period where low volatility is the norm, and not as a definitive end to the Great Moderation.^[18][19]

See also

• 1990s United States boom
• New Economy
• Structural break
• Great Depression of the 1930s

References