Investments  

Smoothing the way

The term Great Moderation is the phrase economists use to describe the period between 1984 and the start of the financial crisis at the end of 2007.

What ‘moderated’ were the volatilities associated with the rates of economic growth and inflation throughout the member countries of the Organisation for Economic Co-operation and Development, and particularly in the US.

During the decades following World War II, the US economy grew at an average annual rate of 3.5 per cent, but from year to year, and indeed quarter to quarter, growth rates varied widely. During the Great Moderation average growth rates declined to 3.2 per cent a year, but the amplitude of the oscillations around the long-term trend fell by more than half. Inflation too became less volatile, and its rate declined significantly, meaning this period was also characterised by relatively slow and fairly predictable price rises.

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There are a multitude of competing explanations for what caused the Great Moderation, and to make sense of them, it is best to divide them into three broad categories:
* The transformation of the economy.

* Dumb luck.

* Smarter policy makers.

A bit about present-day macroeconomic theory will help explain how they differ. To begin, most macroeconomic models share three basic building blocks: households, which consume goods and services and supply labour, firms, which combine labour and capital to produce goods, and policy makers, the governments and central banks, which determine government spending, taxes, and monetary policy.

These models are far too complex to solve with pencil and paper so instead they are fed into a computer to be estimated and analysed numerically. Moreover all models, whether in economics or natural sciences, share a common trait: the phenomena we observe must be categorised as endogenous, exogenous, or safe to ignore. Endogenous phenomena are what we hope to understand, and theoretical models explain the relationships between them.

In a typical macroeconomic model this means output, consumption, wages and price levels, for example. Designating something as exogenous does not mean it does not matter, only that it behaves in ways our theory does not explain or that we choose not to explicitly model. Shocks to total factor productivity (more on this later), or shocks to prices of commodities produced in other countries, are usually exogenous in macroeconomic models. Finally there are phenomena we deem safe to ignore because they are either too small to matter, big but too unpredictable (war, revolution), or big but (we think) too unlikely to ever happen. Regrettably this last category included until recently the seizing up of the financial system.

So start with the first of the candidate explanations for the Great Moderation, the transformation of the economy. This means that the underlying economy, the relationship between the endogenous variables in our models or the way they respond to exogenous shocks, changed during the 1980s. Specifically there is some evidence that firms harnessed information technology to better manage inventories. The result was that the private sector could change what and how much it produced in a more flexible and timely fashion in response to changes in demand and exogenous shocks. A related explanation is that financial innovation, partly resulting from the same improvements in IT but also owing to deregulation, made the investment process better able to respond efficiently to changing conditions, again making the economy more robust to shocks. Finally middle-aged workers are less likely to enter and exit the labour market than the old or young. As the baby boomers entered middle age, the large relative size of this cohort meant the labour supply responded with less volatility in response to, once again, exogenous shocks.