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.
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.
So what about these exogenous shocks? These are the partly unpredictable forces being fed into the models in a way we hope makes the endogenous variables oscillate as they appear to do in the data. An auspicious string of these shocks, or more precisely, a sudden decline in their absolute magnitude, would constitute the sort of ‘dumb luck’ which corresponds to the second candidate explanation. Which shocks? Commodity prices, though not the price of oil, were more stable in this period. Other than that, smaller shocks to total factor productivity appear to dominate. Technically total factor productivity is the part of output growth we infer indirectly after accounting for measured changes in capital or labour inputs, and is thought of as a measure of how efficiently they are used, or a general measure of technological progress. If this proves to be the best explanation (the evidence is mixed), it means we are less likely to enjoy another Great Moderation unless the dampening of these shocks was not simply random.
Finally there is the last explanation, involving improvements in macroeconomic theory and its astute application by policymakers, particularly central bankers. Reading interviews with Alan Greenspan conducted towards the end of his term as chairman of the Federal Reserve in 2006, or the writings of his successor, Ben Bernanke, at around the same time, it is hard not to sense the air of triumphalism that had emerged by then. Yet it would be a mistake to dismiss this explanation simply on the basis of what we know transpired immediately afterward. First it is important to compare their records to that of their predecessors. It was after all the incompetence of the people running the Fed, the failure to understand what falling prices do to real interest rates, that helped make the Depression that started in 1929 so very ‘Great’. In its wake, particularly after World War II, policymakers failed to consider the role expectations play in the economy, convincing themselves that by careful calibration of monetary and fiscal policy it would be possible to achieve near-permanent full employment at the cost of no more than moderate but stable inflation. Instead the high inflation and recession in the 1970s vindicated early critics of Keynesian demand management and hastened the development of the models I described above.
Policymakers too were chastened by this experience. Gone was the goal of full employment and in its place was acknowledgement that, given the inevitability of frictional unemployment in an ever-evolving economy, the best that could be achieved was a dampening of oscillations around a long-term trend. In practice this meant raising short-term interest rates whenever output grew faster than appeared sustainable or the rate of inflation increased by more than its target, and lowering them whenever output or prices appeared to grow too slowly. These policies were subsequently formalised as equations during the early 1990s and became known as Taylor Rules, after John Taylor, who helped develop them.
It seemed to work. History did not end in 1983 or anytime thereafter. What followed were the worldwide stock market crashes of 1987, the collapse of the USSR, the 1997 Asian financial crisis, Russian default in 1998, the tech bubble and crash, and then the attacks of 11 September 2001, along with two wars in Iraq. The fact that the troughs and peaks associated with recession and recovery became less pronounced despite the turbulence seemed to confirm the progress macroeconomic policy had made. In hindsight it seems instead that loose monetary policy designed to mitigate negative shocks served to inflate housing prices and the size of the financial sector. The severity of the subsequent financial crisis was a consequence. And to mitigate the effects of this crisis, many Western governments have allowed public debt burdens to climb to levels not seen since the end of World War II, and central banks have tripled and quadrupled the size of their balance sheets. These are not conditions conducive for a repeat of the Great Moderation.
Michael Ben-Gad is professor of economics at City University London
Key Points
Great Moderation is used to describe the period between 1984 and the start of the financial crisis in 2007.
The high inflation and recession in the 1970s vindicated early critics of Keynesian demand management.
The relationship between the endogenous variables in our models, or the way they respond to exogenous shocks, changed during the 1980s.
