Understanding the Lesser Depression

*J. Bradford DeLong, U.C. Berkeley, September 2011

(2) The Great Moderation

2.2 The Great Moderation:

Accounting for the Great Moderation

Why was the civilian adult employment-to-population ratio so close to its ten-year trailing moving average during the Great Moderation? It was not that there was anything odd or unusual about employment as a measure: other attempts to estimate macroeconomic business-cycle volatility found equally-strong evidence of an equally-large Great Moderation as well.

There were in the mid-2000s three lines of argument for why the Great Moderation had taken hold starting in the mid 1980s.

The first line of argument was that America’s central bank, the Federal Reserve, had finally learned how to do its job well. Under this interpretation, before the mid-1980s Federal Reserve policymakers, because of a combination of short-sightedness, committee group dynamics, and political pressure, oscillated between periods in which it pursued full employment without looking down the road at the effect of its policies on inflation, and periods in which it fought inflation and tried to create excess supply to break cycles of inflationary expectations with little regard for the effects of its policies on employment and capacity utilization. But, on this interpretation, after the Volcker disinflation of the early 1980s the Federal Reserve began to get it right. It now looked forward into the future, and made monetary policy with its eyes not on what inflation and unemployment were now but with its eyes on what inflation and unemployment were likely to be two or more years into the future.

On this interpretation, the Great Moderation was likely to be a permanent result of institutional learning and also of effective institutional independence. After the 1970s both members of congress and presidents concluded that applying pressure to the Federal Reserve was likely to be a political and policy loser, and that the best strategy was simply to repeat that the Federal Reserve was a trusted independent agency charged with making monetary policy judgments. Thus political pressure that may have previously resulted in the stop-go cycles of the late 1960s, 1970s, and early 1980s was removed. In addition, the volatility of the 1970s taught every potential member of the Federal Open Market Committee the importance of taking a relatively long view. And a couple of strong and dominant chairs in the mold of William McChesney Martin in the 1950s and 1960s—Paul Volcker and Alan Greenspan—could both take the long view and enforce their vision of the long view on the FOMC and on the Federal Reserve Board.

There was, however, a second line of argument. It was that the Great Moderation was less the product of better government regulation of the economy by the central bank and more the product of financial deregulation and the growth of more sophisticated financial markets. More sophisticated financial markets allowed both households and businesses to properly smooth spending—to react to an economic downturn not by slashing their consumption and investment spending but by either drawing down financial assets that they had built up during a previous boom or to borrow against earnings that they would make in a future boom. In the pre-1980s world in which the ability of financial institutions to take risks was constrained borrowing and investing were significantly harder. But, this line of argument went, the shift away from tight New Deal financial regulation to a greater tolerance for experimentation and innovation had paid dividends in a substantially reduced size of the business cycle.

The third line of argument was simply that the Great Moderation was due to the absence of major disturbing shocks. Between 1965 and 1980, the argument went, the world economy had been buffetted by an unusually large number of disasters. First came the inflation of the Vietnam War and President Lyndon Johnson’s failure to raise taxes to finance the war, then came the breakdown of the Bretton Woods system of international finance, third came Richard Nixon’s desperate drive for a more inflationary monetary policy to increase his chances for reelection in 1972, which was then followed by the Yom Kippur Arab-Israeli war and the tripling of world oil prices, that was then followed by a sharp slowdown in global productivity growth (the causes of which remain mysterious, shock number six in 1979 with the Iranian Revolution and an additional tripling of world oil prices, and the series of shocks was topped off with number seven with the Latin American debt crisis of the early 1980s.

Staring in 1983, no such similar shocks hit the global economy. Thus, this line of argument went, naturally there was a “Great Moderation”. It would, advocates of this line of explanation argued, come to an end when a substantial shock once again hit the global economy.

At the time, before 2007, of these potential explanations the third seemed the weakest. The second seemed plausible as a partial explanation, but in all likelihood too small to account for the entire magnitude of the Great Moderation. That left the first: skilled monetary management by a federal reserve that understood what it was doing under the wise leadership of the Maestro, Alan Greenspan.

Events since the summer of 2007 have decisively disproved explanations (1) and (2). The Federal Reserve—and other central banks, and legislators, and executive branch officials—have been well behind the curve in their stabilization policy maneuvers since the magnitude of leveraged money-center bank exposure to the losses in low-quality mortgage investments became apparent. Financial deregulation ddi not help but rather poured gasoline on the flames, in the sense that a more tightly regulated financial system would have had much more trouble suffering the total collapse of risk management standards that took place in the 2000s. That leaves explanation (3): for nearly two decades the world economy was very fortunate.

But when Alan Greenspan retired after 17 years as head of the Federal Reserve in 2005 and the Federal Reserve Bank of Kansas City devoted its annual August conference in Jackson Hole, Wyoming to an assessment of his tenure, (3) was very much a minority opinion. The main debate was between the proponents of (1)—more skillful policy—and (2)—deeper, less tightly regulated, and more sophisticated financial markets. Only three economists at the conference strongly argued that the Great Moderation was the result of luck, and luck that might well not last: James Stock, Mark Watson, and Raghuran Rajan.