Is the Great Moderation in Danger?

Stephen Cecchetti, a top economist at the Bank for International Settlements a.k.a. the central banks' central bank, thinks so:

The past 20 years have brought extraordinary prosperity. Growth has risen the world over and this higher growth has come with a remarkable stability. Comparing the 1970s with the most recent decade reveals that the volatility of real growth in the industrialised world has reduced - the standard deviation of real gross domestic product growth has roughly halved.

Although it's a welcome development, what's actually reduced the large swings in growth (and many other economic indicators) has been a mystery to macroeconomists. The leading contenders are

• better monetary policy (guess who likes this one)
• I.T. improvements which helped businesses make quicker adjustments to production and employment
• luck in the form of fewer disruptive shocks (e.g. oil price spikes)
• financial innovations such as securitization that let consumers and businesses smooth spending

For Cecchetti, it's this last one that's been most important:

The result of the last 20 years of financial innovation is that we can insure virtually anything and engage in activities we would not have undertaken in the past. As a result growth has been more stable and business cycles have been less frequent and severe.

And he thinks that with the growing movement to increase regulation on investment banks, there's a chance that innovation will be squashed, bringing an end to the Great Moderation and the benefits that came with it.

But Cecchetti may be overstating his case. Here's why: It's been well established that productivity shocks have accounted for much of the swings in the business cycle since World War II. In a paper published last year, economists found that these shocks (i.e. bad luck) have become much less pronounced since the early 1980's. They couldn't pinpoint why this was the case but they did look at how household consumption and savings patterns have changed. They didn't find, however, as strong connection between this and the decline in the volatility of productivity.

In another recent paper from the Federal Reserve Bank of Atlanta, economists Rajeev Dhawan, Karsten Jeske, and Pedro Silos studied the link between energy prices and productivity and found that prior to the second quarter of 1982, price spikes hurt productivity (which in turn slowed the economy). But this negative effect of higher energy prices on the volatility of GDP has vanished since then, accounting for between 60 percent and 70 percent of the Great Moderation.

While it's true that over the same period we're using a lot less energy as a percentage of the whole economy, this development only accounts for only about 5 percent of the effect I just described. So, it's not simply that we're using less oil, argue the economists, but that the way oil prices affected productivity changed markedly.

What accounts for the change? One suspect, Dhawan told me, is the removal of Nixon and Carter-era price controls by President Reagan in 1981. And this might also be why the current oil price spike we're seeing (or regulation of investment banks) won't mean the end of the Great Moderation.

Comments

[deaverb:]

End of price controls. I remember when with price controls we started to get 48 ingots of aluminum for the same old price for 50. It was a simple solution for us, who needed the aluminum, and the supplier who needed the money at a fair price.

The loser? Society. This was not a "moral" issue; this was a pricing one. Turned everyone into a bazaar.

Not a zero sum game. Oil goes up; good things start to happen too: smaller cars on the road; less driving; less wear and tear on everything from cars, to streets, to people on the road, to pollution.

And finally a domestic solar business seems to have life.

Not all bad.

2008 Jun 24 08:24 AM

[Tao:]

Life is what you focus on.

There should be more control on 'necessities' such as oil. When prices get out of control, it can hurt society. It isn't just the price of oil, it is the price goes up for airline tickets because they use more expensive fuel. The price goes up for almost everything, in fact. Our forefathers knew this and regulated 'necessities, such as utilities. They were smarter than the 'greed is good' crowd.

Sure, solar will become more popular, but it should have been anyway along with windmills.

2008 Jun 24 04:33 PM

[BM1087:]

With the exception that when a few traders control the oil (corn, wheat etc..) market with no downside oil will hit 200+ a barrel and American Society will collapse. Why so the elites can add a few more billions to their piles? If we were as prepared like every other major country in the world we can adjust and make do. Have you ever seen your fellow Americans panic after a few days without Cable TV and A/C? Now just imagine $8 a gal gas.

2008 Jun 24 04:34 PM

[asagefield:]

The good thing about high oil prices is that it makes alternatives look attractive (and reasonable). The market adjusts and alternatives start making inroads and taking away oil's marketshare.

2008 Jun 24 05:37 PM

[Jason Rines...:]

While beaurocrats fought over pork tied into defense spending bills on Iraq, the world outsmarted us economically (even as i-Banks attempted to do this with deravatives). We'll have to learn to compete globally and sell the global consumer what they want to continue to grow (energy and agr and metals). While we focus on energy, this will create millions of skilled jobs here, a new global investment opportunity (especially if this is subsidized by Treasury) cost of exporting these raw materials will drop. That is what needs to be done, but will it be done before the oil shock/real estate pop/financial deleveraging crash the dollar? Good question and wish I had an answer to that one, but I will say I am preparing for that distinct black swan even possibility where a year ago I wasn't.

2008 Jun 24 06:14 PM

[Chandler Lutz:]

Nice article an comments. The argument about the financial regulation is interesting but I have never seen any evidence that a drop in financial regulation has smoothed out the business cycle. I guess arguing about the topic is pointless since the central banks must now regulate/monitor the investment banks after the bear sterns "bailout" (The fed created a moral hazard situation where after the bear sterns bailout all investment banks will believe they have access to the discount window in one form or another; hence those firms must be regulated).

Also, One thing that the author did not mention was the growth of international trade. Since the 1970s international trade has grown exponentially. I do believe that the global economy is still very much tied to the American, but look at the way many American companies have performed internationally while growth has been sluggish or negative in their home markets. Coke, Pepsi, Phillip Morris, car manufacturers, medical companies, computer companies have all seen large overseas growth. Larger markets, larger scale, larger work forces and foreign direct investment should all be included in the talk of moderation. After all, one reason inflation stayed so low over the last 20 or so years was America's ability to outsource low skill work to foreign countries. This also freed up their workforce more highly skilled jobs.

Overall, I doubt anyone could pin moderation on any one thing. In all likelihood it's probably a combination of many factors

2008 Jun 24 06:29 PM

[HARM:]

Stephen Cecchetti is of course speaking for the richest of the very rich, when he calls Easy Al & Heli-Ben's cheap money Fed, and the numerous asset bubbles it spawned, "better monetary policy".

And for the rest of us...? More --not less-- price volatility in housing, food, energy, and many other basic commodities, and a rapidly depreciating currency. Plus, an economy that functions more and more like a "winner-take-all" casino every day, which "efficiently" redistributes wealth from the bottom 90% to the top 10% --with the lion's share going to the uppermost 2%.

"financial innovations such as securitization that let consumers and businesses smooth spending"

Yeah, those subprime mortgage-backed securities and various other wondrous Wall Street "innovations" have really "smoothed out" the housing market. My local markets here (CA) are so "smooth", the median HH income cannot come even close to buying a median priced house with a sane mortgage, and foreclosure sales now outpace regular sales in many counties.

And the risks these "innovations" have caused to the entire banking system are now so large that the Fed & Congress are now openly bailing out large, well connected investment firms: Bear Stearns, TAF, Super-SIVs, new Jumbo $730k GSE loan limit, dirt-cheap 'overnight lending' rates, etc.

God Bless those Wall Street Masters of the Universe!

2008 Jun 24 07:21 PM

[fatcat:]

BS article..lets see what he says12 months from now..The great moderation is the buying power of most peoples life savings..down..

[ED: Comment moderated to remove abuse.]

2008 Jun 24 07:39 PM

[moonbat1775:]

I would absolutely love financial innovation EXCEPT it is built on a dishonest (though legal) banking system. It appears that the need for basic honesty cannot be avoided. When Obama is elected, many profits based on a dishonest system will be coughed up in the form of higher taxes.

<i>John Maynard Keynes,
you've had your fun,
but we find we're living
in your "long run".<i>

2008 Jun 24 07:57 PM

[Robespierre:]

So who really thinks that when you can control the price of a product you can't produce enough off? The solution of the oil "crisis" is on the demand side. Tax gas at the pump so people will change their behavior and buy energy efficient cars. Use the tax for mass transportation. Transform the cities into cities and not just a collection of suburbia. Very good things will come if you let oil find its price all by itself.

2008 Jun 24 08:19 PM

[AlexS:]

We don't have price controls on oil any more. Now we just have supply controls. In this case price controls and supply controls both keep us from exploiting new sources of crude. The resulting inflation will swamp the economy.

2008 Jun 24 10:55 PM

[bcncv:]

What about globalization? The jobs most likely to be lost in a recession are assembly line jobs. Since a MUCH larger percentage of end manufacturing occurs in China these days, could we have simply off-shored the parts of our economy most vulnerable to a recession?

2008 Jun 24 11:41 PM