Was The Great Moderation Worth The Cost?

Once upon a time, not too long ago, policymakers of every stripe were literally dislocating their shoulders patting themselves on the back for having tamed the beasts that afflict economies from time to time. The phenomenon knows as the Great Moderation was thought to have become the new economic paradigm promising a world of near constant growth in which central bankers and political operatives would quickly extinguish any deviation from the desired mean.

Sources and causes of the Great Moderation were much debated and its birth and success had many inventors. No less a luminary than Ben Bernankein a 2004 speech validated the existence and benefits of it. Mr. Bernanke did not attempt to question its reality, staying power or implications, rather he spent his time trying to argue that monetary policy was a major reason for the Great Moderation:

Explanations of complicated phenomena are rarely clear cut and simple, and each of the three classes of explanations I have described probably contains elements of truth. Nevertheless, sorting out the relative importance of these explanations is of more than purely historical interest. Notably, if the Great Moderation was largely the result of good luck rather than a more stable economy or better policies, then we have no particular reason to expect the relatively benign economic environment of the past twenty years to continue. Indeed, if the good-luck hypothesis is true, it is entirely possible that the variability of output growth and inflation in the United States may, at some point, return to the levels of the 1970s. If instead the Great Moderation was the result of structural change or improved policymaking, then the increase in stability should be more likely to persist, assuming of course that policymakers do not forget the lessons of history.

My view is that improvements in monetary policy, though certainly not the only factor, have probably been an important source of the Great Moderation. In particular, I am not convinced that the decline in macroeconomic volatility of the past two decades was primarily the result of good luck, as some have argued, though I am sure good luck had its part to play as well. In the remainder of my remarks, I will provide some support for the “improved-monetary-policy” explanation for the Great Moderation. I will not spend much time on the other two classes of explanations, not because they are uninteresting or unimportant, but because my time is limited and the structural change and good-luck hypotheses have been extensively discussed elsewhere.5 Before proceeding, I should note that my views are not necessarily those of my colleagues on the Board of Governors or the Federal Open Market Committee.

Ah, hubris.

As we now know, the Great Moderation was not meant to last. In fact it has turned to ashes before our eyes in such a blur of speed that one is left to wonder if it ever existed. Indeed it did exist and it may well have been the worst thing that ever happened to us.

Since the Great Depression the economies of the world tended to go through boom and bust phases. Despite downturns, sometimes severe, growth continued on an upward trend line. Sometime in the mid-80’s the U.S. and the world in general embarked on a growth phase seldom witnessed before. Though downturns, severe enough to be classifies as recessions in a couple of cases, occurred they tended to be shorter and inflict far fewer casualties than was previously the case. Each downturn was met with agressive monetary and fiscal policy responses. Each time the medicine was well tolerated by the patient and a remarkable recovery ensued.

The problem wasn’t so much that the patient survived but that the patients survived-almost all of them. For an economy is a collection of economic units and not all are meant to live forever. Past downturns exacted a toll. The weakest economic units fell by the wayside and the pain of their demise was tolerable, uncomfortable, but tolerable. When we began aggressively controlling economic contractions, we also began sparing those that probably should have passed into history.

As this great wave of growth and prosperity rolled on and on it carried the weak with it and also infused men and women with a certain sense of omnipotence. Failure was assumed to no longer be an operative outcome and with no fear of failure, fear of risk diminished to the vanishing point. Both strong and weak alike embraced risk with a fervor.

Then the music stopped. Not only did it stop but all of the pent up weakness and risk that the Great Moderation had fostered or hidden were exposed obscenely. The economy which has for so long protected those that did not deserve protection crumbled and the terminally ill, stripped of their life support, have begun to exhibit end of life symptoms. “Creative destruction” is once again trying to have its way with the economy.

Unfortunately, unleashing that useful weapon might not work this time. For the Great Moderation has kept so many alive and inspired so much excessive risk taking that the normal purge seems not to be an acceptable outcome. Auto companies in the U.S., marginal small exporters in China, banks that forgot the basics should all probably be left to their own devices and fail when necessary. Yet the scope of the danger posed by what some are beginning to call the Great Recession makes significant failure unacceptable.

Politically, the prospect of massive business failures in the midst of such a downturn is not tolerable. Economically, those business failures could easily turn a nasty recession into a full fledged depression. So the necessary cleansing takes a back seat to economic survival. Recovery will come but dragged along will be those who should not have survived. The auto companies will be back in probably a short period of time for more help, Citibank will line up at someones window for another bailout and those Chinese exporters will continue as wards of the state.

It is hard to argue in favor of recessions. Maybe it’s more appropriate to argue that we need to take less heroic actions to stave them off, admit that there is some good that comes from culling the weak from the herd, protect the most vulnerable and accept a little bit of discomfort. The Great Moderation was a hell of a ride but the end of that ride is seemingly dangerous. It probably wasn’t worth it.

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