Bookblogging: Failure of the Great Moderation

Another section of the Great Moderation chapter from my book. I’m getting a lot of value from the comments, both favorable and critical, so please keep them coming.

Failure

Whether it was a real economic phenomenon or a statistical illusion, the Great Moderation, considered as a pattern of long expansions punctuated by brief and mild recessions, is clearly over. In retrospect, it was over by the time its discovery was announced in the early 2000s. The recovery from the 2001 recession was not, as advocates of the Great Moderation supposed, the beginning of a third long expansion in the United States. Rather, it was weak, short-lived and overwhelmingly driven by the unsustainable bubble in housing prices and the expansionary monetary policies of Greenspan and Bernanke. The expansion lasted only six years, and it was four years old before total employment regained the pre-recession peak. All of the employment gains of the expansion, and more, were wiped out in the first few months of the global financial crisis.

The US experience was fairly typical of the developed countries. While some, such as Australia and Canada did rather better, others such as Ireland and Iceland suffered economic meltdowns with output losses in excess of 10 per cent.

But it is not sufficient to point out the obvious fact that the Great Moderation is finished. The thinking that made so many economists willing to endorse claims that the business cycle had been tamed by financial liberalisation remains influential and is implicit in many arguments about policy responses to the Crisis. So it is important to understand why the Great Moderation hypothesis was so badly wrong.

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The dissenters

While the boom persisted, the view that the Great Moderation was the product of unsustainable policies received little attention. It was espoused only by old-style Keynesians, a relatively marginal group on the left of the economics profession, and members of the Austrian School, a fringe group on the right. While the two groups agreed in offering a negative prognosis, they differed radically regarding both diagnosis and proposed cure.

Keynesians argued that, without adequate regulation, financial instability was inevitable. This view was part of the assumed background for Keynesians of all kinds, but it was particularly stressed by the post-Keynesian school associated with the late Hyman Minsky.

Minsky focused on the instability of credit and investment processes in a market economy and argued that capitalist financial systems are inherently unstable because large swings in investor expectations tend to occur over the course of the economic cycle. He argued that in a recession, expectations are subdued. As the recovery gathers pace, profits rise and balance sheets are restored. Caution remains for a period, reflecting memories of the previous downturn. As the economy continues to grow, perhaps spurred further by technological breakthroughs or unexpectedly high rates of growth, profits are rebuilt and expectations of future growth begin to rise. Caution begins to recede. Increasingly, animal spirits are stirred and banks begin lending more freely and credit expands. Even cautious investors are encouraged to join the upward surge for fear of forfeiting profit opportunities. Momentum builds behind what Minsky referred to as the “euphoric economy.” This attracts highly leveraged asset speculators–Minsky called them “Ponzi financiers”–who rely on rising asset prices to service debt and who drive the market further upward. Increasingly, the market is dominated by speculation about sentiments and movements in the market rather than about fundamental asset values.

Minsky’s work became a standard namecheck for Keynesians writing about financial crises past, present and future. For example, Charles Kindleberger used Minsky’s model as the basis for his study Manias, Panics, and Crashes, declaring that “the model lends itself effectively to the interpretation of economic and financial history. In my own work with political scientist Stephen Bell, I noted that the main obstacle to broader acceptance of Minsky’s work was the lack of a formal derivation from microeconomic foundations (see Ch …) and concluded that ‘Another significant cycle of asset price movements, especially in one of the major economies, could see a fundamental revision of thinking about the costs and benefits of liberalized financial systems.’

While Keynesians argued that instability is inherent in weakly regulated financial systems, economists of the Austrian school generally claimed that the business cycle was the product of government intervention, and particularly of central banking. This view was derived from the work of Friedrich von Hayek and Ludwig von Mises, economists who were literally Austrians by birth. But if the Austrians agree on the evils of central banking, they disagree on almost everything else. Some, endorsing the judgement of the mainstream economists who awarded Hayek the Nobel prize in economics, see him as having far surpassed the initial contributions of his teacher von Mises. Others see von Mises as the true source, and his American student Murray Rothbard as his intellectual heir.

The disagreements don’t stop there. Some Austrians, despite generally rejecting government, favor a government-enforced gold standard and the prohibition of fractional reserve banking (the system by which banks lend out most of the money deposited with them, retaining only a fraction to meet the needs of depositors who wish to withdraw their funds). Others advocate ‘free banking’ with no government role of any kind, a position which is perhaps more intellectually consistent, but somewhat undermined by the observation that free banking systems have been tried and failed (the 1890s boom and bust in Australia is a particularly clear-cut example.

Whatever their disagreements and theoretical limitations, Keynesians and Austrians mostly got it right as regards the bubble economy of the decade leading up to the crisis. This is not to say that they predicted the timing and course of the crisis in detail. It is in the nature of bubbles that their bursting is unpredictable and has unpredictable consequences. Even the most accurate prophets, such as Nouriel Roubini of the Stern School of Business focused more on international imbalances and unsustainable housing prices rather than on the largely opaque superstructure of financial transactions that financed and magnified these imbalances.

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Was there really a Great Moderation?

The abrupt end to the Great Moderation raises anew the question of whether it was a real phenomenon or an over-optimistic interpretation of the data. Even when the Great Moderation was generally accepted, it was not the only interpretation put forward. In a paper published by the Brookings Institute in 2001 Olivier Blanchard of MIT and John Simon of the Reserve Bank of Australia argued that the data implied a long-term decline in volatility since the 1950s, interrupted temporarily in the 1970s and early 1980s.

Although this interpretation fitted the data as well as the standard view, it was not widely accepted.The reason is obvious enough. A statistical test suggesting that the economy was much more volatile in the 1950s and 1960s than in the 1990s is hard to accept in view of the actual experience of the postwar boom as a period of strong growth and low unemployment. If measures of volatility contradict this experience, the obvious response is to suggest that they must not be measuring the right thing.

But if data on quarterly volatilty can so easily be used to derive results that are so obviously problematic, this must cast doubt on their use to support the standard Great Moderation story. It is therefore worth looking more closely at the measures and their interpretation.

The first difficulty with a focus on the volatility of output growth is that it takes no account of changes in the average rate of economic growth. Looking at US growth rates, for example, the standard deviation of the rate of economic growth was 2.0 per cent in the 1960s, as compared to 1.5 percentage points in the 1990s. This seems to support the usual story suggesting a decline in volatility

But the average rate of output growth was 4.3 per cent in the 1960s, and only 3.0 per cent in the 1990s. So, expressed relative to the average growth rate, volatility was actually lower in the 1960s.

A second problem is that quarterly volatility measures are sensitive to relatively short-term fluctuations (in the statistical jargon, this is called high-frequency volatility). The same is true of the NBER measure which defines a recession as a downturn lasting a few quarters. These measures have their advantages, but they miss some critical features of the cycle.

Although the post war boom was characterised by relatively frequent recessions these recessions were not felt as being particularly severe because they were typically followed by rapid and strong recoveries – they had to be, given the high average rate of economic growth.

The recoveries following the recessions of 1990-91 and 2001 were different, so different that the term ‘jobless recovery’ was coined to describe them. Well after output had begun to recover, employment kept falling and unemployment kept rising. In each case the recovery in output was sufficient to constitute a recovery according to the popular ‘negative growth’ definition, and also according to the somewhat broader criteria used by the NBER. But to the average person, the early years of these expansions felt much like recessions.

President George HW Bush was among the first casualties of the new-style business cycle. By the time of the 1992 US election, the economy was about 18 months into an expansion, according to the standard measures. But Bill Clinton, campaigning on the slogan ‘It’s the economy, stupid’ was able to capitalise on the actual experience which was that of continuing depressed conditions.

The same experience was repeated after the 2000 recession.

The jobless recovery phenomenon was not confined to the US. In Australia, for example, the economy went into recession in 1989 and, on the standard measures, began a renewed expansion in 1990. But unemployment peaked at … in … and did not regain its 1989 levels until … , … years into one of the longest expansions on record.

As in the US, … The Labor government that had presided over the recession managed to scrape back into office in 1993. By 1996, with an expansion more than five years old, and unemployment rates finally declining, Labor hoped to be rewarded for the recovery. But the opposition parties judged the public mood more accurately, arguing that ‘five minutes of economic sunshine’ was no reward for what was popularly perceived as a multi-year recession.

But if the standard measures of quarterly volatility did not match the experience of workers in general, they fitted very neatly with that of participants in financial markets. For these groups the recessions were periods of severe les

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Individual and aggregate volatility

Economic analysis of the Great Moderation showed a striking paradox. Even though economic aggregates appeared to be more stable than at any time in the past, individuals and families experienced ever-increasing risk, volatility and instability. Risk has, it seems, increased in every dimension. Income inequality has grown substantially, in part because income mobility has increased, but also because lifetime income has become more risky. Short term variability in income has also increased.

This is a surprise. Since aggregate income Is just the sum of all individual incomes, it would seem that an increase in individual risk should translate into an increase in the riskiness of aggregate income, even allowing for the fact that some gains and losses will cancel out.

Economic analysis of the paradox came to the conclusion that the development of financial markets had weakened links between economic variables such as income and consumption. Faced with a decline in income, households could borrow to maintain their consumption levels. As a result, the flow-on impact of a shock in one sector of the economy to consumer demand for the economy as a whole was reduced. This meant that high levels of volatility in individual incomes could co-exist with aggregate stability.

But, was such a pattern sustainable? If variations in income are transitory, then borrowing to maintain living standards through a rough patch makes sense. But responding to a permanent decline in income by going into debt is a recipe for disaster. And it’s obviously difficult to tell in advance whether an income decline is going to be temporary or permanent.

Not surprisingly, as income volatility increased, so did the number of people who got into trouble by relying on borrowing. The most direct measure is the number of people filing for bankruptcy. This has increased in most English-speaking countries, but nowhere more than in the United States. In the early years of the 21st century, more than 2 million people declared bankruptcy every year. In fact, in these years, Americans were more likely to go bankrupt than to get divorced. The commonest immediate causes of bankruptcy were job losses and unexpected health care costs. But the underlying cause was a culture of indebtedness which meant that most people who experienced financial stress rapidly ran into trouble meeting existing commitments.

In 2005, the credit card industry hit back at the rising bankruptcy rates with the Bankruptcy Abuse Prevention and Consumer Protection Act, which put a number of obstacles in the path of people seeking to resolve their debt problems through bankruptcy. In the year before the law came into effect, over two million households rushed to file. In the months immediately following ‘reform’, bankruptcies dropped almost to zero, and remained well below those of the pre-reform period for several years. But the pressures of increasing debt meant that many people had no choice but to negotiate the newly established obstacles to declaring bankruptcy, and the numbers doing so gradually increased.

The onset of the financial crisis was initially reflected more in foreclosures than in bankruptcies. Most mortgages in the US are (legally in some states and de facto in others) non-recourse, which means that, after foreclosing on the house offered as security creditors cannot go after the other assets of the borrower. This means that, even if a foreclosure yields far less than the amount owed, the borrower’s obligations are discharged. For this reason, as long as the crisis was primarily confined to housing markets, bankruptcy rates rose only gradually. But, with the onset of high unemployment, and the end of easy access to credit of all kinds, bankruptcy rates soared in early 2009. It now seems likely that the number of bankruptcies in 2009 will be more than 1.5 million, exceeding all previous years, except for 2005 when people were rushing to beat the deadline of bankruptcy reform.

Despite the volatility of individual income, and the risks of relying on credit markets, economists focused on macroeconomic aggregates continued to celebrate the Great Moderation right through 2007. 2008 came as a rude shock.

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The GFC

The Great Moderation has vanished with surprising rapidity, though in retrospect its unsustainability has been evident since the late 1990s.

Bernanke’s Great Moderation hypothesis was not the first claim that the business cycle had been tamed, and it is unlikely to be the last. Every sustained period of growth in the history of capitalism has led to the proclamation of a New Era, in which full employment and steady economic growth would continue indefinitely. None of these proclamations has been fulfilled.

But, even by the unexacting standards of past economic projections, the Great Moderation has been one of the more spectacular failures. The Golden Age of Keynesianism lasted three decades, and delivered big increases in living standards throughout the developed world.

By contrast, the Great Moderation in the US didn’t really begin until the end of the first Bush recession in the early 1990s, and almost collapsed in the dotcom crash of 2000. It was only the reckless monetary expansionism of Bernanke’s predecessor, Alan Greenspan, that reinflated the bubble economy of the 1990s, and paved the way for an even more disastrous crash a few years later.

It is clear that the global economy is undergoing a severe recession, which will generate a substantial increase in the volatility of output. But even the economy recovers in 2010, as is suggested by some optimistic forecasters, crucial elements of the Great Moderation hypothesis have already been refuted. Over the period of the Great Moderation, all the major components of aggregate output (consumption, investment and public spending) became more stable. By contrast, any recovery will be the result of a massive fiscal stimulus, with a huge increase in public expenditure (net of taxes) offsetting large reductions in private sector demand.

The crisis has also invalidated most of the popular explanations for the Great Moderation. As will be discussed in more detail in Chapter …, the idea that improvements in monetary policy have been a force for economic stabilization looks rather silly, now that a crisis generated within the financial system has brought about a crisis against which the standard tools of monetary policy, based on adjustments to interest rates, have proved ineffective.

It is to the credit of central banks that, when their standard tools failed, they were willing to adopt more radical measures such as quantitative easing (that is, printing money and using it to purchase securities such as government bonds and corporate paper). Such radical steps, which contrast sharply with the passive response to the financial shocks of the Great Depression, have helped to prevent a complete meltdown of the financial system. But willingness to abandon failed policies does not change the fact of failure.

But if the pretensions of central banks have been shaken, those of financial markets have been utterly discredited. There is now no reason to give any credibility to the view that financial markets provide individuals and households with effective tools for risk management. Rather, in aggregate, the unrestrained growth of financial markets has proved, as on many past occasions, to be a source of instability and not a stabilising factor.

Just as the failure of the efficient markets hypothesis has destroyed much of the theoretical basis of the policy framework dominant in recent decades, the collapse of the Great Moderation has destroyed the pragmatic justification that, whatever the inequities and inefficiencies involved in the process, the shift to economic liberalism since the 1970s delivered sustained prosperity. If anything can be salvaged from the current mess, it will be in spite of the policies of recent decades and not because of them.

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China and India

In the wake of the GFC, some advocates of economic liberalism have sought to shift the ground of debate, arguing that, whatever the impact of financial globalisation on developed countries, it has been hugely beneficial for India and China which, between them, account for a third of the world’s population.

There are all sorts of problems with this argument.

The relatively disappointing economic performance of China and India in the postwar decades certainly provides strong grounds for criticising the economic policies of Mao Zedong and Nehru. But even in the days when some observers saw these policies as providing an appropriate development path for the countries that adopted them, no one seriously proposed their adoption by developed countries. And as more attention has been focused on the irrational aspects of these policies (such as the Great Leap Forward, in which people were made to melt down their cooking pots to provide scrap for backyard smelters, which presumably produced new cooking pots, or the dozens of licenses required to undertake the simplest economic activity in India) it has become easier to understand why their removal or relaxation

At the same time, neither of these rapidly-growing economies come anywhere near meeting the standard description of a free-market economy. China still has a huge state-owned enterprise sector, a tightly restricted financial system and a closely managed exchange rate. India began its growth spurt before the main period of market liberalisation and also retains a large state sector. In both countries, as earlier in Japan and South-East Asia, the state has played a major role in promoting particular directions of development.

In summary, while the development success stories of China and India, and, before them of Japan and the East Asian tigers, may have some useful lessons for countries struggling to escape the poverty trap, they can tell us nothing about the relative merits of economic liberalism and social democracy.