About that Great Moderation

The Great Recession was supposed to have buried the triumphalism about the Great Moderation. Alas! As the Great Recession recedes into the past, Great Moderation self-patting is coming back. Nothing could be worse for the future of the global economy than a return to status quo policy framework that has brought so much grief over the past decade.

Broadly, there are three problems with the Great Moderation thesis:

1. To the extent there was a Great Moderation, it purchased lower volatility for a marked worsening in skew. In essence, to take analogy from ecology: in curbing brush fires policymakers have created greater potential for forest fires.

2. A substantial portion of the decline in volatility has to do with developments for which policy can hardly take credit. The global economy, and especially developed economies have increasingly shifted away from good to services. Business cycles are inherently about overproduction of stuff. Secondly, even in the goods producing part of the economy, better inventory management has eliminated the wild inventory swings of cycles past.

3. In the US context, a significant proportion of the dampening of volatility is an artefact of data collection, processing, and massaging.

Great Moderation or Worsening Skew?

The Great Moderation's claim rests on having delivered lower volatility in GDP and inflation. I going to dismiss the lower volatility in inflation because I don't think there are any great benefits to lower inflation volatility. The supposed benefits of stable inflation: 1) low cost of capital and 2) lower relative price distortion are both vastly overestimated. See Sharpe and Suarez  and Nakamura and Steinsson.

As the table below shows, during the Great Moderation era, standard deviation of quarterly change in GDP declined considerably compared with the earlier postwar period. However, note that the Skew has worsened, becoming markedly negative. A negative skew means that steep declines are more likely than suggested by a normal distribution.

As I have argued in my previous blogpost, the desire to smoothen fluctuations has led to increasing financial fragility. The recovery from each of the past three recessions has been sluggish. Although it is fashionable to dismiss the 2001 recession as mild one--employment fell for the longest period and took the longest to recover the previous peak until the 2007-2009 recession. Also, the secular decline in labor force participation among prime age workers was triggered by the 2001 recession.

Financial fragility apart, the Great Moderation era has also generally been associated with prolonged periods of slack in the labor market. Note that the unemployment rate has been above NAIRU for the majority of this period compared with the previous era. Thus, stability in inflation may well have been purchased by keeping the labor market perennially weak, in which case the low overall GDP growth during this era must also be chalked to Great Moderation policies rather than other forces that apologists are wont to do.

 

Increasing Shift to Services

One of the major reasons for lower volatility has nothing to do with great macro policies. The global economy has shifted increasingly to services--a sector that is inherently less volatile than the goods-producing sector. Moreover, inventory investment, which used to account for a significant [art of goods sector volatility pre 1980, has come down thanks to better inventory management practices, which, too, has nothing to do with better macro policies.

It is true that service sector volatility has also declined in the Great Moderation era. However, that decline in volatility has to do with increasing proportion of the services being either not market-determined--eg. healthcare, or imputed services.

Better Data or More Smoothing of Data?

One other factor that has contributed to the lower volatility in recent decades is that the source data has become less volatile--probably reflecting better data collection. data produced by the Bureau of Economic Analysis (BEA) has become significantly smoother than the source data. Consider residential improvements. The source data used to be incredibly volatile, as was the final BEA data (red line below). While the source data has become less volatile, the BEA data has become far less volatile and appears to be an attempt to smooth the source data.

Concluding Remarks

Most people are not aware of the arcane issues in data. I have often found that academic economists working with NIPA data do not fully understand all the issues. Yet, they use the same data to make pronouncements about Great Moderation and suchlike.

There is a strong tendency in some parts of the academia to revisionism--there is big industry attempting to show that the Great Depression was caused by Roosevelt's policies. So, beware. Another couple of years and Great Recession may be seen as just a blip in the vast goodness of the Great Moderation. 

Socializing Risk is Bedrock of Capitalism

A few days ago I tweeted about capitalism, fiat, gold, and cryptos. Seeing the comments, I realized the topic needed to be dealt with in long form. Essentially, the rise of capitalism has gone hand-in-hand with increasing socialization of risk--and this is not a mere coincidence. Central banking, fiat money, social insurance programs, and countercyclical fiscal policy are all intimately related to the expanded socialization of risk. Whether the greater socialization of risk is a moral/ethical is an impossible question that I don't want to get dragged into. Instead, I want to highlight the implications for investors:

1. Although the socialization of risk has had naysayers right from the beginning, every crisis has led to more, not less, socialization of risk over the past 200 years of western capitalism. Those betting on the ultimate collapse of the system--eg. gold bugs--would do well to remember this.
2. The nature of socialization has changed over the past thirty years--the era of inflation targeting and monetary policy dominance--which has profoundly changed the nature of business cycles and the statistical distribution of market outcomes.

Ha Joon Chang had an excellent op-ed in the Guardian several years ago briefly describing the history of the socialization of risk. Basically, starting with limited liability to deposit insurance, governments have enacted policies that attempt to put a floor on losses suffered by risk takers. In the parlance of finance, there is a government put on risky activity. Over time, the government put has expanded to establishing a floor on economic activity and financial markets. Central banking and automatic fiscal stabilizers are part of the expanded government put. The Gold Standard fundamentally interfered with this socialization by constraining governments' ability act in crises. Unsurprisingly, the Gold Standard fell by the wayside. Since Enlightenment, western countries have operated on the principle that man (woman) is the measure of all things and our job is to make life living on this earth (Orwell). It is our belief in our capacity to arrange our affairs and not leave it to providence that marks the radical departure from pre-Enlightenment. In that light, the gold standard is an anachronism--it denies the idea that human beings collectively can durably manage their affairs.

The moral distaste for socialization that some people have often leads them to the erroneous conclusion that such a system must fail, which is very rooted in a religious worldview. Yet such a view would serve an investor poorly.

Over the past thirty years, the nature of the government involvement has changed from establishing a floor to smoothing fluctuations. We have gone from crisis-fighting to promoting tranquility--that is, from selling a put to reducing vol. The original mandate of central banking was to act as a lender of last resort in financial crises. In the post-war era, it expanded to business cycle management. In the inflation targeting era, it has morphed into promising low volatility. Yet, the attempt to deliver low volatility--unlike the attempts to provide a floor--is self-defeating. By promising low and stable inflation, central banks have encouraged excessive leveraging. Credit investors are basically selling a straddle. If economic activity and inflation crater, they suffer losses. On the other hand, if economic activity and inflation are too hot they stand to lose as well, if not on an absolute basis at least on a relative basis. (If economic activity is strong but inflation is contained, then credit investors don't lose on an absolute basis but they fall behind equity investors.) Unsurprisingly, the inflation targeting era has witnessed explosive growth in private sector debt. Ironically, the real beneficiaries are equity investors and government bond investors. Credit investors are effectively selling a put option to the borrowers (equity holders). Lower the premium charged by credit investors, the cheaper the cost of a put for equity investors. Notwithstanding the promises of central bankers, there is a strong human tendency to overpay for lottery like payouts, which is why equity investors are loathe to give dilute their stake. Inflation targeting has made it only easier for equity holders to indulge in their biases.

Meanwhile, the explosive growth in private sector debt makes the financial system unstable and prone to deflationary bias. Even as volatility of economic activity and inflation has gone down, the skew in financial markets has actually worsened in the past thirty years. (I would argue that the skew in economic activity has also worsened but it is harder to present strong statistical evidence.) Take S&P as reported earnings. Earnings declines during recessions have become progressively worse. The same with corporate bond defaults. As a result, each crisis has accentuated safe asset demand and forced the Fed lower and lower, helping T-bond investors.

 
As Minsky said, stability leads to instability. Ashwin Parameswaran used to maintain a terrific blog, Macroresilience, He has argued that policy should aim for resilience (which I like much better than the notion of anti-fragile) not stability. Meanwhile, stability is leading to rebirth of the CDO market.