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.