Central Banking and the Great Moderation

For Project Syndicate: Central Banking and the Great Moderation by Brad DeLong:

http://www.businessday.co.za/articles/topstories.aspx?ID=BD4A507305 IT HAS been 20 years since Alan Greenspan became chairman of the US Federal Reserve. The years since then have seen the fastest global average income growth rate of any generation, as well as remarkably few outbreaks of mass unemployment-causing deflation or wealth-destroying inflation. Only Japan’s lost decade-and-a-half and the hardships of the transition from communism count as true macroeconomic catastrophes of a magnitude that was depressingly common in earlier decades. This “great moderation” was not anticipated when Greenspan took office.

US fiscal policy was then thoroughly deranged — much more so than it is now. India appeared mired in stagnation. China was growing, but median living standards were not clearly in excess of those of China’s so-called “golden years” of the early 1950s, after land redistribution and before forced collectivisation turned the peasantry into serfs. European unemployment had just taken another large upward leap, and the “socialist” countries were so incompatible with rational economic development that their political systems would collapse within two years. Latin America was stuck in its own lost decade after the debt crisis at the start of the 1980s.

Of course, the years since 1987 have not been without big macroeconomic shocks. America’s stock market plummeted for technical reasons that year. Saddam Hussein’s invasion of Kuwait in 1991 shocked the world oil market. Europe’s fixed exchange rate mechanism collapsed in 1992. The rest of the decade was punctuated by the Mexican peso crisis of 1994, the east Asian crisis of 1997-98, and troubles in Brazil, Turkey, and elsewhere, and the new millennium began with the collapse of the dotcom bubble in 2000 and the economic fallout from the terrorist attacks of September 11 2001.

So far, none of these events — aside from Japan starting in the early 1990s and the failures of transition in the lands east of Poland — has caused a prolonged crisis. Economists have proposed three explanations for why macroeconomic catastrophes have not caused more human suffering over the past generation. First, some economists argue that we have just been lucky, because there has been no structural change that has made the world economy more resilient.

Second, central bankers have finally learned how to do their jobs. Before 1985, according to this theory, central bankers switched their objectives from year to year. One year, they might seek to control inflation, but the previous year they sought to reduce unemployment, and next year they might try to lower the government’s debt refinancing costs, and the year after that they might worry about keeping the exchange rate at whatever value their political masters preferred.

The lack of far-sighted decision-making on the part of central bankers meant that economic policy lurched from stop to go; to accelerate to slow down. When added to the normal shocks that afflict the world economy, this source of destabilising volatility created the unstable world before 1987 that led many to wonder why somebody like Greenspan would want the job.

The final explanation is that financial markets have calmed down. Today, the smart money in financial markets takes a long-term view that asset prices are for the most part rational expectations of discounted future fundamental values. Before 1985, by contrast, financial markets were overwhelmingly dominated by the herd behaviour of short-term traders, people who sought not to identify fundamentals, but to predict what average opinion would expect average opinion to be, and to predict it before average opinion did.

When I examine these issues, I see no evidence in favour of the first theory. Our luck has not been good since 1985. On the contrary, I think our luck — measured by the magnitude of the private sector and other shocks that have hit the global economy — has, in fact, been relatively bad. Nor do I see any evidence at all in favour of the third explanation. It would be nice if our financial markets were more rational than those of previous generations. But I don’t see any institutional changes that have made them so.

So my guess is that we would be well-advised to put our money on the theory that our central bankers today are more skilled, more far-sighted, and less prone to either short-sightedly jerking themselves around or being jerked around by political masters who unpredictably change the objectives they are supposed to pursue year after year. Long may this state of affairs continue.

Comments

[Meh]

I think you're missing the effect of various wars on economies. Looking at patterns of warfare gives the first theory quite a lot of backing.

[Matthew Saroff]

Actually, I disagree.

What has happened is that inflation has been redefined by hedonic* calculations, so the numbers are lower, and as a result, central banks do less, and hence screw things up less.

*Hedonics says that better products (faster computers) mean that you are getting more for less. I think that they are bull$%#@. They don't correct for the crappy soda now made with corn syrup.

[Ivan Kitov]

Even simple quantitative analysis can demonstrate that the role of central banks in managing inflation effectively close to zero. Some distinct illustrations are available at
http://inflationusa.blogspot.com/2007/07/what-is-driving-force-of-inflation-and.html

In any case, words never were enough to prove any actual influence of monetary authorities on inflation.

[Mike]

MY 'theory' about that is: Greenspan (wittingly or not) 'engineered' a (politically expedient) way to 'pawn' our national 'nestegg(s)' to the world (and) 'the market(s)' haven't yet 'discovered' America's 'natural' public, trade and/or personal debt 'limit(s)'...

mailto:ditherous@yahoo.com

[anne]

"First, some economists argue that we have just been lucky, because there has been no structural change that has made the world economy more resilient."

Alan Greenspan however argued repeatedly that from 1980 on the American economy first and world economy second were becoming more resilient. I completely agree.

Where Mark Toma would record the great moderation from March 1984, I would take it to somewhere in the summer of 1982. I do not have my notes handy, but I think I traced the change to end July - beginning August 1982.

By March 1984, we were almost 2 years in on wild bull markets in stocks and bonds in America, Europe and Japan. This suggests to me that Alan Greenspan is right, and the moderation was shadowed by American structural changes from the beginning of the decade. Then, Paul Volker changed inflation expectations and the change became evident to investors. Warren Buffett also wrote somewhere that the American economy changed structurally from about 1980.

[anne]

About the beginning of the 1980s, there were important financial innovations. Just about this time investors came to understand the principle of duration in bonds, which radically changed the nature of risk control for institutional investors in bonds.

Vanguard took immediate advantage of duration control and bond investing was revolutionized in a transparent way. Also, as Warren Buffett wrote Freddie Mac and GNMA mortgage bond packages come to market in another revolution.

What more can be thought of?

[anne]

I would only argue with the dating of the change. In the beginning of the 1980s, Fidelity revolutionized stock investing by dramatically lowering costs and publicizing Peter Lynch of Magellan. Vanguard already was indexing at far lower cost, but the advantage was perceived slowly as John Bogle has written. Indexing catches on only by 1982-1983, though beginning in 1976.

Still, Vanguard had put insurance company bond portfolios to shame by 1982-1983 and with Fidelity the mutual fund era was come and insurance company era in decline.

Heck, the below investment grade bond market was in place in 1981.

[anne]

Another memory is John Bogle telling us in lecture of losses in municipal bonds funds run by Citibank before 1980 that ran 20% a year. Vanguard showed what duration was and how to control duration in a portfolio, at minimal cost, and bond investing was revolutionized for professionals and retail investors. There would be no more 20% losses in any decent bond portfolio. But, that meant access to capital for investment grade companies was changed dramatically.

[Bruce Wilder]

"central bankers today are more skilled, more far-sighted"

ah, the born technocrat speaks

first, humans discovered that a central bank was needed.

then, humans discovered that deflation to maintain a "hard money" gold standard was a bad idea.

then, humans discovered that inflation could accelerate, and this was a bad idea.

then, humans discovered that inverting the yield curve is a bad idea.

oh, wait, central bankers have not discovered that last one, yet.

So, yeah, even economists and central bankers, learn, eventually. And, the knowledge that maintaining a steady, positive rate of inflation is a good policy is valuable, even if it did take 300 years of bad experiences.

[Mark Thoma]

To clarify, this is repeated from a comment on my blog (from me):

For the U.S., many mark the date of the onset of the Great Moderation very specifically - March 1984 - though not all agree it's this sharp of a break, and the break point varies across countries.

Here's a graph

http://economistsview.typepad.com/economistsview/2006/01/what_explains_t.html

...

[Update: See, for example, Ramey and Vine: "Interestingly, statistical tests point to a structural break in the first quarter of 1984 rather than to a gradual decline. The phenomenon also appears to extend beyond U.S. borders. Blanchard and Simon (2001) and Stock and Watson (2003a) show that all G-7 countries save Japan have experienced a decline in volatility in recent periods, though the timing and nature of the declines vary by country."] Links to this and other papers here:

http://economistsview.typepad.com/economistsview/2007/07/brad-delong-hat.html

[Craig Nelson]

I do think there has been a institutional change in financial markets with the rise of mutual and hedge funds. I also would guess that the more conservative institutional investors, e.g. pension funds, may have recognized and acted upon the puzzle of the equity premium; the number of underfunded pension funds has increased.

Whether this shift towards those investing for others instead of themselves has made the market more rational or how one would quantify rationality or whether rationality accompanies stability, I haven't a clue.

[Craig Nelson]

A second structural change in the financial markets is the advent of program trading.

[Mike]

...But it's a mixed picture. The good news is Greenspan(& Co.)'s (corporate, political AND academic) contemporaries didn't have to live in the 'real' world, American 'consumers' got to enjoy a bunch of cheap (imported) stuff, our stock market(s) soared and (a few) people made a lot of money. The bad news is 'we' are in debt up to our ears, our infrastructure has been (mostly) neglected, (much of) those sectors of our industrial base which aren't obselete (and/or lethal) have been 'offshored', the fabric of our social/economic life has been shredded, our politics have been thoroughly debased, and someday somebody's gonna have to live with the economic, environmental AND ethical consequences of our so-called 'moderation'.

mailto:ditherous@yahoo.com

[anne]

Following Mark Thoma and Brad DeLong, whenever we date the great moderation, I have often asked and received no reasonable answer as to how many pension funds have performed so poorly these last 25 years through an astonishing extended bull market in stocks, bonds and commercial real estate. What am I always missing?

[knzn]

"Our luck has not been good since 1985. On the contrary, I think our luck — measured by the magnitude of the private sector and other shocks that have hit the global economy — has, in fact, been relatively bad."

If you're talking about demand-side shocks, that may be true, but the relevant good luck has not been on the demand side. And it has been more a question of the direction, rather than the magnitude, of the supply shocks. By almost anyone's account, the NAIRU has fallen significantly since the 1980s, and the productivity growth rate has risen.

It's not so much that we've had good luck since the 1980s, but that we had bad luck in the 1970s. The 60s were not so bad, and to the extent that the 50s were, I would attribute the problems to the great importance of the relatively volatile manufacturing industry, which has become less important in the subsequent years. Not to say that policy is irrelevant, but I think the conventional view (and your view) exaggerates the amount of additional progress that has been made over the past 50 years.

[Ben Ross]

I question the plausibility of the second explanation on what you might describe as mathematical or physical grounds. (Since I'm a physicist by training I'd prefer the latter description.)

When a system is unstable, even a very small fluctuation will trigger its runaway. (Yes, modern electronics has noise suppression systems that can overcome this, but the precision of corrective actions this requires is far, far beyond any conceivable capability of a central banker.) Stability depends on whether the response of a system to shocks is to magnify them or to damp them, not on the size of the shocks. Yes, a stupid central banker (of which there have been examples) can destabilize a stable system by reacting in the wrong direction. But stabilizing something that's unstable is much harder.

I'd suggest looking into a fourth explanation - that the willingness of the Chinese government (and others in east Asia) to accumulate surpluses and loan them back to the U.S. government has been the stabilizing force. This phenomenon has weakened many of the feedback relationships among prices, interest rates, aggregate demand, fiscal policy, etc. As a general matter, it's feedback that causes instabilities, so when you have less feedback you get more stability.

[Dean Baker]

This one looks like playing tennis with the net down. Who is "we" here and what is the basis of comparsion? Certainly Latin America did horribly over this period as did the countries of the former Soviet Union (although Russia is now rebounding strongly). The huge growth in China and india is impressive, but this is the work of Alan Greenspan?

In terms of the U.S./Europe we had a very bad stretch from the 1973 to the dating of the great moderation, but if we take twenty year periods, growth in the U.S. Europe was certainly greater in the period from 1963 to whatever end date is chosen than in the last twenty years.

Finally, we are sitting on huge imbalances in the form of an unsustainable trade deficit and a housing bubble. My bet is that the adjustment will not be pretty. I know that our central bankers like to say that preventing asset bubbles is not part of their job description, but we usually don't let the workers define the job. The economic damage caused by asset bubbles and their collapse swamps the damage from modest increases in the rate of inflation. If our central bankers don't feel competent to deal with asset bubbles, then they should be replaced by people who do.

[anne]

Dean Baker's argument becomes clearer when thinking of the steady flow of financial disruptions from 1987 on; from the short-lived stock market crash in 1987 to the commercial bank collapses to European currency attacks to derivatives losses in 1994 to Maxican devaluation that year and on and on.

Notice however how smoothly the disruptions were handled or passed through. I have mixed opinions about the moderation, but am inclined to agree with Brad DeLong.

[Matt]

I don't understand why Japan's "lost decade and a half" is cited as one of the rare recent examples of a macroeconomic "crisis." Japan remaind a rich country throughout the period. And it was getting richer: GDP growth averaged above 1 percent during what was admittedly a period of stagnation, for per capita growth of maybe 0.7 or 0.8 percent. (Japan's population was still growing until recently.) Unemployment never got very high. True, there were worries that the broken banking system would spark a systemic international crisis, but it never happened. Macro policy was bad--it was never politically possible to make the structural reforms that would have ended the period of stagnation sooner. But Japan showed just how much a rich country can get away with.

[George J. Georganas]

Maybe 1982 or 1984 is the starting year of the "great moderation", but one needs to explain not only the start but why it continued, once it got going.
In my view, the decline in the frequency and intensity of warfare worldwide and the entry of huge numbers of people in the worldwide division of labor (ex-Communist block, the developed parts of China and India and Brazil) must take the credit for the great moderation. Surely, the real risks in a world in which 40% of world population is in the "market system" are much lower than in a world in which 15% of the world population is in the market system. Intelligent economic policy-making or at least mistaken-but-concerted economic policy-making by central banks, governments and supra-national entities (EU, IMF) has helped but was not the critical factor.

[JonF]

Re: When a system is unstable, even a very small fluctuation will trigger its runaway.

Some very complex systems however remain remarkably stable even in the face of major shocks. Living organisms come to mind. There are even some simple systems where this is true: bicycles topple over readily when at rest, but need a fairly substantial force (or torque) to knock them over when they are in motion (due to the moment of inertia associated with angular momentum). Perhaps the economy has reached a stage of complexity where it too needs something overwhelming to knock it out of kilter.

[Ben Ross]

Jon- A motionless bicycle is quite stable when it's lying on its side. It's only unstable when upright. Complex systems too can be stable or unstable.

My point (or rather my starting point) was this: When you see a system run away from equilibrium or enter a large-scale oscillation, you can often identify some initial shock that triggered it. But you can't ascribe the presence or absence of runaway/oscillatory behavior to the presence or absence (or suppression by the intervention of brilliant central bankers, cyclists, or electrical engineers) of shocks - there will always be small random fluctuations. You need to look at the overall stability of the system - whether it amplifies or damps out these small fluctuations.

The amplification of fluctuations is due to feedback, so more often than not, systems will tend to become more stable if you reduce the amount of feedback. But it's certainly possible for complicated systems with a lot of feedback to be stable. Living things are a good example, where feedback (homeostasis) is arranged for stability - evolution has very strongly selected for stability which is almost synonymous with survival.