The simplest way to understand why so many economists saw a Great Moderation in the macroeconomic data is to look at recessions and expansions. Before doing this, it’s worth taking a moment to discuss how economists use the term ‘recession’.
Although it is common to describe the occurrence of two successive quarters of negative economic growth as the “technical” definition of a recession, economists rarely use this definition except as a rough guide to the current state of the economy. Rather, economists in the US generally rely on the National Bureau of Economic Research Business Cycle Dating Committee, which defines a recession as ‘is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales’ and issues judgements as to when recessions begin and end. Similar bodies in other countries make the same kind of judgement, though none has quite the authority of the NBER.
These judgements typically take place a year or so after the event, which is one reason so much attention is paid to the ‘technical definition’. A great deal of energy was expended in the course of 2008, arguing that, despite obvious signs of economic distress, the required two successive quarters of negative growth had not been observed. But in December 2008, the NBER announced that a recession had began a year earlier, in December 2007. The announcement of the end of a recession takes place with a similar delay.
Whatever the defintion, in the years before 1981 (the end of the Volcker recession) recessions in the US were relatively frequent, with the intervening expansions averaging a little over four years. The NBER Committee defined nine recessions between 1945 and 1981, two of which (those of the early 1970s and the double-dip recession of 1980-81, were both long and severe).
By contrast, the period from 1981 to 2007 was one of long expansions and short recessions as measured by the NBER. In the entire period, there were only two recessions, in 1990-91 and 2001, and each lasted only eight months. In the light of past experience of failed claims, it might seem premature to proclaim the end, or at least the taming, of the business cycle on the strength of two good cycles. However, history teaches us that we rarely learn from history, and the prevailing atmosphere of triumphalism ensured a positive reception for statistical analyses that seemed to show that the business cycle had been tamed.
The dating decisions of the NBER are inevitably somewhat subjective, and do not lend themselves to statistical analysis. As result, economists seeking statistical confirmation of the idea that the business cycle had been tamed focused on quarterly economic data. This approach was consistent with the popular idea of a recession as two quarters of negative growth.
The focus on the volatility of quarterly growth also fitted neatly with the prevailing approach to the assessment of macroeconomic policy, called the Taylor rule, after John Taylor details who first formalised it. Taylor argued that central banks should (and mostly did) seek to minimise the variance of the rates of output growth and inflation about their long-run average values.
A variety of statistical tests suggested that the volatility of economic growth rates in the US had declined sharply over the early 1980s. And the moderation was not confined to US output growth. A similar decline was observed in both the average rate of inflation and the volatility of inflation, and in the volality of employment and unemployment rates. Broadly similar patterns were observed in nearly all the main developed countries. The big exception was Japan, where a decades-long bubble in real estate and stock prices burst at the end of the 1980s, paving the way for a long period of stagnation, with occasional brief expansions punctuated by renewed downturns. At the time, though, Japan’s problems were regarded as specifically Japanese, in much the same way as the financial crisis of the late 1990s was seen as a specifically Asian problem of ‘crony capitalism’.
The discovery of the Great Moderation, and, even more, Bernanke’s imprimatur, spawned an instant academic industry. Hundreds of studies dissected the Great Moderation from every possible angle, considering alternative interpretations, causal hypotheses and projections for the future. Participants in the industry displayed the disagreements for which economists are notorious. But, as is commonly the case with specialists in any field, disputes over details concealed broad agreement on fundamentals. In particular, few, if any, writers on the Great Moderation suggested that it was approaching an abrupt end.
On to Implications