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.

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.

The major contributions of the Austrian School were made in the early 20th century by Ludwig von Mises and Friedrich von Hayek, who put forward a theory of the business cycle based on financial markets. According to the theory, the business cycle unfolds in the following way.
The money supply expands either because of an inflow of gold, printing of fiat money or financial innovations that increase the ratio of the effective money supply to the monetary base. The result is lower interest rates. Low interest rates tend to stimulate borrowing from the banking system. This in turn leads to an unsustainable boom during which the artificially stimulated borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas that would not attract investment if price signals were not distorted. A correction or credit crunch occurs when credit creation cannot be sustained. Markets finally clear, causing resources to be reallocated back towards more efficient uses.

This theory was a pretty big advance at the time it was put forward, when the standard classical theory suggested that depressions should not occur and, if they did, would rapidly fix themselves. But it lacked a number of key elements. By focusing on misallocation of capital, it ignored the most obvious feature of the business cycle - massive unemployment of labour. And it had radical implications that were largely overlooked by its proponents. If considered carefully, it implied a rejection of the efficient markets hypothesis (which was implicit in the classical theory, even though it would not be spelt out explicitly for several more decades). That in turn implied that government intervention could be beneficial in offsetting the fluctuations in investment demand associated with the business cycle.

Unfortunately, both Hayek and von Mises were dogmatic supporters of laissez-faire. As a result, having put taken the first steps in the direction of a serious theory of the business cycle, Hayek and Mises spent the rest of their lives running hard in the opposite direction. The took a nihilistic ‘liquidationist’ view in the Great Depression, arguing that businesses that had made bad investments in the boom should be left to fail. And this mistake has hardened into dogma in the hands of their successors. Although the Austrian School was at the forefront of business cycle theory in the 1920s, it hasn’t developed in any positive way since then, and is now largely occupied with dogmatic internal disputes.

It was left to Keynes and his followers to produce the first really convincing theory of the business cycle, and the first effective policy to respond to severe economic crises.

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, 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.

Was there really a Great Moderation?

This section needs work

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. Reliance on access to credit to manage income risk was encouraged by relatively liberal bankruptcy laws which acted as a kind of substitute for a redistributive tax-welfare system. Within the US, the states with the weakest tax systems have typically had the most generous bankruptcy laws.

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.


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.

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 developing countries in the postwar decades provides strong grounds for criticising the economic policies recommended by the development economics literature of the day (not to mention the madness of Maoism). Postwar development theories, largely followed in India by Nehru and his successors, were based primarily on replacing imports of manufactured goods with domestically produced goods aimed at the home market, and on the use of Five-year plans on the Soviet model.

And as more attention has been focused on the irrational aspects of these policies, such as the dozens of licenses required to undertake the simplest economic activity in India (or, even more strikingly, Mao’s absurd ‘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 it has become easier to understand why their removal or relaxation has unleashed rapid economic growth. But even in the days when some observers saw these policies as providing an appropriate development path for the countries that adopted them, they were not seriously discussed as policy options for developed countries.

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. These factors have allowed the Chinese government to undertake a massive stimulus to the economy in response to the global crisis, producing a rapid recovery in economic activity. Similarly, India began its growth spurt before the main period of market liberalisation and 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.

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