Implications

If the Efficient Markets Hypothesis provided the theoretical basis for the resurgence of economic liberalism, the Great Moderation appeared to represent empirical confirmation of its success. The apparent stabilization of the business cycle offered economic liberals the pragmatic justification that, whatever the inequities and inefficiencies involved in the process, the shift to economic liberalism since the 1970s had delivered sustained prosperity. As Gerard Baker wrote in the Times of London in 2007

Economists are debating the causes of the Great Moderation enthusiastically and, unusually, they are in broad agreement. Good policy has played a part: central banks have got much better at timing interest rate moves to smoothe out the curves of economic progress. But the really important reason tells us much more about the best way to manage economies.

It is the liberation of markets and the opening-up of choice that lie at the root of the transformation. The deregulation of financial markets over the Anglo-Saxon world in the 1980s had a damping effect on the fluctuations of the business cycle. These changes gave consumers a vast range of financial instruments (credit cards, home equity loans) that enabled them to match their spending with changes in their incomes over long periods.

(A couple of years later, writing his farewell column for the Times, Baker described this piece as his biggest mistake.)

The Great Moderation seemed to show that, in macroeconomic terms, economic liberalism had succeeded where Keynesianism had failed. The collapse of the Bretton Woods system and the decade of economic disruption that followed it had, it seemed, paved the way for sustained and broad-based growth. Similar improvements in economic stability, observed in a number of English-speaking countries, could be attributed to the radical reforms implemented by such leaders or finance ministers as Margaret Thatcher in the UK, Roger Douglas in New Zealand and Paul Keating in Australia. The European Union was generally seen as a laggard, with little choice but to follow the lead of the Anglosphere.

Causes

Central bankers, and particularly Alan Greenspan and Ben Bernanke, were happy to take the credit for the positive outcomes of the Great Moderation, while, for the most part, ignoring or downplaying the evidence of unsustainable imbalances, and unmanaged risks. For Greenspan in particular, the Great Moderation appeared to be an enduring legacy.

Of course, the claim of improved monetary policy did not rest entirely on the supposed genius of Greenspan and his fellow central bankers. The more serious claim was that, thanks to financial liberalisation, the economy could be stabilised using only a single policy instrument, the short-term interest rate determined by the central bank (in the US this is the Federal Funds rate).

While some analysts focused primarily on the role of monetary policy and central banks, the Great Moderation also fitted naturally into broader triumphalist stories about economic liberalism and globalisation. In particular whereas Keynesianism required national governments to manage macroeconomic risk, the rise of global financial markets allowed such risk to be spread around the world. Since, it was assumed, national economic fluctuations would largely cancel each other out, risk could be moderated without government intervention. All that was required was for investors to hold diversified portfolios, and for capital to flow freely where its return was highest.

A third possibility was, of course, that the Great Moderation was just a run of good macroeconomic luck consisting, in essence of a couple of cycles where the expansion went on a little longer than usual and the recessions were relatively mild. Academic studies tended to mention this possibility, but mostly only to dismiss it. Popular promoters like Baker ignored the question.

The econometric tests reported in studies of the Great Moderation showed a statistically significant change occurring in the mid-1980s. However, it is an open secret in econometrics that such tests mean very little, since the same set of time series data that suggests a given hypothesis must be used to test it. This is quite unlike the biomedical problems for which the statistical theory of significance was developed, where a hypothesis is developed first, and then an experiment is designed to test it.

A fourth possibility, not mentioned at all in most discussions of the Great Moderation was that the apparent stability was actually a reflection of policies that were bound to fail in the end. Simply put, the prosperity apparently generated by economic liberalism was just a bubble waiting to burst, or rather, a series of bubbles, each larger than the last, and each encouraged by a combination of financial deregulation and expansionary monetary policy.

The Great Risk Shift

Beyond bragging rights in the perennial disputes between economic liberals and social democrats, the Great Moderation provided essential support for a central part of the agenda of economic liberalism, the idea that individuals and businesses, rather than governments, were best placed to manage the risks associated with modern economic life. This idea found its expression in what Jacob Hacker has called The Great Risk Shift. Risks that had been borne by corporations or governments were shifted back to workers and households.

Since aggregate employment was seen as more stable than ever, people who lost one job were presumed to be easily capable of finding another, and failure in this task was attributed to personal failings rather than to the workings of the economy. In these circumstances, companies felt the need to be ‘nimble’ and ‘flexible’ in their operations, buzzwords that translated into a willingness to fire large number of workers whenever doing so would yield a short-run increase in profitability. Similarly, there was seen to be less need for generous benefits for the unemployed and these benefits were duly cut or frozen.

The Great Risk Shift extended to such areas as health care and retirement income. The ‘one size fits all’ systems of single-payer health care and retirement income provision introduced in the aftermath of the Depression and WWII were attacked as bloated bureaucracies that crippled individual choice. Instead, it was argued, ordinary households should make their own provision for health insurance and retirement, with a public sector ‘safety net’ being reserved for the indigent and improvident.

Even during the Great Moderation, it was notable that the wealthy elite showed much more enthusiasm for individual risk-bearing when it was undertaken by ordinary employees than they did on their own behalf.

Great show was made of remuneration devices such as options, which gave senior executives the chance to benefit when their company did well and the share price rose. The benefits were taken very happily during the boom years of the late 1990s, when almost all stock prices were going up, regardless of the quality of their management. But, once the bubble burst, enthusiasm for stock options declined. More strikingly, large numbers of companies repriced the options they had already issued, setting the price low enough that their executives were once again ‘in the money’.

Of the institutions that were seen as obstacles to improved economic performance by economic liberals, none has been more vilified than restrictions on dismissal of workers, or requirements for generous redundancy pay. The supposed sclerosis of the European economies was blamed, more than anything else, on the difficulty of firing workers, which, it was argued, acted as a disincentive to hiring. Yet these arguments were forgotten when it came to CEOs. In case after case, failed CEOs have been rewarded with payouts running into millions, or even tens of millions, of dollars, while the workers whose jobs were lost due to their incompetence were lucky to receive a few weeks pay.

The upshot was that, despite their vastly greater capacity to absorb financial shocks, senior executives as group faced no more risk, relative to their average income, than ordinary workers. Relative to their wealth, senior executives faced much less risk than most people. The most disastrous failures among CEOs rarely end up poor, or even back in the middle class. But as long as the Great Moderation continued, inconsistencies like this were disregarded. Companies abandoned any pretence of a social contract with their workers (who were, at an early stage in this process, relabeled as ‘human resources’).

Risk has both an upside and a downside, of course. In the later years of long expansions, the balance of bargaining power in labor markets shifts towards workers, resulting in improved wages and conditions. But, on the whole the downside predominated. Faced with the ever-present risk of job loss, employees accepted a faster pace of work and reduced working conditions as the price of continued employment.
Governments also sought to get out of the business of risk management. Throughout the years of the Great Moderation, economic liberals railed against the social protections of the welfare state, which they saw as both inefficient and outdated. They had some successes, most notably with welfare reform in the United States. But on the whole the welfare state proved surprisingly resilient. Core programs like Social Security in the United States and the National Health Service in Britain enjoy deep and broad popular support.

On to Failure

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