The Great Moderation

‘Stock prices have reached what looks like a permanently high plateau’, Irving Fisher October 1929

As this famous prediction, made only a few days before the Wall Street Crash of 1929, illustrates, the belief that the era of boom and bust has finally been put behind us is not new. In fact, ever since the emergence of industrial capitalism in the early 19th centuries, it has been shaken, and stirred, by periodic booms and busts. And, in every intervening period of steady growth, optimistic observers have proclaimed the dawning of a New Economy, in which the bad old days of the business cycle would be put behind us. Even the greatest economists (and Irving Fisher was a truly great economist, despite his eccentricities) have been fooled by temporary success into believing that the business cycle was at an end.

In 1929, Irving Fisher’s confidence was based in part on the development of the tools of monetary policy implemented by the US Federal Reserve which had been established in 1913 and had dealt successfully with several minor crisis. The central idea was that, in the event of a financial panic, the Fed would lower interest rates and release funds to the banking system until confidence was restored. But the Fed proved unable or unwilling to produce an adequate response to the crisis of 1929, which soon became the Great Depression, an uninterrupted four-year period of decline that threw as much as a third of all workers out of work, not only in the US, but in all the developed countries of the world.

Economists are still arguing about the causes of the Great Depression, and the extent to which mistaken policies contributed to its length and depth. These disputes, once polite and academic, have taken on new urgency and ferocity in the context of the current crisis, which echoes that of 1929 in many ways.

In the aftermath of the Great Depression and World War II, the analysis that held sway over the great bulk of the economics profession was that of John Maynard Keynes. Keynes argued that recessions and depressions were caused by inadequate effective demand for goods and services, that monetary policy would not always be effective in increasing demand, and that governments could remedy the problem through the use of public works and other expenditure programs.

Keynes’ ideas had little impact on the policies pursued during the Depression, although some aspects of the New Deal in the US and of the policies introduced by social democratic governments in Scandinavia and New Zealand could be seen as Keynesian in retrospect. The crucial contrast was between the experience of World War I and its aftermath, ending in the Depression, and that of World War II and the successful economic reconstruction that followed it.

The financing and economic planning of World War II was largely undertaken on Keynesian lines, and Keynesians were quick to draw the lessons for the postwar period. The interwar years were seen as a period of economic waste that contributed greatly to the rise of Hitler and the renewed outbreak of global war in 1939.

As Australia’s White Paper on Full Employment, published in 1945, put it

Despite the need for more houses, food, equipment and every other type of product, before the war not all those available for work were able to find employment or to feel a sense of security in their future. On the average during the twenty years between 1919 and 1939 more than one-tenth of the men and women desiring work were unemployed. In the worst period of the depression well over 25 per cent were left in unproductive idleness. By contrast, during the war no financial or other obstacles have been allowed to prevent the need for extra production being satisfied to the limit of our resources.

The commitment of national governments to maintain full employment was underpinned by the global economic and financial system at the Bretton Woods conference in New Hampshire in 1944. As the war drew to a close, the governments of the Allied countries sought to build an economic system that would prevent the recurrence of Depression, and therefore reduce the risk of renewed war. The Bretton Woods system was based on fixed exchange rates between different currencies, ultimately anchored by the requirement that the US dollar be exchangeable for gold at a price of $35/oz. Bretton Woods also established key international economic institutions, most importantly the International Monetary Fund, the World Bank and the precursors of the World Trade Organization.

The architects of postwar reconstruction hoped to prevent a renewed slump like that of 1919, and to hold unemployment rates below 5 per cent. They succeeded beyond their wildest dreams.

For most developed countries, the years from the end of World War II until the early 1970s represented a period of full employment and strong economic growth unparalleled before or since. Referred to as the ‘Golden Age’ or ‘Long boom’ in English, ‘Les Trente Glorieuses’ in French, and the ‘Wirtschaftswunder’ in German, this period saw income per person in most developed countries more than double. With declining inequality and the introduction of more or less comprehensive welfare states, the gains were greatest for those at the bottom of the income distribution. But in an environment of stable growth and ever-increasing demand for their products, business leaders were happy to accept a larger role for government and the implicit contract that guaranteed steady work and high wages for their unionised employees in return for a government commitment to keep the economy at or near full employment.

By the 1960s, many Keynesian economists were prepared to announce victory over the business cycle. Attention turned to more ambitious goals of ‘fine-tuning’ the economy, so that even ‘growth recessions’ (temporary slowdowns in the rate of economic growth that typically produced a modest increase in unemployment rates) could be avoided.

Pride goes before a fall. By 1970, the Bretton Woods system was under serious pressure. Inflation in the United States had rendered untenable the commitment to hold the price of gold at $35/ounce. And whereas previous episodes of inflation had been brought under control quite rapidly through Keynesian contractionary policies, these policies were becoming less effective as inflationary expectations became embedded and as the social restraint generated by memories of the Depression broke down.

The last years of the Keynesian Golden Age saw a struggle over income distribution that virtually guaranteed an inflationary outburst. Union militancy, fuelled by Marxist rhetoric came into sharp conflict with the emerging speculative capitalism, driven by revived global financial markets. Firms raised prices to meet wage demands, spurring yet further wage demands to compensate for higher prices.

The coup de grace came with the oil shock of 1973, which was both a reflection of the inflationary outburst that was already under way and the cause of a further upsurge. Within a couple of years the entire edifice of postwar prosperity had collapsed and the Long Boom came to a painful and chaotic end. The 1970s and 1980s were decades of high unemployment and inflation (the ugly term ‘stagflation’ was coined to describe the ugly and unprecedented appearance of these two economic evils simultaneously, rather than as part of a cycle of inflationary boom and deflationary slump). Repeatedly, seemingly promising recoveries fizzled or collapsed into even more severe recessions.

At least by comparison with these dismal decades, the 1990s were an era of prosperity for the developed world, and particularly for the United States. The boom of the late 1990s produced improvements in income across the board, after a long period of stagnation for those in the lower half of the income distribution. The boom in the stock market produced even bigger gains for owners of stocks. House prices were slower to move, but because they are such a large part of household wealth, contributed even larger capital gains.

The long and strong expansion of the 1990s, combined with political events such as the collapse of the Soviet Union produced a new air of optimism and, in many cases, triumphalism. The success of books like Fukuyama’s The End of History and Thomas Friedman’s The Lexus and the Olive Tree reflected the way they matched the popular mood.

Economists were a little late to the party. Well into the 1990s, they worried about weak productivity growth, the possibility of resurgent inflation and unemployment rates that remained high by the standards of the postwar boom.

By the early 2000s, however, it was possible to look at the US data and discern a pattern that was the very opposite of a lost golden age. Rather, the datacould be read as showing a decline in the volatility of output and employment. Although the statistics did not yield a definitive interpretation, most observers saw the decline in volatility as a once-off dropping that took place in the mid-1980s, after the early 1980s recession, induced by the restrictive policies of Fed Chairman Paul Volcker that put an end to the 1970s upsurge inflation. This apparent decline in volatility, coinciding with the Chairmanship of Volcker’s successor, Alan Greenspan became known as The Great Moderation, a phrase coined by James Stock of Harvard University and Mark Watson of Princeton University.

Greenspan own successor, Ben Bernanke, graduated summa cum laude from Harvard in 1975, and completed a PhD at MIT in 1979. Bernanke is a leading figure in the generation of economists whose careers began after the breakdown of the long boom, and have largely coincided with Greenspan era. Unsurprisingly perhaps, Bernanke was among those who did most to revive the idea of a New Age of economic stability. He also popularised the use of the term the “Great Moderation” to describe it, using it as the title of a widely-publicised speech given in 2004.

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