The Great Moderation Never Ended

In 2002, Stock and Watson pointed out that the volatility in the growth rate of real GDP between 1984 and 2001 was much lower than it had been between 1960 and 1983, a phenomena dubbed the great moderation. In 2004, Ben Bernanke credited better monetary policy for the great moderation–meaning, of course, better monetary policy under Volcker, Greenspan and (Governor and later Chair) Bernanke. Other people credited sectoral changes in the structure of the economy such as the shift away from volatile sectors like manufacturing to less volatile sectors like health care. Improved information technology that led to better inventory control and smoother adjustments is another explanation. Some even argued that the great moderation was due to financial innovation! Yet others said it was just dumb luck. The dumb luck view got a boost with the great recession in 2008. Subsequently, many people mocked the idea of the great moderation and those who had tried to take credit.

Yet it is now clear that the great recession interrupted but did not end the great moderation. Since the great recession ended, growth in real GDP has been much less volatile than in the 1950s to 1980s. Indeed, volatility has been lower even taking into account the great recession. In the graph, for example, I simply bound the peaks and valleys. More sophisticated measures show the same thing.

Of the possible explanations, we can now rule out luck. The economy isn’t confronted with fewer shocks than in the past but rather we are adjusting to shocks more successfully. Overall, however, I’d say the causes of the great moderation are still up for grabs.

One problem with most of the theories is that they predict more moderation over time. Manufacturing has continued to decline as a share of GDP, for example. Information technology has gotten much better since 1984. Financial innovation has, if anything, increased in scope. If you squint maybe the great moderation has gotten a bit more moderate over time but that isn’t clear.

Better monetary policy does fit the data in the sense that it could have been a one-time learning (thank you Milton Friedman). But I find it difficult to believe that policy makers are so much wiser than in the past or even that monetary policy has that much influence over the real economy. We also have to grapple with the fact that many countries have experienced a great moderation. In my view this pushes towards an explanation on the real side of the economy, albeit that is a judgment call that the world is more similar in real factors like technology than it is in policies.

We can rescue some of the real theories with limits or endogenous offsets. Inventory control, for example, can only get so good and not better. I find this plausible but it would be more convincing if we could pinpoint the key innovation. Some financial innovations might reduce volatility but ala Minsky also cause people to take more risks (an endogenous offset). That too has some plausibility but again it would be better if we could pinpoint which were the volatility decreasing innovations and which the volatility increasing innovations.

It’s striking that the great moderation never ended and we still have no solid explanation for why it happened.


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