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Is the Great Moderation over?

Is the Great Moderation over?

In what appeared to be a case of spectacularly bad timing, the Bank of England held a conference in September 2007 on 'sources of macroeconomic stability'.

You see, from the early 1980s the business cycle in developed economies had become much less volatile. A term had been coined for this stability: the 'Great Moderation'.

However, that picture, from all appearances, came crashing down during the financial crisis. Imagine what the senior Bank of England officials thought, listening to conference participants, only to be dragged from proceedings to authorise liquidity facilities for Northern Rock in an attempt to stem the first bank run in the UK since 1866!

With the onset of the global financial crisis (GFC), the Great Moderation was declared dead. It looked like volatility was back. The official website commemorating the Federal Reserve's centenary says the Great Moderation ran from 1982 to 2007. Phil Lowe, the Reserve Bank of Australia's Deputy Governor, said in a 2013 speech, 'Recall that prior to the crisis, there was the Great Moderation' (emphasis added).

But to paraphrase Mark Twain, I think reports of the Great Moderation's death have been greatly exaggerated. [fold]

Check out the graph below. It shows rolling five-year standard deviations of GDP growth for Australia, the US and the UK. Basically, at any point on the graph, the level of the line shows the standard deviation of growth for the previous five years. The decline in volatility during the 1980s is plain to see. So is the spike up in the US and the UK in 2008, although volatility did not reach the level of the 1970s. Australia sailed through the crisis relatively smoothly, so volatility stayed low.

A funny thing has happened though. Now that 2008 and early 2009 has fallen out of the window of the rolling standard deviation, volatility is back down to the pre-GFC levels. While the level of growth may be somewhat disappointing, it has been stable.

I don't think the Great Moderation left us. The key question is: what drove the Great Moderation in the first place? In a paper published in 2008, Steve Davis and James Kahn looked at the numbers and concluded:

Our explanation for the aggregate volatility decline stresses improved supply-chain management, particularly in the durable goods sector, and, less important, a shift in production and employment from goods to services.

If they are right, there is no reason to suspect the Great Moderation has disappeared. Their arguments are buttressed by delving into the disaggregated data from the national accounts. They also note that, in fact, the Great Moderation appears just to be the continuation of a longer term trend. The decline of business cycle volatility in the US had dated back to at least World War II. The apparent abrupt nature of the fall in volatility in the 1980s is the result of an unusual spike in volatility in the 1970s.

What should we make of the GFC in this context?

It was a large shock, so large shocks can still happen. But another takeaway is that the consequences of such shocks are perhaps not as dire as they once were. Some think the shock that hit the global economy in 2008 was as big as the shock that caused the Great Depression, but improved policy – through monetary easing and other liquidity provision to the banks – staved off 20% unemployment in the US. If this interpretation is correct, it provides another reason – improved policy – for why volatility will be lower than it had been in the past.

There is a further wrinkle to this story. In the same speech mentioned above, Phil Lowe suggested that now that the Great Moderation was over, the rebound in volatility would be something that would hold back investment.

Given the evidence from the graph above and from Davis and Kahn, I'm inclined to disagree.

Photo courtesy of Flickr user Brookings Institution.

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