The Breakdown

Explaining Southern California's economy

Econ 474: Whatever happened to the 'Great Moderation?'

I'm introducing a recurrent weekly feature to the blog. It's called "Econ 474," and I'll leave it to the commenters to figure out why. For my part, I'll say that I want to blog about some key economics and business topics that bear on Southern California, but I'd like it to be a bit more involved that good-old Econ 101. 

Today, let's take a look at what, prior to the financial crisis. economists were calling the "Great Moderation." The current Federal Reserve Chairman, Ben Bernanke, summarized it pretty well in a 2004 speech -- before he succeeded Alan Greenspan, and obviously four years prior to the financial crisis:

One of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility. In a recent article, Olivier Blanchard and John Simon (2001) documented that the variability of quarterly growth in real output (as measured by its standard deviation) has declined by half since the mid-1980s, while the variability of quarterly inflation has declined by about two thirds.1 Several writers on the topic have dubbed this remarkable decline in the variability of both output and inflation "the Great Moderation." Similar declines in the volatility of output and inflation occurred at about the same time in other major industrial countries, with the recent exception of Japan, a country that has faced a distinctive set of economic problems in the past decade....Reduced macroeconomic volatility has numerous benefits. Lower volatility of inflation improves market functioning, makes economic planning easier, and reduces the resources devoted to hedging inflation risks. Lower volatility of output tends to imply more stable employment and a reduction in the extent of economic uncertainty confronting households and firms. The reduction in the volatility of output is also closely associated with the fact that recessions have become less frequent and less severe.

Boy, that sounds great, doesn't it? The opposite of the 20th century's most feared economic event, the Great Depression. So what went so horribly, horribly wrong that the old volatility paradigm didn't just come back, but came back with a vengeance? I mean, look at the chart above: in 2008, real GDP growth plunged to a level not seen since the recession of 1982 (which some economists argue was a recession created by the government specifically to break the back of high inflation).  The scary, up-and-down jazz of the 1950-1985 period hasn't returned — yet. But the aftermath of the Great Recession, or the Great Stagnation, or whatever you want to call it, is still being written.

In Southern California, the apparent end of the Great Moderation hit hard — the housing sector was crushed as unemployment above the national average took hold and thousands of construction workers lost jobs. 

A big question is whether the previous moderating pattern will resume once the financial crisis is well behind us. A major challenge with credit-driven economic downturns is that the recovery tends to take much longer than with "normal" business cycle recessions. So what economists will struggle with in coming years is figuring out whether the previous pattern of microeconomic volatility will return or whether some new pattern will emerge —possibly moderation punctuated by volatility spikes. Only time will tell. But the next time economist start saying that volatility is under control, people are likely to be much more skeptical.

Chart: Wikimedia Commons

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