Christina Romer, the head of President Obama’s Council of Economic Advisors, is a liberal economist. The LBJ Presidential Library in Austin is a Democratic shrine. But on a September evening in 2007, Romer used that venue to deliver a bluntly negative assessment of the economic policies that began in the Kennedy and Johnson years. What macroeconomists had believed and done in the heady liberal hour of the 1960s, she declared, was simply wrong—a “mistaken revolution” that hurt the country. “Far from being the high point of economic policymaking in the postwar era, the 1960s represented the beginning of a long dark period for macroeconomic policy,” she said.
Her story went something like this: macroeconomists got cocky in the 1960s, thinking that policy makers could set unemployment at whatever rate they wanted by accepting a related level of inflation. But unemployment can in fact go only so low—to a “natural rate” that depends on real economic factors beyond the influence of monetary or fiscal policy. Trying to push unemployment below 4 percent led to persistent inflation and, ultimately, stagflation, the previously unthinkable combination of high unemployment and high inflation. It took the terrible recession of 1981–82 to kill off inflation. Economists learned their lesson, went back to the more reasonable assumptions of the 1950s but with more-sophisticated models, and we got the “Great Moderation” of the past two decades.
“We have seen the triumph of sensible ideas and have reaped the rewards in terms of macroeconomic performance,” Romer concluded. “The costly wrong turn in ideas and macropolicy of the 1960s and 1970s has been righted and the future of stabilization looks bright.”
She was, as we now know, wrong about the happy ending. In retrospect, what is striking about Romer’s lecture is not the chastened tone of its opening but the celebratory nature of its conclusions. “Better policy, particularly on the part of the Federal Reserve, is directly responsible for the low inflation and the virtual disappearance of the business cycle in the last 25 years,” she said (emphasis added). “In this area, the policy mistakes of the 1960s were a painful, but not permanent, detour on the road to excellent economic performance.”
I don’t mean to pick on Romer, who is a fine and careful scholar. Until recently, this triumphalist view was the conventional wisdom. And it isn’t 100 percent wrong. Fed policy really did break inflation and keep it low. The relative stability from the mid-’80s to last year really was much better than the economic chaos of the 1970s.
But containing inflation and eliminating, or noticeably dampening, economic downturns are two entirely different things. Congratulating policy makers for “the virtual disappearance of the business cycle” oversteps the evidence and encourages the hubris that fostered the current crisis and could make recovery more difficult. The conventional explanation for the Great Moderation gives too much credit to easily identifiable economic policy makers—“I feel the contribution of good policy cannot be overstated,” said Romer—and too little to all those anonymous managers and workers whose everyday actions get summarized in the aggregate statistics that Fed economists watch so closely.
Research published in journals like the American Economic Review, dating back to a 2000 article by Margaret McConnell of the New York Fed and Gabriel Perez-Quiros of the European Central Bank, tells a different story. This line of research says that good Fed policy was necessary but not sufficient, that the business cycle never disappeared, and that most of the Great Moderation emerged not from deliberate government policy but from changes in business practices that occurred for competitive reasons having nothing to do with macroeconomic goals.
In the Summer 2008 issue of the Journal of Economic Perspectives, economists Steven J. Davis and James A. Kahn review this research and further dissect the evidence from both aggregate statistics and individual measurements of things like the lead times for ordering production materials and fluctuations in household spending. What they find fits the broad outlines of Romer’s story—but not its congratulatory conclusion. The Great Moderation looks a lot like the staid 1950s, with better inventory management and more-flexible employment contracts.
Companies that make durable goods—products that last a long time, like refrigerators, cars, and computers—got better at predicting sales and adjusting production. When demand dropped, inventories didn’t pile up, so plants didn’t have to shut down until they could sell all that extra stuff. Work hours might have fluctuated more but temporary layoffs, which used to be routine, became rarer. Economic statistics got less volatile, not because of Fed policy (though low inflation made this evolution easier and more apparent) but because of changing business practices. Those innovations made businesses more productive and efficient, but they didn’t eliminate recessions or the pain they cause.
When economists talk about the Great Moderation, they don’t mean simply growth without inflation—something Fed policy deserves credit for. They mean fewer and smaller fluctuations in overall output, otherwise known as GDP. If you graph the rate of GDP growth from 1947 to 2007, you get a jagged line that does look less jumpy beginning in the mid-1980s. Something did change. The question is what.
Davis, a professor at the University of Chicago Graduate School of Business, and Kahn, of NYU’s Stern School of Business and the New York Fed, look at GDP as the sum of different kinds of industries and then compare the fluctuations within them. Not every part of the economy moves in the same way.
As a general rule, durable-goods production tends to be the most volatile sector of the economy. Since people usually have a stock of durables in use, when times get tight, they put off new purchases. What seem like small cutbacks to the end buyer translate into big swings for the producer. Consider a business that owns 100 trucks and needs to replace two trucks this year. Business sags, so the firm replaces only one truck, operating with 99—a 1 percent reduction in its fleet but a 50 percent reduction in the truck maker’s sales. (Similarly, if half the people who might buy a consumer durable—a new TV, say—decide to put it off for a year, that’s a 50 percent drop in sales.) Services, by contrast, tend to be the least volatile part of the economy, with nondurable goods such as clothes and groceries somewhere in the middle.