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.
When Davis and Kahn broke down the GDP data by sector, they found that from 1970 on, the size of fluctuations in services didn’t change much. Nondurable goods became only modestly less volatile than they had been before 1980. The dramatic smoothing of the jagged line that appears when you graph all of GDP together mirrors what happened in only a single sector: durable goods. So the Great Moderation wasn’t a general phenomenon. It was something that happened in that one particular part of manufacturing. (The economy’s shift to more services and less durable-goods production did calm things down, but not enough to account for the big change.)
Another way to look at the GDP graph is to think of fluctuations over different lengths of time. To take a simple case, economic output is much greater in the daytime than at night, and greater during the week than on the weekend. If you chart them on a graph, these fluctuations will look much bigger than the difference between a recession and a boom. But nobody worries about them, because they’re predictable and take place over very short periods of time.
Similarly, it’s easier for people to adjust their saving and spending for short-term layoffs or reductions in work hours than for long-term job cuts amid a recession. The goal of what macroeconomists call “stabilization policy” is to curb the sustained and unpredictable fluctuations—specifically the downturns—that create the business cycle.
Davis and Kahn divided GDP fluctuations into two categories: “high-frequency” cycles lasting fewer than 12 quarters; and “business cycles” lasting longer. (Since World War II, the average business cycle, from peak to peak, has lasted more than six years.) They compared the two kinds of cycles in each of three distinct periods: 1954–69 (“relatively tranquil”), 1970–83 (“turbulent”), and 1984–2004 (the Great Moderation, up to the end of the available data).
Sure enough, the big change after 1983 wasn’t in the long-term ups and downs of the business cycle, which returned to the pre-1970 pattern. It was in the high-frequency fluctuations, which got dramatically less severe after 1983. This fits the result that Davis and Kahn found when they looked at durable-goods makers. Improvements in business operations had eliminated many short-term ups and downs. The long-term business cycle, meanwhile, simply returned to the kinds of fluctuations experienced in the ’50s and ’60s—a relief after the crazy ride of the 1970s but hardly an end to recessions.
Unfortunately, this modest story isn’t the one that policy makers accepted. “The Fed believed in itself a lot,” says Kahn. “It patted itself on the back for its role in the Great Moderation, thinking that monetary policy had rounded some corner and it was a new age.” And in trying to achieve the dream of permanent stabilization, overly ambitious macroeconomists instituted policies that once again led to unintended consequences—not inflation this time, but a real-estate bubble.
In 2001, the Fed aggressively cut interest rates, driving them down much lower than its policies since the mid-1980s would have predicted. The goal was to stave off recession and avoid the kind of deflation that Japan had experienced in the 1990s. But the cuts backfired. Those excessively low rates set off a housing bubble and all the consequences that flowed from it. The peak of the boom, Stanford economist John B. Taylor estimates, saw about 250,000 more new housing starts a year than there would have been if the Fed had followed its old practices. (Similar patterns of low interest rates and housing bubbles also occurred in many European countries.)
To make matters worse, Taylor argues, once the financial crisis began in August 2007, policy makers and many Wall Street traders misdiagnosed the problem as a shortage of liquidity—something the Fed could address by making it easier for banks to borrow from the government. But the problem was really so-called counterparty risk: financial institutions couldn’t trust the securities they were buying from and selling to each other. To compensate for this risk, banks charged each other much higher interest rates.
“This was not a situation like the Great Depression where just printing money or providing liquidity was the solution; rather it was due to fundamental problems in the financial sector,” Taylor writes in a survey of his published research on the crisis. The only way to fix the problem is to clean up the banks’ balance sheets, bringing in more capital to make them stronger and marking down bad loans (reducing their principal amounts) to make them more trustworthy.
That prescription is more painful, and much less politically palatable, than slashing interest rates or ramping up federal spending. But the need for restructuring is what makes serious financial crises different from ordinary recessions—and why the recessions those crises set off tend to last an especially long time. The longer the restructuring is postponed, the longer the recession will linger, as Japan learned during its “lost decade” of the 1990s.
“It isn’t just Japan,” says Harvard economist Kenneth S. Rogoff, who with Carmen M. Reinhart of the University of Maryland has analyzed 800 years of banking crises. “You can study all the financial crises, and there is a common pattern, that the faster you mark down the assets in the financial system and recapitalize the banks,” the sooner the economy recovers, he says. “As long as you leave the banking system sick, you’re not going to have sustained growth.”
Good policy may limit the pain. But, as the unknown story of the Great Moderation itself suggests, even the best policy can go only so far. As discomfiting as it is to both market optimists and policy activists, a certain amount of instability is inherent to the economy.
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