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.)