Is the Great Moderation in Danger?

Stephen Cecchetti, a top economist at the Bank for International Settlements a.k.a. the central banks' central bank, thinks so:

The past 20 years have brought extraordinary prosperity. Growth has risen the world over and this higher growth has come with a remarkable stability. Comparing the 1970s with the most recent decade reveals that the volatility of real growth in the industrialised world has reduced - the standard deviation of real gross domestic product growth has roughly halved.

Although it's a welcome development, what's actually reduced the large swings in growth (and many other economic indicators) has been a mystery to macroeconomists. The leading contenders are

better monetary policy (guess who likes this one)
I.T. improvements which helped businesses make quicker adjustments to production and employment
luck in the form of fewer disruptive shocks (e.g. oil price spikes)
financial innovations such as securitization that let consumers and businesses smooth spending

For Cecchetti, it's this last one that's been most important:

The result of the last 20 years of financial innovation is that we can insure virtually anything and engage in activities we would not have undertaken in the past. As a result growth has been more stable and business cycles have been less frequent and severe.

And he thinks that with the growing movement to increase regulation on investment banks, there's a chance that innovation will be squashed, bringing an end to the Great Moderation and the benefits that came with it.

But Cecchetti may be overstating his case. Here's why: It's been well established that productivity shocks have accounted for much of the swings in the business cycle since World War II. In a paper published last year, economists found that these shocks (i.e. bad luck) have become much less pronounced since the early 1980's. They couldn't pinpoint why this was the case but they did look at how household consumption and savings patterns have changed. They didn't find, however, as strong connection between this and the decline in the volatility of productivity.

In another recent paper from the Federal Reserve Bank of Atlanta, economists Rajeev Dhawan, Karsten Jeske, and Pedro Silos studied the link between energy prices and productivity and found that prior to the second quarter of 1982, price spikes hurt productivity (which in turn slowed the economy). But this negative effect of higher energy prices on the volatility of GDP has vanished since then, accounting for between 60 percent and 70 percent of the Great Moderation.

While it's true that over the same period we're using a lot less energy as a percentage of the whole economy, this development only accounts for only about 5 percent of the effect I just described. So, it's not simply that we're using less oil, argue the economists, but that the way oil prices affected productivity changed markedly.

What accounts for the change? One suspect, Dhawan told me, is the removal of Nixon and Carter-era price controls by President Reagan in 1981. And this might also be why the current oil price spike we're seeing (or regulation of investment banks) won't mean the end of the Great Moderation.

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