 THE GREAT MODERATION Stock prices have reached what looks like a permanently high plateau. —ATTRIBUTED TO IRVING FISHER, October 1929 A zombie idea is one that keeps on coming back, despite being killed. In the history of economics, there can be no more durable zombie idea than that of a New Era, in which full employment and steady economic growth would continue indefinitely. Every sustained period of growth in the history of capitalism has led to the proclamation of such a New Era. None of these proclamations has been fulfilled. As Irving Fisher's famous prediction, made only a few days before the Wall Street Crash of 1929, illustrates, the belief that the era of boom and bust has finally been put behind us is not new. In fact, ever since the emergence of industrial capitalism in the early nineteenth century, the global economy has been shaken, and stirred, by periodic booms and busts. And, in every intervening period of steady growth, optimistic observers have proclaimed the dawning of a New Economy in which the bad old days of the business cycle would be put behind us. Even the greatest economists (and Irving Fisher was a truly great economist, despite some spectacular eccentricities) have been fooled by temporary success into believing that the business cycle was at an end. In 1929, Irving Fisher's confidence was based in part on the development of the tools of monetary policy implemented by the U.S. Federal Reserve, which had been established in 1913 and had dealt successfully with several minor crises. The central idea was that, in the event of a financial panic, the Fed would lower interest rates and release funds to the banking system until confidence was restored. But the Fed proved unable or unwilling to produce an adequate response to the stock market crash of October 1929. The Great Crash was followed by four years of uninterrupted decline that threw as many as a third of all workers out of work, not only in the United States, but all around the world. Economists are still arguing about the causes of the Great Depression, and the extent to which mistaken policies contributed to its length and depth. These disputes, once polite and academic, have taken on new urgency and ferocity in the context of the current crisis, which echoes that of 1929 in many ways. In the aftermath of the Great Depression and World War II, the analysis that held sway over the great bulk of the economics profession was that of John Maynard Keynes. Keynes argued that recessions and depressions were caused by inadequate effective demand for goods and services and that monetary policy would not always be effective in increasing demand. Governments could remedy the problem through the use of public works and other expenditure programs. The rapid return to full employment in the war years seemed to confirm Keynes's analysis. As Australia's White Paper on Full Employment, published in 1945, put it: Despite the need for more houses, food, equipment and every other type of product, before the war not all those available for work were able to find employment or to feel a sense of security in their future. On the average during the twenty years between 1919 and 1939 more than one-tenth of the men and women desiring work were unemployed. In the worst period of the depression well over 25 per cent were left in unproductive idleness. By contrast, during the war no financial or other obstacles have been allowed to prevent the need for extra production being satisfied to the limit of our resources. (Commonwealth of Australia 1945, 1) In sharp contrast with previous wars, the full employment of the war years was maintained after the return of peace. For most developed countries, the years from the end of World War II until the early 1970s represented a period of full employment and strong economic growth unparalleled before or since. Referred to as the "Golden Age" or "Long Boom" in English, "Les Trente Glorieuses" in French, and the "Wirtschaftswunder" in German, this period saw income per person in most developed countries more than double. By the 1960s, many Keynesian economists were prepared to announce victory over the business cycle. Walter Heller, chairman of the Council of Economic Advisors under John F. Kennedy, hailed the switch to active fiscal policy in the 1960s, saying "We now take for granted that the government must step in to provide the essential stability at high levels of employment and growth that the market mechanism, left alone, cannot deliver." Attention turned to the more ambitious goal of "fine-tuning" the economy so that even "growth recessions" (temporary slowdowns in the rate of economic growth that typically produced a modest increase in unemployment rates) could be avoided. Pride goes before a fall. In the 1970s, the seemingly endless postwar boom came to an abrupt halt. It was replaced by accelerating inflation and high unemployment. Keynesian fiscal policies, aimed at eliminating unemployment, were abandoned. Restrictive monetary policies and high interest rates allowed central banks to squeeze inflation out of the system over the course of the 1980s. The pressure for price stability was reinforced by globalization, and particularly by the growing size and influence of the global financial sector. While price stability returned, the full employment of the postwar era was gone, and has never truly returned. Economic growth returned gradually, but, at least in developed countries, never regained the rapid rates of the postwar boom. It seemed that the idea of a New Era was dead, once and for all. But zombie ideas are not so easily killed. BIRTH: CALM AFTER THE STORMS If only by comparison with the dismal 1970s and 1980s, the 1990s were an era of prosperity for the developed world, and particularly for the United States. The boom of the late 1990s produced improvements in income across the board, after a long period of stagnation for those in the lower half of the income distribution. The boom in the stock market produced even bigger gains for the wealthy. House prices were slower to move, but because they are such a large part of household wealth, contributed even larger capital gains. The long and strong expansion of the 1990s, combined with political events such as the collapse of the Soviet Union, produced a new air of optimism and, at least in the United States, triumphalism. The success of books like Francis Fukuyama's The End of History and Thomas Friedman's The Lexus and the Olive Tree reflected the way they matched the popular mood. Fukuyama argued that the great conflicts that made history something more than the passing of time were over, and that the end of the Cold War marked "the end point of mankind's ideological evolution and the universalization of Western liberal democracy as the final form of human government." Fukuyama assumed that "Western" implied "capitalist." However, he showed some ambivalence about the meaning of "capitalism." Fukuyama's use of this term implied a triumphant market liberalism. But in defending the factual claim of a universalized social order, his use of "capitalism" encompassed the whole range of political and economic systems observed in Western societies, from Scandinavian social democracies to the winner-take-all society then emerging in the United States. Friedman dispenses with such nuance. In a book full of cute phrases and memorable metaphors, the most prominent was the "Golden Straitjacket." This was Friedman's way of saying that, in a globalized economy, adherence to the principles of market liberalism would guarantee golden prosperity. On the other hand, any deviation from those principles would bring down the wrath of the "Electronic Herd" of interconnected global financial markets. Fukuyama's celebration of the new order made him an intellectual superstar. His books were widely cited, if not quite so widely read. Friedman's breezy boosterism, by contrast, did not earn him so much intellectual credit, but it put him on the bestseller lists. Everyone wanted to be part of the new Lexus-owning world. Economists were a little late to the party. Well into the 1990s, they worried about weak productivity growth, the possibility of resurgent inflation, and unemployment rates that remained high by the standards of the postwar boom. By the early 2000s, however, it was possible to look at the U.S. data and discern a pattern that was the very opposite of a lost golden age. Rather, the data could be read as showing a decline in the volatility of output and employment. Most economists saw the decline in volatility as a once-off dropping that took place in the mid-1980s, after the early 1980s "Volcker" recession, so called because it was induced by the restrictive anti-inflation policies of Fed chairman Paul Volcker. Although most attention has been focused on the volatility of output, the most important impact of recessions is the variability of employment, which is best measured by the employment/population ratio. As with measures of GDP volatility, the standard measures of employment volatility declined noticeably after 1985. This apparent decline in volatility largely coincided with the chairmanship, lasting nearly twenty years, of Volcker's successor, Alan Greenspan. Whether deservedly or not, Greenspan, rather than Volcker, got the credit. Greenspan's status as the source of all economic wisdom was symbolized in the ultimate Washington accolade, a biography (or rather, hagiography) from Bob Woodward, entitled Maestro. Greenspan's successor, Ben Bernanke, graduated summa cum laude from Harvard in 1975, and completed a Ph.D. at MIT in 1979. He is, therefore, a leading figure in the generation of economists whose careers began after the breakdown of the long postwar boom, and coincided with the Greenspan era. Unsurprisingly perhaps, Bernanke was among those who did most to promote the idea of a New Era of economic stability. Bernanke also popularized the use of the term the Great Moderation to describe the New Era. This term was originally coined by James Stock of Harvard University and Mark Watson of Princeton University. Bernanke used it as the title of a widely publicized speech given in 2004. The Great Moderation was hailed, like previous periods of prosperity, as representing the end of the business cycle. As Gerard Baker wrote in The Times of London in 2007: Economists are debating the causes of the Great Moderation enthusiastically and, unusually, they are in broad agreement. Good policy has played a part: central banks have got much better at timing interest rate moves to smooth out the curves of economic progress. But the really important reason tells us much more about the best way to manage economies. It is the liberation of markets and the opening-up of choice that lie at the root of the transformation. The deregulation of financial markets over the Anglo-Saxon world in the 1980s had a damping effect on the fluctuations of the business cycle. These changes gave consumers a vast range of financial instruments (credit cards, home equity loans) that enabled them to match their spending with changes in their incomes over long periods. (Baker 2007) A couple of years later, writing his farewell column for The Times, Baker wrote an unusually candid admission of error, saying, My biggest intellectually missed opportunity was the one that essentially informed so much of my economic commentary in the past couple of years. And one, I suppose in my defence, I could say was shared by quite large number of economists more qualified than I. It was a faith in the idea called the Great Moderation. (Baker 2009) The economic crisis that began in 2007, and is still continuing, marks a dramatic end to "moderation" in economic outcomes. And, as we will see, it represents the failure of the set of ideas to which Baker and others attributed the supposed New Age. To understand both the widespread appeal and the ultimate failure of these ideas, it is necessary to understand the birth and death of the "Great Moderation" theory. The simplest way to understand why so many economists saw a Great Moderation in the macroeconomic data is to look at recessions and expansions. Before doing this, it's worth taking a moment to discuss how economists use the term recession. It is common to describe the occurrence of two successive quarters of negative economic growth as the "technical" definition of a recession. However, economists rarely use this definition except as a rough guide to the current state of the economy. Rather, economists in the United States generally rely on the assessments made by the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER). The NBER defines a recession as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales." The Dating Committee issues judgments as to when recessions have begun and ended. Similar bodies in other countries make the same kind of judgment, though none has quite the authority of the NBER. These judgments typically take place a year or so after the event, which is one reason so much attention is paid to the "technical definition." A great deal of energy was expended in 2008, arguing that, despite obvious signs of economic distress, the required two successive quarters of negative growth had not been observed. But in December 2008, the NBER announced that a recession had begun a year earlier, in December 2007. The announcement of the end of a recession takes place with a similar delay. Whatever the definition, in the years before 1981 (the end of the Volcker recession) recessions in the United States were relatively frequent, about one every five years. The NBER committee defined nine recessions between 1945 and 1981, two of which (those of the early 1970s and the double-dip recession of 1980–81) were both long and severe. By contrast, the period from 1981 to 2007 was one of long expansions and short recessions. In the entire period, there were only two recessions, in 1990–91 and 2001, and each lasted only eight months. In the light of past experience of failed claims, it might seem premature to proclaim the end, or at least the taming, of the business cycle on the strength of two good cycles. However, history teaches us that we rarely learn from history. The prevailing atmosphere of triumphalism ensured a positive reception for statistical analyses that seemed to show that the business cycle had been tamed. The dating decisions of the NBER are inevitably somewhat subjective and do not lend themselves to statistical analysis. As result, economists seeking statistical confirmation of the idea that the business cycle had been tamed focused on quarterly economic data. This approach was consistent with the popular idea of a recession as two quarters of negative growth. The focus on the volatility of quarterly growth also fitted neatly with the prevailing approach to the assessment of macroeconomic policy, called the Taylor rule, after John Taylor who first formalized it in 1993.6 Taylor argued that central banks should (and mostly did) seek to minimize the variance of the rates of output growth and inflation about their long-run average values. (Continues...) | 
