The Great Moderation myth

Ahh … the Great Moderation – now wasn’t that a laugh. Today I have been examining data in preparation for a new project I am beginning on inflation response functions. Thinking about the data made me recall the sheer arrogance of my profession. And an article in the Melbourne Age prompted this further by way of coincidence. The idea that the economics profession had solved the business cycle by implementing inflation targetting-type policies and pursuing fiscal austerity was the flavour of the late 1990s and early 2000s. I was even told several times in the last decade that I was mad running a research centre which focused on unemployment because that problem had been solved too. Economists of my persuasion were regularly ridiculed at conferences and meetings. And then … the crisis struck confirming everything that us “idiots” had been saying for more than a decade. And yet, the chief proponents of the Great Moderation lie still aspire to top public office.

On February 20, 2004 the current US Federal Reserve Board Governor Ben S. Bernanke made one of the worst speeches by an official of a major policy institution ever. It was entitled The Great Moderation.

At the time, I was among only a few macroeconomists who poured scorn on the propositions that Bernanke outlined as “truth”. Now, the experience of a big economic crisis has demonstrated to anyone with two eyes and something grey between the ears that the idea was bereft and a statement so wilful in its neglect that it is a wonder the proponent hasn’t been run out of town.

I note that there is now growing opposition to Bernanke’s confirmation for a second term as Federal Reserve chairman although it seems that the conservatives in the Democrat camps won’t let their man fall. Chief conservative – the US President – is still supporting him. I outlined a case against his reappointment in this blog – Bernanke should quit or be sacked.

Saturday’s Melbourne Age (January 23, 2010) had an article by Clancy Yeates entitled – Swings, roundabouts and psychology: Economics 101.

Yeates analyses the way in which the real economy swings between boom and bust driven by fluctuations in private spending – most notably private capital formation. He said that:

CRISES have a way of reminding us of old lessons that were conveniently forgotten in the good times. And as growth finds its feet, many economists are scrambling to revisit one such distant memory from Economics 101: the “boom and bust”‘ cycle.

The current crisis has reasserted what the arrogant mainstream of my profession tried to deny – that left alone the private market will not be able to mainstain long periods of output and employment growth.

The mainstream macroeconomists increasingly tried to claim in the 1990s and up until the recent crisis that they had “won” – been vindicated and those stupid keynesians would never see the light of day again.

One notable example, is the 2003 presidential address to the American Economic Association, Robert E. Lucas, Jnr of the University of Chicago said:

My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades. There remain important gains in welfare from better fiscal policies, but I argue that these are gains from providing people with better incentives to work and to save, not from better fine tuning of spending flows. Taking U.S. performance over the past 50 years as a benchmark, the potential for welfare gains from better long-run, supply side policies exceeds by far the potential from further improvements in short-run demand management.

Yes, the great moderation became the norm and economists started to concentrate on increasingly banal and crazy research programs (like writing mathematical models to describe when a couple moved from holding hands to more advanced petting – and topics like that – I kid you not).

Yeates also turned to the financial side of the economy and considers it was:

… the big blunder economists made when looking at cycles in the long boom of the 1990s and 2000s. Amid an unprecedented run of growth and low inflation, most economists tended to overlook the impact asset prices and credit could have on the “real” economy.

In 2004, US central banker Ben Bernanke coined the phrase “Great Moderation” to describe these boom years, where a type of blind optimism took hold. Sure, there were still recessions, but their relatively mild character convinced many the cycle had been laid to rest.

And as happens when the good times are rolling, people came up with explanations of why this time was “different”. Whether it was through new technology or monetary policy, the optimists claimed that the business cycle had finally been defeated.

The rest, as they say, is history. In one of economists’ biggest failures, many sat idle while dangerous risks ran rampant in the system, culminating in the meltdown of 2008.

Aah, the great moderation. How comforting the academic halls in the economics departments around the world had become. They had triumphed over the interventionists who had over-regulated the economy, sucked the enterprise out of private enterprise, allowed trade unions to become too powerful, and bred generations of indolent and unmotivated individuals who only aspired to live on the dole.

As an aside, it is not accurate to say that Bernanke “coined” the term – “the great moderation”. In fact it was Harvard economists James Stock and Mark Watson who mentioned it in their 2002 paper “Has the Business Cycle Changed and Why” – you have to pay for the paper but you can view the abstract HERE. In general, the NBER papers are not worth the paper they are printed on.

In his 2004 speech – The Great Moderation – Bernanke claimed that:

One of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility.

He drew attention to a 2001 article by Blanchard and Simon (‘The Long and Large Decline in U.S. Output Volatility’, Brookings Papers on Economic Activity, 1, 135-64) who measured volatility using the standard deviation of the quarterly real GDP growth and the inflation rate.

Bernanke claimed the “Great Moderation” delivered numerous benefits:

Lower volatility of inflation improves market functioning, makes economic planning easier, and reduces the resources devoted to hedging inflation risks. Lower volatility of output tends to imply more stable employment and a reduction in the extent of economic uncertainty confronting households and firms. The reduction in the volatility of output is also closely associated with the fact that recessions have become less frequent and less severe.

This has been one of the major claims of the neo-liberals over the years. Inflation targeting proponents claim that it has several advantages over other types of monetary policy. Economists outline the virtues of this approach in terms of higher sustainable growth rate and enhanced policy credibility.

Many of the gains are attributed to the fact that inflation targeting approach provides the central bank with the independence it needs to be credible, transparent and accountable. As a consequence, this independence overcomes the time inconsistency problem raised by Sargent whereby an inflation bias is generated by the pressure the elected government places (implicitly or explicitly) on non-elected officials in the central banks to achieve popular outcomes.

Thus inflation targeting can lock in a low inflation environment. They argued that it not only reduces inflation variability but also reduces the variance of output growth. If certainty in monetary policy generates more stable nominal values, it is argued that lower interest rates and reduced risk premiums follows. This stimulates higher real growth rates via an enhanced investment climate.

Further, inflation persistence is allegedly reduced because one time shocks to the inflation rate are quickly eliminated by the policy coherence. The reduced inflation variability allows more certainty in nominal contracting with less need for frequent wage and price adjustments. This in turn means less need for indexation and short-term contracts.

However, the implications of this are a ‘flatter’ short-run Phillips curve. In other words, higher disinflation costs. I will come back to that.

Bernanke then turns to the question of why “macroeconomic volatility declined?” He discussed “three types of explanations” – “structural change, improved macroeconomic policies, and good luck”.

The structural change explanations focus on so-called improvements “in economic institutions, technology, business practices, or other structural features of the economy have improved the ability of the economy to absorb shocks.”

In this vein, as a demonstration of his perspicacity not!, Bernanke highlights:

The increased depth and sophistication of financial markets, deregulation in many industries, the shift away from manufacturing toward services, and increased openness to trade and international capital flows are other examples of structural changes that may have increased macroeconomic flexibility and stability.

So in the confirmation process he should be asked to explain this claim.

First, the so-called “increased depth and sophistication of financial markets” has now been shown to be short-hand for the dazzling array of financial instruments that the Wall Street bankers devised to feed their growing greed and that no-one could assess for risk and which contaminated world economies and blew up not long after Bernanke was waxing lyrical.

These financial instruments were just draining the bounty that the real economy was producing – financial markets are largely parasitic in this regard – they don’t produce very much productive activity themselves (see this blog – Financial markets are mostly unproductive).

The drain was feeding into the coffers of a small number of very wealthy institutions (and the individuals behind them) at the expense of real wages growth for the workers who were producing ever increasing per unit returns to business firms (see this blog – The origins of the crisis for more on these distributional shifts).

Second, the degregulation he so glowingly implicates allowed the financial markets to increasingly operate outside the purview of the government bodies charged with advancing public purpose. So, increasingly, the financial markets were pursuing goals that had nothing to do with the welfare of the citizens and the stability of the overall real economy.

The way in which the financial engineers went into overdrive as their behaviour became increasingly unregulated helps explain why households and firms became so indebted in this period. I know that an individual is ultimately the one who signs the loan form and has to take some of the responsibility.

But the sophistication of the sales and marketing tools employed by the banks and other players in the financial markets were elevated to such a plane that the average (greedy) householder had no chance against the pitch they were given nor any hope of understanding completely what they were getting themselves into.

It was also often said in this period that we should not worry about the debt accumulation because our wealth was growing faster. The problem was that the components of wealth were sensitive to market movements while the nominal value of the debt was not (especially in the deflationary period that followed).

And we saw the absurdity of governments allowing their citizens to borrow massive proportions of total debt in foreign currencies which was always a recipe for disaster. How could the Latvian government, for example, allow something like 80 per cent of their home mortgage market to be written in foreign currencies? Their experience is not uncommon in this period.

Bernanke then considered the “second class of explanations” which focus “on the arguably improved performance of macroeconomic policies, particularly monetary policy”. He says:

The historical pattern of changes in the volatilities of output growth and inflation gives some credence to the idea that better monetary policy may have been a major contributor to increased economic stability … Few disagree that monetary policy has played a large part in stabilizing inflation, and so the fact that output volatility has declined in parallel with inflation volatility, both in the United States and abroad, suggests that monetary policy may have helped moderate the variability of output as well.

I will ignore the explanations of “luck” but Bernanke noted that if they were relatively more important then “we have no particular reason to expect the relatively benign economic environment of the past twenty years to continue”.

Clearly wanting to advance the ideological propositions, Bernanke said:

If instead the Great Moderation was the result of structural change or improved policymaking, then the increase in stability should be more likely to persist, assuming of course that policymakers do not forget the lessons of history.

My view is that improvements in monetary policy, though certainly not the only factor, have probably been an important source of the Great Moderation. In particular, I am not convinced that the decline in macroeconomic volatility of the past two decades was primarily the result of good luck …

So I wonder what his explanation is now.

Even during this so-called Great Moderation the claims made by the mainstream economists were fairly spurious.

The following table shows the standard deviation for real GDP growth rates (quarterly) and the standard deviation of quarterly inflation rates using OECD Main Economic Indicators for several countries. Some data is not available for some of the decades.

You can see that for most countries, real output growth variability has once again increased in the last decade compared to the 1990s. Australia stands out as an exception, largely because the current recession was not as severe thanks to the early and substantial fiscal intervention.

Further, inflation variablity has not been uniformly lower in the 2000s compared to the 1990s

The next table shows the average rates of quarterly real GDP growth and the inflation rate and unemployment rates for the same decades.

This table shows the impacts of the tighter monetary policy overall (targetting and non-targetting nations) combined with the neo-liberal consensus that fiscal austerity was necessary to support the tighter monetary policy. The fiscal austerity was clearly more important in explaining the slowdown in real growth though.

Australia, despite being the so-called darling of the OECD because it introduced the privatised labour market services and other deregulation and formally adopted inflation targetting, has performed poorly over the last few decades by comparison to the 1960s. The so-called growth decade (2000s) has seen the lowest average real growth since the 1960s.

The ten years of budget surpluses prevented the economy from reaching its potential and so unemployment remained relatively high during the last several decades.

The same story is obvious for all other countries. The “Great Moderation” reduced variability but also reduced overall growth rates. Further it is clear that the high real GDP growth rates of the 1960s were associated with generally low inflation rates.

Clearly, the subdued growth that occurred in the “Great Moderation” was also associated with persistently high unemployment rates in all nations. The welfare losses involved were enormous. All sorts of excuses were given for this rise in the unemployment rate but it is obvious that it was because policy makers prevented real GDP growth rates from reaching potential.

They started to use unemployment as a policy tool in their misguided fight against inflation and then tried to doctor the facts with new theories like the natural rate of unemployment. Please read my blog – The dreaded NAIRU is still about! – for more discussion on this point.

The other point to note is that the unemployment data understates the degree of slack that policy makers allowed to persist. The 5.5 per cent average unemployment rate for Australia has to be supplemented by an average underemployment rate of around 4 per cent over the 2000s.

The real question then is how large are the output losses following discretionary disinflation? The magnitude of the real losses is considered to depend on the degree of inflation persistence. The increased use of inflation targeting has been associated with persistently high (though declining) unemployment in most OECD economies. Some economists argue that inflation-first monetary policy (of which inflation targeting is an evolved form) has caused the lack of jobs, especially in European economies, over the 1990s.

While some extreme elements of the profession, who still consider rational expectations to be a reasonable assumption, will deny any real output effects, most economists acknowledge that any disinflation engendered by this approach will be accompanied by a period of reduced output and increased unemployment (and related social costs) because a period of (temporary) slack is required to break inflationary expectations.

To measure the real losses economists have used the concept of a sacrifice ratio which is the accumulated loss of output during a disinflation episode as a percentage of initial output expressed as ratio of the accumulated reduction in the inflation rate. So if the sacrifice ratio was two it would mean that a one-point reduction in the trend inflation rate is associated with a GDP loss equivalent to 2 per cent of initial output.

The hardcore mainstream deny they exist in any meaningful way while other less manic mainstream economists suggest that they exist in the short-run only and are modest and ephemeral.

For example, in the famous September 1996 Statement on the Conduct of Monetary Policy set out how the Reserve Bank of Australia was approaching the attainment of its three identified policy goals (full employment, price stability and external stability). It elaborated the adoption of inflation targeting as the primary policy target.

In terms of the priorities, the Statement said (RBA, 1996: 2):

These objectives allow the Reserve Bank to focus on price (currency) stability while taking account of the implications of monetary policy for activity and, therefore, employment in the short term. Price stability is a crucial precondition for sustained growth in economic activity and employment.

The rest of the text emphasised the need to target inflation and inflationary expectations and the complementary role that “disciplined fiscal policy” had to play. There was no discussion about the links between full employment and price stability except that price stability in some way generated full employment even though the former required disciplined monetary and fiscal policy to achieve it.

The RBA said that the trade-off between inflation and unemployment while something that might be considered in the short-term is not a long-run concern because, following NAIRU logic, it simply doesn’t exist. They claimed that in the long-run the growth performance of the economy is determined by the economy’s innate productive capacity, and it cannot be permanently stimulated by an expansionary monetary policy stance. Any attempt to do so simply results in rising inflation.

The following diagram is a simple graphical depiction of the sacrifice ratio concept and captures the way most empirical studies have pursued the estimation of sacrifice ratios. The cumulative output loss as a consequence of the actual output falling below potential output is depicted by the shaded area. In this diagram, output resumes at its potential level at the exact end of the disinflation period (defined as the period between the peak inflation and the trough inflation).

The resulting estimates of sacrifice ratios, even though they are still significant (around 1.3) are underestimates because they ignore the impacts of persistence and hysteresis. They assume that the disinflation episode has a relatively finite, short-term impact on real GDP growth and before long the actual growth path converges on the potential path (which was unchanged by the policy change).

However, in the real world, it is clear that a prolonged period of reduced real GDP growth lasts beyond the formal disinflation period and that the potential real GDP growth path also declines as the collateral damage of low confidence among firms curtails investment (which slows down the growth in productive capacity).

Persistence assumes that actual output is assumed to remain below potential after the disinflation period has finished. The longer this disparity exists the longer is the persistence. Hysteresis theories purport permanent losses of trend output as a consequence of the disinflation. I published an often-cited paper in 1993 (Applied Economics) on the issue of persistence and hysteresis (and covered it in my PhD research).

The important point is that to estimate the sacrifice ratio you have to not only consider the short-term losses but also the longer-term losses arising from persistence and hysteresis.

The following diagram captures these impacts and shows that the losses are much greater than would be estimated using the concepts in the first diagram (above). You can see that potential output falls after some time (as investment tails off) and actual output deviates from its potential path for much longer. So the estimated costs of the disinflation (and fiscal austerity supporting it) are much larger.

So the real question then is how large are the output losses following discretionary disinflation? Focusing on variability is unlikely to give you much of an idea of the welfare losses (or benefits) arising from the policy stance.

Empirical estimates of the sacrifice ratio show that the period of the Great Moderation was certainly not costless.

While some extreme elements of the profession, who still consider rational expectations to be a reasonable assumption, will deny any real output effects, most economists acknowledge that any disinflation engendered by this approach will be accompanied by a period of reduced output and increased unemployment (and related social costs) because a period of (temporary) slack is required to break inflationary expectations.

The magnitude of the real losses is considered to depend on the degree of inflation persistence. The increased use of inflation targeting has been associated with persistently high (though declining) unemployment in most OECD economies. Some economists argue that inflation-first monetary policy (of which inflation targeting is an evolved form) has caused the lack of jobs, especially in European economies, over the 1990s.

In my 2008 book with Joan Muysken – Full Employment abandoned, we consider the estimation of sacrifice ratios in some detail.

The conclusions we draw from an extensive literature analysis and our own empirical work are:

  • Formal econometric analysis does not support the case that inflation targeting delivers superior economic outcomes. Both targeters and non-targeters enjoyed variable outcomes and there is no credible evidence that inflation targeting improves performance as measured by the behaviour of inflation, output, or interest rates.
  • There is no credible evidence that central bank independence and the alleged credibility bonus that this brings bring faster adjustment of inflationary expectations to the policy announcements. There is no evidence that targeting affects inflation behaviour differently.
  • Sacrifice ratios estimates confirm that disinflations are not costless; the average ratio for all countries over the 1970s and 1980s episodes is around 1.3 to 1.4. Significantly, the average estimated GDP sacrifice ratios have increased over time, from 0.6 in the 1970s to 1.9 in the 1980s and to 3.4 in the 1990’s. That is, on average reducing trend inflation by one percentage point results in a 3.4 per cent cumulative loss in real GDP in the 1990s.

The work I have done in this field which is summarised (with references) in the book show that the Great Moderation was actually associated with higher sacrifice ratios.

Australia, Canada, and the UK, who announced policies of inflation targeting in the 1990s, do not have substantially lower sacrifice ratios compared to G7 countries who did not announce such policies. Australia does record a lower average ratio during the targeting period than in the 1980s, averaged across the three methods it is 1.2 per cent, however this figure is not lower than the average for all previous periods. Canada records a higher sacrifice ratio in the 1990s of 3.6 per cent. The ratio for the UK during inflation targeting is significantly higher at 2.5 per cent (relative to quite low sacrifice ratios in previous periods). Meanwhile Italy, Germany, Japan and the US, average 0.6, 2.3, 2.9 and 5.8, respectively. Thus inflation targeting does not appear to have produced better outcomes in terms of reducing the costs of disinflation (although obviously we have not controlled for other factors).

The evidence is clear that inflation targeting countries have failed to achieve superior outcomes in terms of output growth, inflation variability and output variability; moreover there is no evidence that inflation targeting has reduced persistence.

Other factors have been more important than targeting per se in reducing inflation. Most governments adopted fiscal austerity in the 1990s in the mistaken belief that budget surpluses were the exemplar of prudent economic management and provided the supportive environment for monetary policy.

The fiscal cutbacks had adverse consequences for unemployment and generally created conditions of labour market slackness even though in many countries the official unemployment fell. However labour underutilisation defined more broadly to include, among other things, underemployment, rose in the same countries.

Further, the comprehensive shift to active labour market programs, welfare-to-work reform, dismantling of unions and privatisation of public enterprises also helped to keep wage pressures down. It is clear from statements made by various central bankers that a belief in the long-run trade off between inflation and employment embodied in the NAIRU has led them to pursue an inflation-first strategy at the expense of unemployment.

Disinflations are not costless irrespective of whether targeting is used or not. They have risen for the seven countries from on average 0.7 in the 1970s to 3.5 in the 1990s. This implies that any attempt to bring down inflation nowadays with 1 per cent-point will result in a cumulative loss in GDP of 3.5 per cent on average. In terms of unemployment the latter can be interpreted roughly speaking as a cumulative increase by 7 per cent.

The increase in the sacrifice ratio over time illustrates that reduced inflation variability allows more certainty in nominal contracting with less need for frequent wage and price adjustments. The latter in turn means less need for indexation and short-term contracts and leads towards a flatter short-run Phillips curve. Thus a consequence of inflation targeting is that the costs of disinflation become higher.

In 2000, the late Franco Modigliani said that (‘Europe’s Economic Problems’, Carpe Oeconomiam Papers in Economics, 3rd Monetary and Finance Lecture, Freiburg, April 6, page 3):

Unemployment is primarily due to lack of aggregate demand. This is mainly the outcome of erroneous macroeconomic policies … [the decisions of Central Banks] … inspired by an obsessive fear of inflation, … coupled with a benign neglect for unemployment … have resulted in systematically over tight monetary policy decisions, apparently based on an objectionable use of the so-called NAIRU approach. The contractive effects of these policies have been reinforced by common, very tight fiscal policies (emphasis in original)

However, the real costs of inflation targeting lie in the ideology that accompanies it such that fiscal policy has to be passive. The failure of economies to eliminate persistently high rates of labour underutilisation despite having achieved low inflation is directly a consequence of this fiscal passivity.


Those who are considering Bernanke for a second term should think again.

He is one of the coterie that allowed this crisis to happen and while the damage was unfolding right under his eyes joined in the sophistry that the mainstream economics profession refined to a high degree.

The problem is that sophistry is … just that. Lies.

If Obama is to have any credibility at all he must start culling from his ranks all these liars. And in doing so, I don’t think that a return to Volcker is an improvement.

That is enough for today!

This Post Has 7 Comments

  1. I think Bill has talked of this. Just for the reference of other readers. A few quotes from:


    Chairman Ben S. Bernanke
    Current economic and financial conditions and the federal budget
    Before the Committee on the Budget, U.S. House of Representatives, Washington, D.C.June 3, 2009

    Clearly, the Congress and the Administration face formidable near-term challenges that must be addressed. But those near-term challenges must not be allowed to hinder timely consideration of the steps needed to address fiscal imbalances. Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth.

    Nevertheless, even as we take steps to address the recession and threats to financial stability, maintaining the confidence of the financial markets requires that we, as a nation, begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby-boom generation and continued increases in medical costs


  2. Dear All,

    How about “increased openness to trade and international capital flows.” as claimed by Bernanke? Aren’t the low cost export goods of South Korea and a couple of decades later, on much larger scale, those of China, pulling global inflation downward (not commodities though)? Not a cheap bargain, though, for those who side with the view (I have yet to be convinced either way) that it also takes jobs away from developed nations.

  3. If monetary control of inflation is bunk and/or overly tight, then one would ask how inflation really should be addressed (or what level would be acceptable). Governments love to spend- would far higher spending be a sustainable policy? What places limits on such spending? What then controls inflation? In your ideal world, monetary policy would be defunct, setting interest rates permanently at zero and putting fiscal spending in control of stock (money) flows to the economy. How would this be fine-tuned when demands for spending become entrenched, and, through the usual mechanisms of corruption, unresponsive to rational policy? How would they respond to periodic inflations/deflations of private credit? Don’t get me wrong, I am sympathetic- I just don’t understand how an MMT world would really work.

  4. It wouldn’t. Once you remove all the perceived restrictions arising from the gold standard, which still underlie almost all neoliberal economics, you are left with an economy that must be run by human choices. Under gold, those who do not care to contribute to the public welfare, for instance, could always say, “Ooops! We’re out of gold. Can’t feed the widows and orphans now. It’s horrible, surely, but we’re just out of money. There’s nothing we can do.” It wouldn’t even matter if we weren’t out of gold; they could just say so and who could argue with them?

    But if that limit, the gold limit, were not there, then the public welfare, and everything else, would have to be chosen by actual people in real ongoing time. What “rational policy” actually is would be continually before us. We would have to choose.

    We’re not there yet.

  5. carping demon,

    Your elucidation is also a succinct explanation as to why a lot of people who should don’t “get it”. Once it becomes clear that the economy is run by human choices, ordinary people who believe they are living in democracies may expect to have a say in those choices. The free market, as it is now, is about the wealthy making all of the choices. The latter are quite attached to that situation and pay the salaries of those who keep the mainstream economic thinking right where it is. Which is gold standard thinking and policies.

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