THE GREAT MODERATION


Since the early 1980s the US economy has undergone a significant shift with the old 3-4 year business cycle giving way to much greater economic stability as since 1984 the US

has experienced only two minor recession. It appears that the US has shifted from having a recession roughly every 4 years to one every 10 years, or even less frequently. This was one of the justifications for higher stock market valuation and the great bull market of the late 1990s. But since 2000 the market PE has returned to the same relationship it had to interest rates and inflation that prevailed before 1995. Of course this implies that the stock market has gone back to discounting a 3-4 year economic-stock market cycle.

Generally, three or four main factors are credited with this change.

One is the improvement in information technology so that firms no longer make the inventory errors that generated recessions. One example of this was just completed. Last fall firms started to accumulate unwanted inventories as the inventory/shipments or sales ratio started rising. In the old days this would have lead to a major inventory accumulation that was followed by a sharp drop in output or a recession as firms finally liquidated the unwanted inventories. But this time firms reacted very quickly and liquidated the unwanted inventories before the problem became so severe it caused a recession rather then just a slowdown.

The past year’s inventory correction also demonstrated a second cause of the great moderation–the growing importance of international trade. In the old days if a retailers wanted to cut inventories it would cut back orders to a domestic manufacturing firm and that firm would have to cut output and lay off workers and this generated a negative Keynesian multiplier. Now, a great portion of the drop in orders is to China and other foreign producers who have to make the correction. We now export the recession and it shows up in the data as a drop in imports that actually boost reported real GDP growth. But this also means the US no longer gets the big snap back in output when the inventory liquidation is over. This was one reason the last two recoveries were weak by historic norms.

A third factor is a lack of shocks. Much of the poor economic performance of the 1970s was blamed on the oil shocks so the absence of such oil shocks was credited as part of the reason for the great moderation. But recently we have experienced another oil and commodity shock and it is not generating a recession as it did in the 1970s. Consequently, the luck or shock explanation for the great moderation is fading away.

Tightly tied into the impact of shocks or luck is the fourth factor explaining the great moderation is improved productivity. In the 1970s productivity was poor and unit labor cost rose so much that firms had little choice to pass through the higher oil and other commodity prices. But this cycle productivity has been so good that firms could absorb much of the higher oil and commodity prices and still sustain strong profits.

The final factor used to explain the great moderation is better policy, especially better monetary policy. As far as fiscal policy is concerned there was a significant policy shift in the early 1980s from tax cuts or deficit spending to stimulate demand to tax cuts or deficits to stimulate supply. Does demand create its own supply, or does supply create its own demand? For monetary policy it looks like the shift was from policy rules that gave inflation and unemployment roughly equal weight in determining policy to policy rules that gave fighting inflation a much greater weight.

So how do we evaluate these changes. Roughly, we have traded-off having frequent, severe recession for having much less frequent and milder recessions and lower inflation for about a 0.5 annual percentage point slowing of trend real GDP growth or about 0.25 percentage point weaker per capita real GDP growth So what does this look like. Maybe comparing actual real GDP to potential real GDP is one way to make the comparison. Potential real GDP is a measure of capacity calculated by the CBO based on growth in productivity and labor force. Thus, real GDP is a % of potential GDP is a measure of capacity utilization, or of actual economic performance relative to US economic capacity.

As the chart shows there was a major structural shift around 1980. Prior to 1980 actual real GDP was above potential real GDP almost two-thirds of the time while since 1980 it was only above potential about 2.5% of the time. It is like the old Army recruiting slogan, “Be All You Can Be”. Before 1980 it looks like the economy was “ All It Could Be” while since 1980 it has been “Less Than It Could Be”. Moreover, since 1980 as we experienced much more idle resources real potential GDP growth also slowed significantly as the following chart shows. The chart has two trend lines. A straight line for productivity pessimist and a curved line for productivity optimist.

When I look at these charts I reach a couple of conclusions. One, it looks like the difference in the pre-1980 era and the post-1980 is that the shift in monetary policy to giving inflation a greater weight than employment worked through the mechanism of creating sufficient excess capacity in the economy—a form of Phillip Curve analysis . Second, in contrast to supply-side policies Keynesian demand management worked to generate too strong an economy before 1980.. But since1980 supply-side policies have massively failed to stimulate strong economic growth. Of course, there are other explanations. One is that the strong economies of the 1950s and the 1960s was due to the stimulus and demands stemming from the Korean and Viet Nam wars. Of course that just leads to the conclusion that the Bush administration is just not really trying to win the Iraq war because it is giving the military the resources they need to win the war. Leave it to team Bush to provide virtually the only historic example of a was not stimulating he economy.

Otherwise, I’ll just leave these comments and charts as the start of a good discussion.

Comments Off on THE GREAT MODERATION | |