David Leonhardt: Was the "Great Moderation" An Illusion?

A very good article by David Leonhardt in today’s New York Times raises a question that would have been regarded with considerable skepticism as recently as, say, even August, when the perturbations in the debt markets seemed to be the largely the result of the subprime meltdown. That question is whether the Great Moderation, the period regarded as an economic golden age which featured solid growth rates for advanced economies, tame inflation, and even relatively mild crises, was built on tidal sands.

Leonhardt says what some who have formerly been portrayed as alarmists have said for a while: a boom, or even merely good growth, that relies heavily on excessive debt creation, particularly when the proceeds of borrowing are either consumed or simply invested poorly, is bound to come to a bad end as the overhang has to be worked off. Either you have a contraction as consumption is redirected to debt reduction, or inflation which will have the effect of reducing the debt, but also erodes the real value of other financial assets.

Leonhardt describes stimuli and risks that we now recognize were not well understood at the time, and led them to take actions that with the fullness of time, now appear to have significant, unanticipated costs. With perhaps a morbid turn of mind, I am reminded of the case of a steel magnate of the 1920s, Eben Byers, who was overly fond of a stimulant of a very different sort, a popular tonic known as Radithor which contained radium. His daily dose, which initially gave the sportsman the illusion of health and plenty of energy, led to a miserable death at age 51, having lost his teeth, nearly half his body weight, and suffering holes in his jaw.

Let’s hope our recent elixir isn’t remotely as toxic. However, Leonhardt argues that there are good reasons to believe that the slowdown we are entering won’t be as mild as those of 1990-1991 and the beginning of this century.

From the New York Times:

Until a few months ago, it was accepted wisdom that the American economy functioned far more smoothly than in the past. Economic expansions lasted longer, and recessions were both shorter and milder. Inflation had been tamed. The spreading of financial risk, across institutions and around the world, had reduced the odds of a crisis.

Back in 2004, Ben Bernanke, then a Federal Reserve governor, borrowed a phrase from an academic research paper to give these happy developments a name: “the great moderation.”

These days, though, the great moderation isn’t looking quite so great — or so moderate.

The recent financial turmoil has many causes, but they are tied to a basic fear that some of the economic successes of the last generation may yet turn out to be a mirage. That helps explain why problems in the American subprime mortgage market could have spread so quickly through the world’s financial system. On Tuesday, Mr. Bernanke, who is now the Fed chairman, presided over the steepest one-day interest rate cut in the central bank’s history.

The great moderation now seems to have depended — in part — on a huge speculative bubble, first in stocks and then real estate, that hid the economy’s rough edges. Everyone from first-time home buyers to Wall Street chief executives made bets they did not fully understand, and then spent money as if those bets couldn’t go bad. For the past 16 years, American consumers have increased their overall spending every single quarter, which is almost twice as long as any previous streak.

Now, some worry, comes the payback. Martin Feldstein, the éminence grise of Republican economists, says he is concerned that the economy “could slip into a recession and that the recession could be a long, deep, severe one.”…..

But a recession is now more likely than not. It may well have started already….

The bigger question is how severe the recession will be if it does come to pass. The last two, in 1990-1 and 2001, have been rather mild, which is a crucial part of the great moderation mystique. There are three reasons, though, to think the next recession may not be.

First, Wall Street hasn’t yet come clean. Even after last week, when JPMorgan Chase and Wells Fargo announced big losses in their consumer credit businesses, financial service firms have still probably gone public with less than half of their mortgage-related losses, according to Moody’s Economy.com. They’re not being dishonest; they just haven’t untangled all of their complex investments.

“Part of the big uncertainty,” Raghuram G. Rajan, former chief economist at the International Monetary Fund, said, “is where the bodies are buried.”

As Mr. Rajan pointed out, this situation is more severe than the crisis involving Long Term Capital Management in the late 1990s. That was a case in which a limited set of bad investments, largely at one firm, had the potential to drive down the value of other firms’ holdings in the short term. Those firms then might have stopped lending money because they no longer had the capital to do so. But their own balance sheets were largely healthy.

This time, the firms are facing real losses, which will almost certainly curtail lending, and economic growth, this year.

The second problem is that real estate and stocks remain fairly expensive. This shows just how big the bubbles were: despite the recent declines, stock prices and home values have still not returned to historical norms.

David Rosenberg, a Merrill Lynch economist, says that the stock market is overvalued by 10 percent relative to corporate earnings and interest rates. And remember that stocks usually fall more than they should during a bear market, much as they rise more than they should during a bull market.

The situation with house prices looks worse. Until 2000, the relationship between house prices and rents remained fairly steady. The same could be said about house prices relative to household incomes and mortgage rates. But the boom of the last decade changed this entirely.

For prices to return to the old norm, they would still need to fall 30 percent across much of Florida, California and the Southwest and about 20 percent in the Northeast. This could happen quickly, or prices could remain stagnant for years while incomes and rents caught up.

Cheaper stocks and houses will benefit many people — namely those who don’t yet own a home and still have most of their 401(k) investing in front of them. But the price declines will also lead directly to the third big economic problem.

Consumer spending kept on rising for the last 16 years largely because families tapped into their newfound wealth, often taking out loans to supplement their income. This increase in debt — as a recent study co-written by the vice chairman of the Fed dryly put it — “is not likely to be repeated.” So just as rising asset values cushioned the last two downturns, falling values could aggravate the next one.

“What people have done is make an assumption that these prices could continue rising at the rate they had been,” said Ed McKelvey, an economist at Goldman Sachs. “And that does seem to have been an unreasonable assumption.”

Certainly, there are some forces to push in the other direction. Outside of Wall Street, corporate balance sheets remain remarkably strong, while the recent fall in the dollar will help American companies to sell more goods overseas.

But it’s hard not to believe that the economy will pay a price for the speculative binge of the last two decades, either by going through a tough recession or an extended period of disappointing growth. As is already happening, banks will become less willing to lend money, households will become less willing to spend money they don’t have and investors will become more alert to risk.

Welcome to the new moderation.

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  1. Anonymous

    This is so important in the understanding of the long term stupidity of The Fed!

    Testimony of Chairman Alan Greenspan
    The economic outlook
    Before the Joint Economic Committee, U.S. Congress
    June 9, 2005

    http://www.federalreserve.gov/Bo…092/ default.htm

    Although a “bubble” in home prices for the nation as a whole does not appear likely, there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels.

  2. x

    An explanation for the great moderation, and a true story.

    We’re one of the largest houses, and we were discussing whether to go long or short Monday night. We decided to go long because … we thought with the S&P so far down there was a good chance the Fed would lower its rates and the market would go back up. So Fed, thank you. You’re predictable. But you shouldn’t be selling anything of value for free.

  3. Juan

    For those who take the time to examine and analyse global and U.S. postwar data, it stands out that ‘the great moderation’ would be more appropriately labeled the great stagnation. That is, avg annual real GDP, productivity, real wages, nonfinancial rate of profit, etc., all shifted downwards while unemployment, rate of financial ‘profit’, size of informal sector, etc., increased.*

    Capitalism’s “Golden Age” ended in the early 1970s, an ending that, with the early 1980s double slump, became evident to all but the most superb ideologues.

    *See, for example, Angus Maddison’s OECD work, UMass’ James Crotty’s papers on neoliberalism, Dumenil and Levy’s papers on profit rate differentials, and many more, all of which detail the above.

    I would include the data but have found that, no matter how respected the sources, it is generally dismissed in favor of financial markets performance and/or ‘market knows best’ nostrums…as though it is possible to grasp the latter without comprehending the highly sharpened contradiction between real and financial. A failure which, you see, has had much to do with evident poor to no grasp of why (and how) we are where we are today.

  4. Yves Smith


    Agreed 100%, and didn’t get into the “growth hasn’t been that great” argument for precisely the reasons you raised. And add to that, as Michael Shedlock has pointed out, that our GDP is exaggerated due to hedonic adjustments, which no other advanced economy makes.

    If you had to point to a single culprit, it’s the shift from a manufacturing to a service economy. You can’t get the same kind of productivity gains in a service economy that you can in one that makes goods.

    And I also wonder how much of the productivity gains in service business comes from real Tayloresqe process improvements, versus simply squeezing more out of workers. Everyone I know who works in large firms is doing 50% more than they did 5 years ago for very little more in inflation-adjusted pay.

    I don’t understand why prevailing stock market multiples have increased. 18 is now regarded as normal, when in my youth, that was a sign of a very toppy market.

  5. Lune

    I wouldn’t blame the transition from manufacturing to services per se. Rather, I would blame the decline of unionization.

    Remember that 100 years ago, manufacturing jobs were poorly paid, dangerous, and led to shortened lives with poor health and injuries rather than a ticket to the comforts of the middle class. What made manufacturing the source of high wage, comfortable jobs for low to semi-skilled people were the changes fought for by unions.

    As unions have declined, it’s no surprise that jobs pay less for more work and fewer protections. There’s no intrinsic reason why service jobs can’t be unionized. After all, cashiers at WalMart, office workers locked in their cubicles, and even doctors battling with insurance companies are all faced with asymmetric power in the bargaining process. And at their most basic, that’s what unions address.

    Anyone who believes services are somehow different from manufacturing and can’t be unionized should check out Hollywood, perhaps the most unionized industry out there. The various guilds have managed to protect their workers against extremely asymmetric negotiations and manage to ensure fair distribution of profits, benefits e.g. health insurance and pension plans, etc. all while not stifling the creative process of movie making.

    I think if the rest of the service sector wants to improve their lot, they need to realize that unions aren’t just for high school grads with dirt under their fingernails.

  6. Yves Smith


    I don’t disagree with your observation about the fact that unions have gotten an undeserved bad rap. However, the point about productivity is somewhat different. Productivity measures output per unit labor input. The application of capital to labor, as in manufactiuring, lets you show continuing gains in productivity. That’s much more difficult to pull off on an ongoing basis in service industries.

    Dean Baker makes your point about white collar labor often. While they aren’t perceived to be unions, what the heck are the AMA, the AICPA, and the state bar associations other than the oversight bodies for craft guilds?

  7. Lune


    I’m not so sure that improving productivity in services is harder than in manufacturing, but rather is indeed related to the lack of unions in services and the recent moves to outsourcing. Why? The crucial distinction is that you’re measuring productivity as output per unit of labor, while companies view it as output per unit of wages. In other words, companies look to maximize profit; one way they can do this is to pay their workers the same amount, but get more work out of them (your definition of productivity improvement). That’s hard, as it entails continuously training workers, redesigning processes, etc. The easier way is to cut wages or outsource the work to a cheaper place (after all, who cares if you have twice as many Chinese doing the job if each one costs 1/4 the wages of an American?).

    The only time that managers undertake the difficult task of improving labor productivity is when they’re forced to because union contracts prevent cutting wages or outsourcing jobs.

    An example is illuminating. Dell Computers had a policy for a very long time (not sure if it still holds) that all of their computers would be assembled in the U.S. But in order to keep that goal while still being price-competitive, Dell spent an incredible amount of managerial energy on improving the productivity of its laborforce. They would spend millions to figure out how to shave 10 seconds off a computer’s assembly time.

    The rest of the computer industry decided instead to outsource their assembly lines to 3rd parties in China and Taiwan. After all, outsourcing requires very little thinking compared to the challenge of how to do the same job locally.

    In short, I would assert that the service sector would see just as big productivity improvements as the manufacturing sector if it were unionized to the point that companies had no choice but to improve productivity rather than take the lazy way out and cut wages or outsource every job they can find.

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