Another longish extract from my book project. Corrections and suggestions of all kinds are welcome. I’m also thinking it might be good to have a website where it’s possible to look at, and comment on, all the draft chapters, but I suspect people prefer the atmosphere of a comments thread. Any thoughts on this?
‘Stock prices have reached what looks like a permanently high plateau’, Irving Fisher October 1929
As this 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 19th centuries, it 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 his 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 US Federal Reserve which had been established in 1913 and had dealt successfully with several minor crisis. 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 crisis of 1929, which soon became the Great Depression, an uninterrupted four-year period of decline that threw as much as a third of all workers out of work, not only in the US, but in all the developed countries of 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 immediate aftermath of the Great Depression, however, the analysis that held sway over the great bulk of the economics profession was that of John Maynard Keynes.
The global financial crisis bears obvious similarities to the crises that precipitated the world into the Great Depression of the 1930s. Unsurprisingly, perhaps, much of the debate about policy responses has focused on the way in which different countries handled (or mishandled) the Great Depression. In particular, in the United States, a great deal of time has been spent debating traditional views of the New Deal as a relatively successful (though imperfect) response to the Depression and revisionist accounts in which New Deal policies prolonged the Depression.
But the global success of Keynesian ideas in the postwar period owed little to the experience of the New Deal. The crucial contrast was between the experience of World War I and its aftermath, ending in the Depression, and that of World War II and the successful economic reconstruction that followed it.
The financing and economic planning of World War II was largely undertaken on Keynesian lines, and Keynesians were quick to draw the lessons for the postwar period. The interwar years were seen as a period of economic waste that contributed greatly to the rise of Hitler and the renewed outbreak of global war in 1939.
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.
The architects of postwar reconstruction hoped to prevent a renewed slump like that of 1919, and to hold unemployment rates below 5 per cent. They succeeded beyond their wildest dreams. The decades following the war were a period of unparalleled prosperity for developed countries, with economic growth higher and unemployment lower than at any time before or since.
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. With declining inequality and the introduction of more or less comprehensive welfare states, the gains were greatest for those at the bottom of the income distribution. But in an environment of stable growth and ever-increasing demand for their products, business leaders were happy to accept a larger role for government and the implicit contract that guaranteed steady work and high wages for their unionised employees in return for a government commitment to keep the economy at or near full employment.
By the 1960s, many Keynesian economists were prepared to announce victory over the business cycle. Attention turned to more ambitious goals 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. By 1970, the Bretton Woods system was under serious pressure. Inflation in the United States had rendered untenable the commitment to hold the price of gold at $35/ounce. And whereas previous episodes of inflation had been brought under control quite rapidly through Keynesian contractionary policies, these policies were becoming less effective as inflationary expectations became embedded and as the social restraint generated by memories of the Depression broke down.
The last years of the Keynesian Golden Age saw a struggle over income distribution that virtually guaranteed an inflationary outburst. Union militancy, fuelled by Marxist rhetoric came into sharp conflict with the emerging speculative capitalism, driven by revived global financial markets. Firms raised prices to meet wage demands, spurring yet further wage demands to compensate for higher prices.
The coup de grace came with the oil shock of 1973, which was both a reflection of the inflationary outburst that was already under way and the cause of a further upsurge. Within a couple of years the entire edifice of postwar prosperity had collapsed and the Long Boom came to a painful and chaotic end. The 1970s and 1980s were decades of high unemployment and inflation (the ugly term ‘stagflation’ was coined to describe the ugly and unprecedented appearance of these two economic evils simultaneously, rather than as part of a cycle of inflationary boom and deflationary slump). Repeatedly, seemingly promising recoveries fizzled or collapsed into even more severe recessions.
At least by comparison with these dismal decades, 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 owners of stocks. 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, in many cases, triumphalism. The success of books like Fukuyama’s The End of History and Thomas Friedman’s The Lexus and the Olive Tree reflected the way they matched the popular mood.
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 US data and discern a pattern that was the very opposite of a lost golden age. Rather, the datacould be read as showing a decline in the volatility of output and employment. Although the statistics did not yield a definitive interpretation, most observers saw the decline in volatility as a once-off dropping that took place in the mid-1980s, after the early 1980s recession, induced by the restrictive policies of Fed Chairman Paul Volcker that put an end to the 1970s upsurge inflation. This apparent decline in volatility, coinciding with the Chairmanship of Volcker’s successor, Alan Greenspan became known as The Great Moderation, a phrase coined by James Stock of Harvard University and Mark Watson of Princeton University.
Greenspan own successor, Ben Bernanke, graduated summa cum laude from Harvard in 1975, and completed a PhD at MIT in 1979. Bernanke is a leading figure in the generation of economists whose careers began after the breakdown of the long boom, and have largely coincided with Greenspan era. Unsurprisingly perhaps, Bernanke was among those who did most to revive the idea of a New Age of economic stability. He also popularised the use of the term the “Great Moderation” to describe it, using it as the title of a widely-publicised speech given in 2004.
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’.
Although it is common to describe the occurrence of two successive quarters of negative economic growth as the “technical” definition of a recession, economists rarely use this definition except as a rough guide to the current state of the economy. Rather, economists in the US generally rely on the National Bureau of Economic Research Business Cycle Dating Committee, which defines a recession as ‘is 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’ and issues judgements as to when recessions begin and end. Similar bodies in other countries make the same kind of judgement, though none has quite the authority of the NBER.
These judgements 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 the course of 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 began a year earlier, in December 2007. The announcement of the end of a recession takes place with a similar delay.
Whatever the defintion, in the years before 1981 (the end of the Volcker recession) recessions in the US were relatively frequent, with the intervening expansions averaging a little over four 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 as measured by the NBER. 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, and 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 details who first formalised it. Taylor argued that central banks should (and mostly did) seek to minimise the variance of the rates of output growth and inflation about their long-run average values.
A variety of statistical tests suggested that the volatility of economic growth rates in the US had declined sharply over the early 1980s. And the moderation was not confined to US output growth. A similar decline was observed in both the average rate of inflation and the volatility of inflation, and in the volality of employment and unemployment rates. Broadly similar patterns were observed in nearly all the main developed countries. The big exception was Japan, where a decades-long bubble in real estate and stock prices burst at the end of the 1980s, paving the way for a long period of stagnation, with occasional brief expansions punctuated by renewed downturns. At the time, though, Japan’s problems were regarded as specifically Japanese, in much the same way as the financial crisis of the late 1990s was seen as a specifically Asian problem of ‘crony capitalism’.
The discovery of the Great Moderation, and, even more, Bernanke’s imprimatur, spawned an instant academic industry. Hundreds of studies dissected the Great Moderation from every possible angle, considering alternative interpretations, causal hypotheses and projections for the future. Participants in the industry displayed the disagreements for which economists are notorious. But, as is commonly the case with specialists in any field, disputes over details concealed broad agreement on fundamentals. In particular, few, if any, writers on the Great Moderation suggested that it was approaching an abrupt end.
If the Efficient Markets Hypothesis provided the theoretical basis for the resurgence of economic liberalism, the Great Moderation appeared to represent empirical confirmation of its success. The apparent stabilization of the business cycle offered economic liberals the pragmatic justification that, whatever the inequities and inefficiencies involved in the process, the shift to economic liberalism since the 1970s had delivered sustained prosperity. 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 smoothe 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.
(A couple of years later, writing his farewell column for the Times, Baker described this piece as his biggest mistake.)
The Great Moderation seemed to show that, in macroeconomic terms, economic liberalism had succeeded where Keynesianism had failed. The collapse of the Bretton Woods system and the decade of economic disruption that followed it had, it seemed, paved the way for sustained and broad-based growth. Similar improvements in economic stability, observed in a number of English-speaking countries, could be attributed to the radical reforms implemented by such leaders or finance ministers as Margaret Thatcher in the UK, Roger Douglas in New Zealand and Paul Keating in Australia. The European Union was generally seen as a laggard, with little choice but to follow the lead of the Anglosphere.
Central bankers, and particularly Alan Greenspan and Ben Bernanke, were happy to take the credit for the positive outcomes of the Great Moderation, while, for the most part, ignoring or downplaying the evidence of unsustainable imbalances, and unmanaged risks. For Greenspan in particular, the Great Moderation appeared to be an enduring legacy.
Of course, the claim of improved monetary policy did not rest entirely on the supposed genius of Greenspan and his fellow central bankers. The more serious claim was that, thanks to financial liberalisation, the economy could be stabilised using only a single policy instrument, the short-term interest rate determined by the central bank (in the US this is the Federal Funds rate).
While some analysts focused primarily on the role of monetary policy and central banks, the Great Moderation also fitted naturally into broader triumphalist stories about economic liberalism globalisation. In particular whereas Keynesianism required national governments to manage macroeconomic risk, the rise of global financial markets allowed such risk to be spread around the world. Since, it was assumed, national economic fluctuations would largely cancel each other out, risk could be moderated without government intervention. All that was required was for investors to hold diversified portfolios, and for capital to flow freely where its return was highest.
A third possibility was, of course, that the Great Moderation was just a run of good macroeconomic luck consisting, in essence of a couple of cycles where the expansion went on a little longer than usual and the recessions were relatively mild. Academic studies tended to mention this possibility, but mostly only to dismiss it. Popular promoters like Baker ignored the question.
The econometric tests reported in studies of the Great Moderation showed a statistically significant change occurring in the mid-1980s. However, it is an open secret in econometrics that such tests mean very little, since the same set of time series data that suggests a given hypothesis must be used to test it. This is quite unlike the biomedical problems for which the statistical theory of significance was developed, where a hypothesis is developed first, and then an experiment is designed to test it.
A fourth possibility, not mentioned at all in most discussions of the Great Moderation was that the apparent stability was actually a reflection of policies that were bound to fail in the end. Simply put, the prosperity apparently generated by economic liberalism was just a bubble waiting to burst, or rather, a series of bubbles, each larger than the last, and each encouraged by a combination of financial deregulation and expansionary monetary policy.
The Great Risk Shift
Beyond bragging rights in the perennial disputes between economic liberals and social democrats, the Great Moderation provided essential support for a central part of the agenda of economic liberalism, the idea that individuals and businesses, rather than governments, were best placed to manage the risks associated with modern economic life. This idea found its expression in what Jacob Hacker has called The Great Risk Shift. Risks that had been borne by corporations or governments were shifted back to workers and households.
Since aggregate employment was seen as more stable than ever, people who lost one job were presumed to be easily capable of finding another, and failure in this task was attributed to personal failings rather than to the workings of the economy. In these circumstances, companies felt the need to be ‘nimble’ and ‘flexible’ in their operations, buzzwords that translated into a willingness to fire large number of workers whenever doing so would yield a short-run increase in profitability. Similarly, there was seen to be less need for generous benefits for the unemployed and these benefits were duly cut or frozen.
The Great Risk Shift extended to such areas as health care and retirement income. The ‘one size fits all’ systems of single-payer health care and retirement income provision introduced in the aftermath of the Depression and WWII were attacked as bloated bureaucracies that crippled individual choice. Instead, it was argued, ordinary households should make their own provision for health insurance and retirement, with a public sector ‘safety net’ being reserved for the indigent and improvident.
Even during the Great Moderation, it was notable that the wealthy elite showed much more enthusiasm for individual risk-bearing when it was undertaken by ordinary employees than they did on their own behalf.
Great show was made of remuneration devices such as options, which gave senior executives the chance to benefit when their company did well and the share price rose. The benefits were taken very happily during the boom years of the late 1990s, when almost all stock prices were going up, regardless of the quality of their management. But, once the bubble burst, enthusiasm for stock options declined. More strikingly, large numbers of companies repriced the options they had already issued, setting the price low enough that their executives were once again ‘in the money’.
Of the institutions that were seen as obstacles to improved economic performance by economic liberals, none has been more vilified than restrictions on dismissal of workers, or requirements for generous redundancy pay. The supposed sclerosis of the European economies was blamed, more than anything else, on the difficulty of firing workers, which, it was argued, acted as a disincentive to hiring. Yet these arguments were forgotten when it came to CEOs. In case after case, failed CEOs have been rewarded with payouts running into millions, or even tens of millions, of dollars, while the workers whose jobs were lost due to their incompetence were lucky to receive a few weeks pay.
The upshot was that, despite their vastly greater capacity to absorb financial shocks, senior executives as group faced no more risk, relative to their average income, than ordinary workers. Relative to their wealth, senior executives faced much less risk than most people. The most disastrous failures among CEOs rarely end up poor, or even back in the middle class. But as long as the Great Moderation continued, inconsistencies like this were disregarded. Companies abandoned any pretence of a social contract with their workers (who were, at an early stage in this process, relabeled as ‘human resources’).
Risk has both an upside and a downside, of course. In the later years of long expansions, the balance of bargaining power in labor markets shifts towards workers, resulting in improved wages and conditions. But, on the whole the downside predominated. Faced with the ever-present risk of job loss, employees accepted a faster pace of work and reduced working conditions as the price of continued employment.
Governments also sought to get out of the business of risk management. Throughout the years of the Great Moderation, economic liberals railed against the social protections of the welfare state, which they saw as both inefficient and outdated. They had some successes, most notably with welfare reform in the United States. But on the whole the welfare state proved surprisingly resilient. Core programs like Social Security in the United States and the National Health Service in Britain enjoy deep and broad popular support.