Five years ago this month the Great Moderation ended. To be precise December 2007 is the month that the NBER business cycle dating committee designated as the peak of the third and final expansion of the Great Moderation and the beginning of the Great Recession.
Hundreds of research papers have been written on the nature and causes of the Great Moderation, which got started around 1983. While that research began long after the Great Moderation got underway (I published one of the earliest papers on it in 1998), we should not wait so long to start seriously researching the causes of the post-Great Moderation period, regardless of how this period is eventually named by economists.
In my view, the framework that Ben Bernanke used in a February 2004 paper to study the causes of the Great Moderation is a good one. It goes back to research that started before the Great Moderation. Bernanke characterized the Great Moderation as a reduction in (1) the variance of inflation and (2) the variance of real GDP. He used the following diagram (it is a replica of Figure 1 in his paper) in which these two measures are on the horizontal and vertical axes respectively. Using the diagram he represented the Great Moderation as a move from point A to point B. He showed that a primary cause was better monetary policy, and he represented this by showing that better policy brought the economy closer to the true policy tradeoff curve (TC2) rather than the occurrence of a shift in the curve (from TC1 to TC2) . I completely agree with that interpretation.
But what caused the end? I have updated Bernanke’s diagram by adding a point C and a line from point B to point C (in red), based on the empirical volatility measures in the table below for the three periods. Observe that the post-Great Moderation deterioration does not simply retrace the previous improvement. It is nearly vertical, reflecting that virtually all the deterioration is in the output variability dimension.
In my view monetary policy was a major factor in the end of the Great Moderation just as it was the major factor in the Great Moderation itself. I review the reasons for this view in this paper on central bank independence versus policy rules which I am presenting at the annual meeting of the American Economic Association next month.
This week Russ Roberts released the third episode in his innovative new interview series called “The Numbers Game.” The innovation is to add graphs and other visuals—and thereby helpful numerical information—to his popular podcast interview series EconTalk.
The first three episodes go together to form a three part series on the economy and in particular on the nature and cause of the weak recovery from the 2007-2009 recession. The episodes also go together in that I was Russ's guest on all three—yes, a volunteer subject for Russ’s new experiment.
All the episodes are on YouTube.The first episode establishes that the recovery actually has been weak—even compared to other recoveries following deep recessions and financial crises. The second episode examines the possible causes of the weakness, and the third episode concentrates on what, in my view, is the main cause—economic policy.
It’s challenging to integrate charts effectively into a podcast of an interview, but it’s very worthwhile, especially in economics. Charts give the interviewee a chance to show the facts behind the arguments and then the interviewer can ask about and debate those facts. And it is even possible for the interviewer to add some challenging new charts as Russ did with a bar chart on a survey of economists in the third episode. Charts are also an invaluable way to convey ideas, and, speaking as a teacher, that’s why I love charts.
I think that Russ and his collaborator in this new endeavor, Shana Farley, have done a fantastic job. They have thought about everything, including putting up little caricatures of Russ and his guests like the one of me here. I hope they keep it up with many more episodes of The Numbers Game.
The Fed’s announcements yesterday increase monetary policy uncertainty in two fundamental ways.
Quantitative Easing on Steroids?
First, the new quantitative easing announcement implies a gigantic increase in the size of the Fed’s balance sheet and thus effectively an amplification of the policy risks and uncertainty which I have discussed, for example, in this oped with George Shultz and other colleagues in September. The Fed now plans to purchase $85 billion a month of longer-term Treasury and mortgage backed securities until there is substantial improvement in the labor market, which requires a completely unprecedented increase in reserve balances as illustrated in this chart.
The chart shows reserve balances held by banks at the Fed. These are used to finance the large scale asset purchases. The chart assumes that substantial labor market improvement is defined by the 6.5% unemployment rate the Fed is using to assess when to raise interest rates. Thus, assuming the central tendency forecast of the FOMC, the announced buying spree will bring reserve balances to about $4 trillion in mid-2015. The risk is two-sided. If the Fed does not draw down reserves fast enough during a future exit, then it will cause inflation. If it draws them down too fast, then it will cause another recession.
Another Great Deviation On the Way?
Second, the new state-based zero interest rate policy will lead to interest rates far below levels that created good performance in the past and close to levels that eventually created high unemployment. In an effort to explain the new policy during the press conference yesterday, Ben Bernanke referred to the Taylor rule, saying:
"So it's really more like a reaction function or a Taylor rule if you will. I don't want--I'm--I'll get it--I'm ready to get the phone call from John Taylor. It is not a Taylor rule but it has the same feature that it relates policy to observables in the economy such as unemployment and inflation."
In fact, the Fed’s new state-based policy calls for the federal funds rate to stay way below the Taylor rule, as did the calendar-based policy. You can see this deviation in two ways: a chart or some algebra.
Consider the following chart (an updated version of a chart due to Bob DiClemente) which I used in my talk last month at the Cato Institute. The red line shows the interest rate according to the Taylor rule with the future values based on FOMC forecasts for inflation and growth. The zero interest rate forecasts by most FOMC members (shown by the dots) for mid-2015—a time when, they forecast, the unemployment rate will be about 6.5 percent—are more than 2 percentage points below the Taylor rule. (The gray line is a version of the Taylor rule used by Janet Yellen and others at the Fed.)
You can also plug in values into the Taylor rule:
R = 2 + π + 0.5(π - 2) + 0.5Y
where R is the federal funds rate, π is the inflation rate, and Y is the GDP gap.
Assume that Y = -2(U-5.5) where U is the unemployment rate and 5.5 is the long-term unemployment rate implied by FOMC projections. Then when the unemployment rate is 6.5% and the inflation rate is 2%, the interest rate is 2+2 -1 = 3%. So there is a 3 percent deviation.
The last time the deviation between the Taylor rule and the actual rate was this large was in the “too low for too long” period of 2003-2005 which helped create the boom which led to the bust, the financial crisis, and the recession. High unemployment was the result. The deviation was also this large during the economic mess of the 1970s. High unemployment, along with high inflation, was the result then too.
Comparison with Larry Ball’s Calculations
Larry Ball did a very similar algebraic calculation with similar conclusions about the difference between the Fed’s future policy rate and the Taylor rule, which Greg Mankiw posted on his blog earlier today.
However, Larry finds that the actual interest rate was not below the Taylor rule in the 2003 period. This result is contrary to empirical research by George Kahn, me and others. The difference may be due to Larry's using an implied coefficient on the output gap which is larger than .5. Nevertheless, the deviation Larry uncovers is much larger than in the 1970s, which in itself raises risks.
For a respite from the saga of the fiscal cliff why not read some of the latest books on monetary economics and policy? Below is a list of books on money published in 2012 which I found to be interesting and provocative. You can find a common theme in these books: that poor economic performance provides convincing evidence of the need for a sound rules-based monetary policy. But you can also find disagreement about how to achieve such a policy with proposals for interest rate rules, money growth rules, fixed exchange rate systems, nominal GDP targeting, and gold and commodity standards. Though my favorite is a simple interest rate rule (also discussed in this book on the Taylor rule), one can learn a lot by studying the case for other rules.
I enjoyed reading this book, perhaps because I agree so much with the general themes and conclusion that U.S. monetary policy—by creating a boom and a bust—led to the financial crisis and the great recession. But, as I said in my back cover review of the book, David Beckworth and the other authors—including Lawrence H. White, Diego Espinoza, Christopher Crowe, Scott Sumner, Jeffrey Rogers Hummel, William Woolsey, Nick Rowe, Josh Hendrickson, Bill White, Larry Kotlikoff, and George Seglin—go much further. For example, the chapter by David Beckworth and Christopher Crowe puts forth their original theory of the Fed’s “monetary superpower” status and the resulting unfortunate international repercussions of these boom-bust monetary policies. Scott Sumner writes on why nominal GDP targeting would work better than recent and current policy, and Larry Kotlikoff explains how his narrow banking proposals would help to prevent future crises. More generally the authors of this book show why economic policy got off track, why alternative explanations of the boom—such as a global-saving glut—are flawed, and why monetary policymakers must return to rules-based policies in the future.
The clever irony of this title, of course, is that the world is still largely on the dollar standard, despite its being unloved. Ron McKinnon, my Stanford colleague, begins by asking why the dollar standard is “unloved” and explains that it is because U.S. monetary policy has often been mismanaged. He particularly laments the periods when U.S. monetary policy caused global instability, including the “Nixon shock” with the ensuing inflation in the 1970s and what he calls the “Bernanke shock” in recent years, and on the latter he is on the same page as David Beckworth and Christopher Crowe. McKinnon is much more positive about policy in the 1980s and 1990s. He clearly explains why the Fed’s current zero interest rate policy causes destabilizing carry trade opportunities and commodity bubbles, and is interfering with the allocation of capital. He also shows why, despite all these problems, the world has continued to use the dollar, warning that it will not last if American monetary policy does not mend its ways. McKinnon has always been an advocate of rules-based policy, but has focused on an international system of fixed rather than flexible exchange rates, and that view is evident throughout the book.
Roads to Sound Money, Alex Chafuen and Judy Shelton, Atlas Economic Research Foundation, Washington D.C. 2012
As the title suggests, this collection of essays, which Judy Shelton and Alex Chafuen have put together, makes the case for many different “roads” to the goal of a sound rules-based monetary system with contributions by Gerry O’Driscoll, Steve Hanke, Allan Meltzer, Jerry Jordan, Sean Fieler, Lew Lehrman, George Selgin, and Lawrence H. White, the latter two contributors also included in the Beckworth collection. Shelton gives a nice short summary of all the chapters in the Forward. For example, O’Driscoll hammers home the inherent problems with discretionary monetary policies and shows why he believes the gold standard would be an improvement despite its imperfections, a proposal that Lew Lerhman makes the case for in his chapter and in more detail in the second edition of his book The True Gold Standard. In contrast, in Meltzer’s nice review of his monumental history of the Fed, he concludes that a more rules based policy like we had in the 1980s and 1990s would be sufficient. Hanke reminds us that good monetary policy means more than keeping inflation low, and raises questions about the view that policy is just fine if an inflation target is hit. Seglin’s essay in an informative excursion into the operations of the New York Fed in the money markets with a concrete proposal for the Fed to dramatically broaden and increase the number of dealers it engages with. Jerry Jordan’s essay focusses on fiscal discipline rightly arguing that bad fiscal policy usually leads to bad monetary policy.
Hetzel makes a compelling case that policy failure was the main cause of the recent financial crisis, and more generally that “monetary disorder” rather than a “market disorder” is the cause of poor macroeconomic performance over many years. At the same time, he acknowledges and discusses disagreements among those who argue for rules rather than discretion. For more details see my review of this book from Economics One earlier this year.
This book is all about monetary policy making in practice. It shows in fascinating detail how Paul Volcker, starting in 1979, was able to implement a major change for the better in monetary policy that lasted for more than two decades. It also shows how Volcker learned how to implement such a change while working as Under Secretary of the Treasury under George Shultz in the early 1970s. For more details see my review of this book from the Wall Street Review earlier this year.