Wed, Jul 04, 2007 page9

• The source of our unanticipated 20-year `great moderation'

  • By J. Bradford DeLong
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  It has been 20 years since Alan Greenspan became chairman of the US Federal Reserve Bank. The years since then have seen the fastest global average income growth rate of any generation, as well as remarkably few outbreaks of mass unemployment-causing deflation or wealth-destroying inflation. Only Japan's lost decade-and-a-half and the hardships of the transition from communism count as true macro-economic catastrophes of a magnitude that was depressingly common in earlier decades.

  This "great moderation" was not anticipated when Greenspan took office. The US' fiscal policy was then thoroughly deranged -- much more so than it is now.

  India appeared mired in stagnation. China was growing, but median living standards were not clearly in excess of those of China's so-called "golden years" of the early 1950s, after land redistribution and before forced collectivization turned the peasantry into serfs. European unemployment had just taken another large upward leap, and the "socialist" countries were so incompatible with rational economic development that their political systems would collapse within two years. Latin America was stuck in its own lost decade after the debt crisis at the start of the 1980s.

  Of course, the years since 1987 have not been without big macro-economic shocks. America's stock market plummeted in the fall of that year. Saddam Hussein's invasion of Kuwait in 1991 shocked the world oil market. Europe's fixed exchange rate mechanism collapsed in 1992. The rest of the decade was punctuated by the Mexican peso crisis of 1994, the East Asian crisis of 1997 to 1998, and troubles in Brazil, Argentina, Turkey and elsewhere, and the new millennium began with the collapse of the dot-com bubble in 2000 and the economic fallout from the Sept. 11 terrorist attacks.

  Moreover, today's global imbalances and misaligned real exchange rates threaten to bring on not just mild recession, but significant and prolonged depression. Yet, so far, none of these events -- aside from Japan starting in the early 1990s and the failures of transition in the lands east of Poland -- has caused a prolonged crisis.

  Economists have proposed three explanations for why macroeconomic catastrophes have not caused more human suffering and derailed long-run economic growth over the past generation. First, some economists argue that we have simply been lucky, because there has been no structural change that has made the world economy more resilient. According to this view, we have simply rolled the dice and won five times in a row. We should be happy and grateful, but we should not expect it to continue.

  Second, central bankers have finally learned how to do their jobs. Before 1985, according to this theory, central bankers switched their objectives from year to year.

  One year, they might seek to control inflation, but the previous year they sought to reduce unemployment, and next year they might try to lower the government's debt refinancing costs, and the year after that they might worry about keeping the exchange rate at whatever value their political masters say they prefer.

  The lack of far-sighted decision-making on the part of central bankers meant that economic policy lurched from stop to go to accelerate to slow down. When added to the normal shocks that afflict the world economy, this source of destabilizing volatility created the unstable world before 1987 that led many to wonder why somebody like Greenspan -- who had previously only spent a couple of years in government -- would want the job.

  The final explanation is that financial markets have calmed down. Today, the smart money in financial markets takes a long-term view that asset prices are for the most part rational expectations of discounted future fundamental values. Before 1985, by contrast, financial markets were dominated by the herd behavior of short-term traders, people who sought not to identify fundamentals, but to predict what average opinion would expect average opinion to be, and to predict it before average opinion did.

  Thus, central bankers were stuck trying to control a world economy shocked by random changes in the animal spirits of investors and traders.

  When I examine these issues, I see no evidence in favor of the first theory. Our luck has not been good since 1985. On the contrary, I think our luck -- measured by the magnitude of the private sector and other shocks that have hit the global economy -- has, in fact, been relatively bad.

  Nor do I see any evidence at all in favor of the third explanation. It would be nice if our financial markets were more rational than those of previous generations. But I don't see any institutional changes that have made them so.

  So my guess is that we would be well-advised to put our money on the theory that our central bankers today are more skilled, more far-sighted, and less prone to either short-sightedly jerking themselves around or being jerked around by political masters who unpredictably change the objectives they are supposed to pursue year after year.

  Long may this state of affairs continue.

  J. Bradford DeLong is a professor of economics at the University of California at Berkeley and was assistant US Treasury secretary in the Clinton administration.

  Copyright: Project Syndicate
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