The Great Moderation is Dead

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Every now and then you will come across something that sparks your curiosity and leads to further investigation. Such an occurrence for me came when I read the Dallas Fed September 2007 Economic Letter, "The 'Great Moderation' in Output and Employment Volatility: An Update." I was intrigued by the clear shift in economic volatility as measured by real GDP and employment that occurred in the early 1980s. The paper made some interesting findings explaining where the decline in volatility was coming from, though my own personal beliefs were that these factors would change dramatically over the next decade. While I never did write an article on the subject back in 2007 I did put my ideas on the back burner for another time. Clearly volatility has changed dramatically over the last three years as “The Great Moderation” has met the “Great Recession.” I believe the economic volatility we have witnessed over the last few years will be here to stay rather that just a bad memory. In short, expect more boom and bust cycles ahead which will have direct consequences on investment strategies going forward.

"The Great Moderation" Meet "The Great Recession"

There was a clear and identifiable shift in economic volatility that occurred in the 1980s which later came to be termed “The Great Moderation” by Harvard economist James Stock in his 2002 paper, “Has the Business Cycle Changed and Why?” The period of lower volatility since the 1980s has been associated with longer expansions in the business cycle and shorter and more infrequent contractions. Commenting on “The Great Moderation” (TGM) and its possible explanations is the Dallas Fed in the 2007 report below.

The 'Great Moderation' in Output and Employment Volatility: An Update

On average, the five recessions from 1959 to 1983 were 47 months apart, lingered 12 months and were associated with a 2.17 percent peak-to-trough decline in real gross domestic product. By contrast, the 1990 downturn came after 92 months of expansion, lasted eight months and involved a 1.26 percent decline in GDP. The 2001 slump ended a record 120 months of uninterrupted growth, lasted eight months and entailed a GDP decline of only 0.35 percent. More generally, quarterly growth in both real GDP and jobs became markedly less volatile after 1983.

Explanations for this “Great Moderation,” as it’s called, include structural changes in the economy, improved monetary policy and simple good luck.

Potentially important structural changes include the elimination of ceilings on deposit interest rates, broader access to credit markets through financial innovations like home equity loans, tighter inventory controls facilitated by technology, and the globalization of output and labor markets.

By improved monetary policy, analysts typically have in mind central bank actions that respond more quickly and forcefully to emerging inflation pressures, so that medium to long-term price expectations remain contained.

As for good luck, analysts cite the reduced frequency of economic shocks comparable to the 1973 Arab oil embargo and 1979 oil price spike.

The Dallas Fed concluded that the decline in GDP volatility came from smaller swings in investment and consumer durables (component of retail sales), while the decline in employment volatility was predominantly due to a shrinking manufacturing sector that is more volatile than the service sector, all of which are structural changes in the economy. While the Dallas Fed economists attributed the reduced volatility predominantly to structural changes, Fed Chairman Ben Bernanke was more inclined to pat central bankers on the back believing it was improved monetary policy that was the driving factor for the reduced volatility. Mr. Bernanke put forth his view of TGM in a meeting back in 2004, with an excerpt from his conclusion below (emphasis added).

Remarks by Governor Ben S. Bernanke (February 20, 2004)

The Great Moderation

The Great Moderation, the substantial decline in macroeconomic volatility over the past twenty years, is a striking economic development. Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed. I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well. Moreover, because a change in the monetary policy regime has pervasive effects, I have suggested that some of the effects of improved monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks. This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s.

I am in agreement with Mr. Bernanke that central bankers have played a major role in the reduced economic volatility since the early 1980s. However, while Mr. Bernanke believes the role of central bankers has been a positive force, I for one do not, which is where I differ greatly with Mr. Bernanke’s comments. What the Greenspan and Bernanke Fed of the 1980s through the present have merely done is paper over the business cycle by not allowing prior economic excesses to run their course by bailing out this institution or that institution, dramatically lowering interest rates, and goosing the money supply. What this has led to is the U.S. debt super cycle (The Great Reflation Experiment: Implications for Investors) in which debt expanded far greater than GDP. In the figure below you can see a discernible pick up in the growth of bank credit relative to GDP that occurred in the early 1980s, and absolutely exploded in the last decade.

bank credit as % of gdp

Source: Federal Reserve, BEA

As the debt super cycle took to flight with a vengeance after the mid 1980s, there was a general decline in economic volatility as measured by GDP and employment. However, imbalances can only stretch so far to the point that they come snapping back like a rubber band. This was certainly the case when the U.S. consumer’s savings rate fell into negative territory, and after they ran up all forms of credit to the point that the household debt to GDP ratio more than doubled from 45% to over 90%. That snap back occurred with “The Great Recession” that we recently experienced on a scale not seen since the Great Depression, with economic volatility moving to greater extremes than was even seen prior to the supposed TGM.

the great moderation meet the great recession

Source: BEA, BLS

What’s been interesting this time around in the recent recession compared to prior recessions is that forces that helped mute the severity and duration of prior recessions actually contributed to the dramatic decline seen in the recent recession. While the majority of the employment volatility comes from the manufacturing sector (goods-producing) we saw a huge spike in negative volatility coming from the service sector that had been the major source of stability in prior recessions given its larger share of the economy or lower volatility.

the great moderation meet the great recession

Source: BLS

In prior recessions the decline in retail sales was either moderate to non existent and played a large role in getting the economy out of a recession as retail sales typically rose within six months of a recession’s inception and accelerated even further one year out. The current case is quite the stand out as retail sales collapsed during the last recession and, while investors and analysts are falling all over themselves with the large pick up in retail sales and earnings of consumer discretionary stocks, some reality is in order. Retail sales are quite depressed from their prior peak levels and are rising much slower than in past cycles. Not surprisingly, the abnormal cycle in retail sales led to an abnormal cycle in service employment which either is flat or rising during prior recessions. This time around service employment contributed to economic volatility rather than being a stabilizing factor.

retail sales cycles during recessions

Source: BLS

service producing employment cycles during recessions

Source: BLS

One casual observation of the heightened economic volatility during the 1960s to early 1980s versus TGM is that the earlier period was associated with rising interest rates while TGM was associated with falling interest rates. Could the pick up in economic volatility also be signaling an eventual trend change in interest rates?

the great moderation meet the great recession

Source: BEA, BLS, Federal Reserve

There is currently great debate over inflation versus deflation and whether interest rates will be higher or flat/lower in this decade. My personal leaning is towards higher interest and inflation rates and I think the Greek credit crisis is a perfect example of why. Governments can only act irresponsibly for so long before the bond market reacts and punishes prior fiscal irresponsibility with rapidly rising interest rates as they dump government debt. The Greek labor unions are unwilling to take lower wages and benefits and thus not cooperating with the Greek government to help bring down their deficits. Given an unlikelihood of fiscal discipline and a higher probability of future default, bond investors have been dumping Greek debt in dramatic fashion such that yields on 2-year Greek debt have surged from under 2% in December to more than 16% recently; a jump of 700% in the government’s borrowing costs in less than six months!

greek 2 year interest rates greek 5 year cds

Source: Bloomberg

While sovereign debt crisis in the last half century have been outside U.S. boarders, a U.S. debt crisis is brewing that may change that. While many have dismissed the possibility that the U.S. may lose its AAA-rated status, more and more in the financial sector are becoming convinced that not only is such an event a possibility, but inevitable. Zero Hedge highlighted today a 68 page report by Willem Buiter from Citigroup that makes a pretty compelling case for a fiscal crisis in the U.S. Comments from Zero Hedge on the Buiter piece are given below:

Willem Buiter Issues His Most Dire Prediction Yet: Sees "Unprecedented" Fiscal Crises, US Debt Inflation And Fed Monetization

Doomsday scenarios from the establishment periphery always come fast and furious, especially in our day and age when bankrupt sovereigns are the norm, not the exception. And the "faster and furiouser" these come, the more steadfast the core is in refuting that the reality is much, much worse than portrayed on the mainstream media. Which is why we were very surprised when we read Willem Buiter's latest Global Economic View (recall that he works for Citi now). In it the strategist for the firm that defines the core of the establishment could not be more bearish. In fact, at first we thought that David Rosenberg had ghost written this. Once the apocryphal truthsayers such as Buiter become mainstream within the mainstream, it is only a matter of time before the marginal opinion shifts to match that of those who have been prognosticating doom all along (for all the right reasons). In the below piece, Buiter presents a game theory type analysis, which concludes that the US and other sovereigns will soon be forced into fiscal austerity. Among his critical observations (we recommend a careful read of the entire 68 pages), are that the US is highly polarized, and that the Fed, which is "the least independent of leading central banks" would be willing to implement "inflationary monetisation of public debt and deficits than other central banks." The next step of course would be hyperinflation. And Buiter sees America as the one country the most likely to follow this route. Most troublingly, Buiter predicts that a massive crisis is the only thing that can break the political gridlock in the US in order to fix the broken US fiscal situation. Must read.

While not included in the excerpt above, Zero Hedge provides the key highlights from the 68 page report, and one key point that stands out is the Buiter believes that there may not be a single AAA-rated sovereign country left five years from now. As a country or corporation’s debt is downgraded yields spike to compensate investors for the greater level of risk associated with lower debt ratings. Thus, if Buiter is correct that there will be widespread downgrades of sovereign debt over the next few years we will likely see an upswing in global yields which will likely only exacerbate economic volatility going forward making The Great Moderation a distant memory.

Part of the fallout that will come from heightened economic volatility in the years ahead will be a return to normalcy in the sense that the business cycle will return to the normal length of 3-4 years, not the 7-10 years associated with the 1980s through 2007 linked to The Great Moderation. This topic of more boom and bust cycles and investment implications will be covered next Tuesday.

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