What is the Great Moderation?

The Great Moderation refers to the period from the mid-1980s to the late 2000s when many advanced economies, particularly the United States, experienced stable economic growth, low inflation, and diminished volatility in business cycles. This era was characterized by reduced frequency and severity of recessions and a general sense of economic stability. It is a term coined by economists to describe the apparent shift from the volatile economic periods of the 1970s, marked by stagflation and oil crises, to a period of relative tranquility in macroeconomic performance.

The Great Moderation is generally thought to have begun around 1984, following the economic disruptions of the late 1970s and early 1980s. This period continued until the financial crisis of 2007-2008, which abruptly ended the stability that had defined the previous two decades. During this era, economic growth became steadier, with milder fluctuations in GDP, unemployment, and inflation.

Historical Background

To understand the Great Moderation, it is essential to contrast it with the preceding periods of economic instability. The 1970s were a decade of high inflation and stagnant economic growth, known as stagflation, which was exacerbated by the oil shocks of 1973 and 1979. In response, central banks, particularly the Federal Reserve under Chairman Paul Volcker, implemented tight monetary policies to control inflation, leading to sharp recessions in the early 1980s. However, by the mid-1980s, inflation had been brought under control, and economies began to stabilize.

The period between 1984 and the mid-2000s saw significant reductions in the volatility of key economic indicators, particularly inflation, GDP growth, and unemployment. Economists and policymakers debated the causes of this stabilization, attributing it to various factors, including improved monetary policies, structural changes in the economy, and good luck in avoiding major economic shocks.

Key Characteristics of the Great Moderation

Several key features define the Great Moderation:

1. Declining Macroeconomic Volatility:
   During the Great Moderation, the fluctuations in GDP growth, inflation rates, and unemployment became less pronounced. Recessions were fewer and less severe than in previous decades, and periods of expansion were longer and more stable.
2. Stable Inflation:
   Inflation was a major concern in the 1970s and early 1980s, but it became more stable during the Great Moderation. Central banks, particularly the Federal Reserve, adopted a more systematic approach to managing inflation, often targeting a low and stable rate of price increases. This shift was a crucial part of the overall macroeconomic stability during the period.
3. Longer Economic Expansions:
   The expansions during the Great Moderation were longer than those in previous periods. For example, the U.S. economy experienced a sustained expansion from 1991 to 2001, one of the longest periods of uninterrupted growth in its history.
4. Milder Recessions:
   When recessions did occur during the Great Moderation, they were generally shorter and less severe than those of earlier decades. The 1990-1991 and 2001 recessions were mild compared to the deep recessions of the early 1980s or the Great Depression.

Causes of the Great Moderation

Economists have proposed several explanations for the Great Moderation. While there is no consensus on a single cause, the following factors are widely cited as contributing to the reduced volatility of this era:

1. Improved Monetary Policy

One of the most widely accepted explanations is the role of improved monetary policy, particularly in the United States. After the high inflation of the 1970s, the Federal Reserve, under Chairman Paul Volcker, shifted to a more proactive approach to controlling inflation. This strategy was continued under Alan Greenspan, who emphasized maintaining low and stable inflation. By anchoring inflation expectations, central banks were able to reduce the frequency and severity of recessions, contributing to overall economic stability.

Additionally, central banks became more transparent and data-driven in their decision-making processes. They increasingly adopted inflation targeting and used interest rates as a primary tool to control inflation and influence economic activity. These improvements in monetary policy helped to smooth out economic fluctuations and maintain stability during the Great Moderation.

2. Structural Changes in the Economy

Another explanation for the Great Moderation involves structural changes in the global economy. Technological advancements, globalization, and improvements in inventory management systems played a significant role in reducing economic volatility. The adoption of just-in-time inventory practices, for example, allowed businesses to manage supply chains more efficiently, reducing the risk of overproduction and inventory buildups, which in turn moderated the boom-and-bust cycles that had characterized previous decades.

Technological advancements in communication and production processes also contributed to more efficient economic coordination. Globalization further contributed to the stability of the period. As economies became more interconnected, countries diversified their sources of goods and services, reducing the impact of localized economic shocks. Additionally, access to global markets allowed businesses to tap into new sources of growth, helping to stabilize economic activity.

3. Good Luck

Some economists argue that a large part of the Great Moderation can be attributed to good fortune. During this period, the global economy was relatively free from major shocks such as oil crises, wars, or financial crises. The absence of significant external shocks helped to maintain the stability of economic growth. While the world economy was not entirely free from disruptions, such as the Asian Financial Crisis of 1997 or the bursting of the dot-com bubble in 2000, these events were relatively contained and did not lead to widespread or prolonged recessions in major economies like the United States.

Criticism and Limitations of the Great Moderation

While the Great Moderation is often celebrated as a period of stability and growth, it was not without its criticisms and limitations:

1. Masked Financial Risks:
   Some critics argue that the stability of the Great Moderation masked underlying financial risks that eventually led to the global financial crisis of 2007-2008. The prolonged period of low volatility and economic expansion contributed to complacency among policymakers, financial institutions, and investors. This complacency led to increased risk-taking, excessive borrowing, and the development of speculative bubbles, particularly in the housing market.
2. Rising Income Inequality:
   Another criticism of the Great Moderation is that, while overall economic volatility decreased, income inequality in many advanced economies, particularly the United States, increased. During this period, wealth became increasingly concentrated in the hands of the top earners, while wages for middle- and lower-income workers stagnated. Critics argue that the benefits of the Great Moderation were not evenly distributed across society.
3. Overreliance on Monetary Policy:
   Some economists argue that the success of the Great Moderation led to an overreliance on monetary policy as the primary tool for managing economic stability. This overreliance may have contributed to the mismanagement of emerging risks in the financial sector, as other policy areas, such as financial regulation and fiscal policy, were neglected or deemed less important.
4. Unsustainable Debt Levels:
   The period of low interest rates and stable economic growth during the Great Moderation contributed to a buildup of private and public debt. In particular, households and financial institutions accumulated significant levels of debt, which became unsustainable when the financial crisis hit. The excessive leverage in the economy was a key factor in the severity of the 2008 financial crisis.

End of the Great Moderation

The Great Moderation came to an abrupt end with the global financial crisis of 2007-2008. The collapse of the housing market, combined with the failure of major financial institutions, led to a severe recession, often referred to as the Great Recession. The financial crisis exposed the vulnerabilities that had built up during the seemingly stable years of the Great Moderation.

The crisis shattered the belief that advanced economies had achieved a permanent state of stability. It also led to widespread rethinking of economic and financial policies, with renewed focus on financial regulation, systemic risk, and the role of fiscal policy in stabilizing economies.

The Bottom Line

The Great Moderation was a period of reduced economic volatility, stable inflation, and steady growth that lasted from the mid-1980s to the late 2000s. It is attributed to improved monetary policies, structural changes in the economy, and a certain degree of good luck in avoiding major external shocks. However, the period also had its downsides, including the masking of financial risks and growing income inequality, which contributed to the financial crisis of 2007-2008. The Great Moderation remains a significant chapter in modern economic history, offering lessons about the balance between stability and risk in managing economies.