Young Economics.

I grew up during the Great Moderation… (Part 1 of 3)

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I grew up during the great moderation, enrolled during the savings glut and will graduate into a historic financial crisis. If you’re around my age (22), the same goes for you. Unsure what these terms mean? Don’t worry, that’s what this series of posts is aimed to clear up. But to tempt you to keep reading, I will say that these are events and trends that will be written into history as the building blocks for wherever society goes in the 21st century. These have made up the backdrop of our lives for the past 25 years, and stepping back it’s easy to see how they’ve influenced me to make the decisions I have. It’s nice to believe we get to write our own history, but the last few months have made me realize how the directions we go seem to be partially laid out for us.

But enough of that for now, this post will present some facts and I’ll come back to the speculation in part 3. The following will spell out the idea of the Great Moderation. To begin, comments made by Ben Bernanke in 2004 (link)

“ One of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility. In a recent article, Olivier Blanchard and John Simon (2001) documented that the variability of quarterly growth in real output (as measured by its standard deviation) has declined by half since the mid-1980s, while the variability of quarterly inflation has declined by about two thirds.1 Several writers on the topic have dubbed this remarkable decline in the variability of both output and inflation “the Great Moderation.”

So basically, the main idea is that economic life has been much more predictable during our lifetimes than ever before. What does this mean? On the effects, here’s a blurb from an excellent article I would recommend.(link)

“…as dull as it all may seem, the Great Moderation has been … consequential… It is surely the main reason that political volatility has declined in much of the West. … The economic implications are much larger. In the absence of wild swings in activity, businesses and households can plan much more easily. The most obvious benefit can be seen in interest rates. Longer-term rates … have what is called a “term premium”, an extra amount of interest that lenders require to protect them against the risks that big fluctuations in the economy and interest rates will undermine the value of their investment. But since those swings have been eliminated largely, interest rates can stay much lower.”

These effects map to three types of people in the economy: lenders, borrowers and consumers. The borrowers wake up in a world where the cost of accessing money is lower. It’s now easier to implement your business plan and build that factory.

Lenders wake up in a world that is much more predictable. They feel like their forecasts have more relevance and they don’t have to set so much money aside to guard against uncertainty. The amount of lending done on a fixed pool of deposits can expand to improve bottom lines.

Consumers wake up and notice the money they save doesn’t generate as much interest income. It doesn’t make as much sense to let their savings lie around listlessly. Thus they decide to use a larger proportion of their earnings to buy real goods.

Overall, this was a period favourable to business and enterprise. To date, no one has being able to offer a definitive answer to why our system smoothed itself out, although there are a few competing hypotheses. A few of the prominent ones are suggestions of better inventory management strategies, a fuller economic understanding of monetary policy effects, demographic trends (as the population ages, people become firmly rooted in their careers with fewer fluctuations in the labour market) and even a stipulation that it has all been good luck. But whichever way you choose to look at, this was a period that was very friendly to capitalist society, and those individuals involved with business, finance and the market.  The following is a graph of S&P 500 futures since 1984.

S&P 500 Futures

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Written by jk

March 15, 2009 at 3:00 pm

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