Stephen King: Good luck, not good providence, was at the core of happier times

It is now difficult to talk with a straight face of the so-called era of stability

Monday, 22 June 2009

We stand at a momentous point in macroeconomic policy thinking. A couple of years ago, it was possible to argue that monetary arrangements were good enough to avoid, or at least temper, nasty economic developments. We understood enough, apparently, to avoid the mistakes of the 1970s. We were living through the Great Moderation, the Great Stability or, as Mervyn King, the Governor of the Bank of England, once put it, the NICE (non-inflationary continuous expansion) decade.

Two years later, after the onset of the biggest financial meltdown in living memory and the deepest, most synchronised, global downswing since the 1930s, it is no longer obvious that the Great Moderation amounted to much. Policymakers may have avoided a repeat of the 1970s, with its noxious mixture of high inflation and stagnant growth, but it is now difficult to talk with a straight face of Moderation, Stability or NICE-ness.

The Great Moderation was a story about the reduced volatility of output and inflation and "no more boom and bust", which Gordon Brown probably wishes he had never uttered. There is no doubt that, for a while, economic developments were favourable. From the mid-1980s in the US and the mid-1990s in the UK, it appeared that economic life had become more stable. The question all along was whether this stemmed from structural changes in economic behaviour, from the impact of new, and improved, policy frameworks, or just good luck.

Unsurprisingly, central bankers used to claim credit for this Moderation. In 2004, Ben Bernanke, then a Governor at the Federal Reserve, said "improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation ... but to the reduced volatility of output as well ... This conclusion ... makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s."

In a 2007 speech, Mervyn King echoed these sentiments saying "the change in framework in 1997 helped to anchor expectations of inflation ... By doing so, it has made it possible for the MPC to keep inflation closer to target, with smaller changes in monetary policy and hence fluctuations in output, than would otherwise have been the case."

If all of this is true, why have we just seen a global economic meltdown on a scale far bigger than anything since the 1930s? Part of the answer is contained within a 2002 academic paper in which the phrase "The Great Moderation" was first coined.

James Stock and Mark Watson of the US National Bureau of Economic Research asked, "Has the business cycle changed and why?" Their conclusions were not as encouraging as those of Messrs Bernanke and King.

Having examined all sorts of possible explanations for the Moderation – a shift from a manufacturing to a services-based economy, improved inventory management, a calmer housing market and smaller policy and price "shocks" – they concluded that "better" monetary policy could account for no more than 20 to 30 per cent of the reduction in economic volatility since the mid-1980s. Much more of the reduction was down to good luck. "We are left with the unsettling conclusion that the quiescence of the past 15 years could well be a hiatus before a return to more turbulent economic times."

Stock and Watson received plenty of criticism for their rather nihilistic conclusion. Messrs Bernanke and King were quick to point out that the last couple of decades had delivered plenty of bad luck. The Asian crisis, the hedge fund Long Term Capital Management's (LTCM) collapse, the Argentine debt default, the technology bubble, the 2000 stock market crash and 9/11 were all examples of shocks which, in earlier decades, would more easily have upset the economic apple-cart. Perhaps, then, the new monetary frameworks, with independent central banks devoted to the goal of price stability, had helped to anchor economic expectations.

On this issue, I have sympathy with Bernanke and King. I recall the debates that took place in the aftermath of the Thai baht collapse in 1997, which heralded the Asian crisis: how far should growth forecasts for the rest of the world be slashed? In the event, they were cut too far. The same happened after LTCM in 1998 and after 9/11 in 2001. On each of these occasions, economists under-estimated the resilience of economies to these unpleasant shocks.

In the light of recent events, it strikes me that Stock and Watson were on to something, however.

Central bankers were lucky for a while because Western economies benefited from remarkably low imported inflation, a result of the outsourcing and off-shoring of manufacturing production over the last 20 years. This enabled policymakers to leave interest rates at low levels, helping to fuel a debt-driven housing boom. Their luck ran out in the middle of this decade as the benefits of low goods price inflation were more than offset by the costs of high commodity price inflation as emerging economies boomed.

At a deeper level, the entire philosophy of inflation targeting seems to be creaking. If the only problem was 1970s-style stagflation, where inflation is too high and growth too low, then perhaps inflation targeting did the trick. Avoiding the 1970s seems like a very narrow measure of policy success. How about avoiding the Depression of the 1930s? These periods were not preceded by excessively high inflation. Indeed, an inflation-targeting central bank would have been mostly satisfied with US economic performance in the late-1920s.

Periods of price stability too often seemed to be followed by periods of economic instability. And perhaps that is the ultimate problem with the Great Moderation. If people begin to believe the policymaking priesthood's claims of lasting economic stability, they will begin to take decisions which, in more volatile economic times, might have seemed foolish.

Whether or not inflation makes an appearance, credit booms always do. Policymakers got lucky because, for a while, it seemed that inflation was the only macroeconomic problem to be solved, and policymakers knew how to solve it. No longer can that view be credibly held. The policymakers' luck has now run out.

Stephen King is managing director of economics at HSBC