August 2, 2018 / 10:05 AM / in 9 months

Breakingviews - Hadas: The Great Moderation is due for revival

LONDON (Reuters Breakingviews) - The Great Moderation – snicker, snort. Surely, the idea that modern economies have no need for economic cycles was killed off by the great financial crisis of 2008. Like the “end of history” proclaimed after the fall of the Soviet Union, this notion seems to belong in the dictionary of utopian follies.

A picture illustration of US dollar, Swiss Franc, British pound and Euro bank notes, taken in Warsaw, January 26 2011

Such a dismissal is too hasty. The economic tools needed to avoid the overheating of booms and the underspending of busts are readily available. Indeed, they have already been put to good use.

Consider the original source of economic cycles: the weather. For centuries, the alternation of good and bad crops would lead to sharp changes in the income and spending of farmers, and often of everyone else. Now, though, managed production, government payments, and judicious credit arrangements keep farm incomes fairly constant.

Similar tools have dampened inventory cycles, which succeeded the meteorological ones. Optimistic companies still sometimes produce too much and hire too many people, and their failures lead to cutbacks. However, just-in-time production and better information flows now keep supply more closely aligned with demand. Besides, judicious credit arrangements ensure that losses from inventories are modest and spread too widely to wreak economic havoc.

The most powerful counter-cyclical weapon is the rise of the relatively stable service sector. Services account for 70 to 80 percent of GDP in developed economies. Only a small proportion is subject to big swings in capital investment; the rest involves little more than paying people to do things. These steady payments dampen the effects of falls and increases elsewhere in the economy.

Government deficit spending is another significant modern addition to the macroeconomic armoury. The government can spend when the private sector is hesitant. Monetary policy is also supposed to moderate or stimulate demand as needed.

Still, the global meltdown that was nearing its climax a decade ago showed that the combined power of information, regulation, judicious credit and fiscal and monetary policy were not strong enough to maintain the Great Moderation which Ben Bernanke, then a member of the U.S. Federal Reserve’s Board of Governors, described in 2004.

The central weakness was the reckless credit system. Economic cycles today are predominantly financial. Loans and financial investments are first made too freely available. Then the money is taken away too abruptly.

Thus construction, which is largely financed by debt, is especially prey to booms and busts. Financial consideration shapes the willingness of entrepreneurs to take risks, and the enthusiasm of existing companies for borrowing to pay for new capacity.

And the credit cycles keep rolling along. Even though the official U.S. interest rate is rising, money is still mostly cheap around the world. The results are cheering, in the way that people under the influence of drugs are animated. GDP growth remains solid and steady, while money flows recklessly across borders and corporate credit standards decline.

In other words, the world is going through a less extreme version of the last Great Moderation. This one is also likely to end unhappily. The current cyclical excesses will probably be followed by another period of undue despondency.

Why is credit not kept under tighter control? The pattern of dangerous cycles was already clear by the 1960s, when the American economist Hyman Minsky articulated what he would later call his “financial instability hypothesis”. This can be summarised in a sentence: unless lending is heavily regulated, it will always become excessive.

Investors have long encapsulated Minsky’s insight in their folk wisdom of markets driven by alternating excesses of fear and greed. Until 2009, though, most economists and regulators preferred to imagine that the economy was guided by rational individuals. Anti-cyclical credit regulation has become more fashionable since the last crisis, but the restrictions have been too tentative and localised to slow the global financial juggernaut.

No one knows how much firm and coordinated regulation of credit could accomplish. Sceptics often argue that greed is too much a part of human nature to be tamed by mere rules and official expectations.

The experience of modern economies suggests such pessimism is unwarranted. Rules, expectations and good design have helped to neutralise the bad effects of other indelible and unhelpful human traits. Carelessness and recklessness persist, but driving, flying and construction work are much safer than in the past. The decline in cigarette smoking shows that even producers of a highly profitable and addictive product can be restrained.

The prerequisite for those successes was a shared commitment. That is totally lacking when it comes to curbing financial enthusiasm. On the contrary, politicians still mostly welcome unduly strong stock markets and rapidly rising house prices. Regulators still fear unstoppable recessionary declines and wasted growth potential far more than they worry about credit excesses.

In this environment, attempts to smooth out the credit cycle will likely remain too weak to help much. It will probably take another multinational debt-induced recession to make tough policies look plausible. Indeed, the current almost free rein of credit enthusiasm makes such an idea-changing recession all the more likely.


Reuters Breakingviews is the world's leading source of agenda-setting financial insight. As the Reuters brand for financial commentary, we dissect the big business and economic stories as they break around the world every day. A global team of about 30 correspondents in New York, London, Hong Kong and other major cities provides expert analysis in real time.

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