Please, less “technique” and more substance

I think there is something very wrong with this kind of analysis and its implications. The Federal Reserve Bank of New York has just published this post on its blog, Liberty Street. It´s called: “The Great Moderation, Forecast Uncertainty, and the Great Recession” and here´s what they have to say:

The Great Recession of 2007-09 was a dramatic macroeconomic event, marked by a severe contraction in economic activity and a significant fall in inflation. These developments surprised many economists, as documented in a recent post on this site. One factor cited for the failure to anticipate the magnitude of the Great Recession was a form of complacency affecting forecasters in the wake of the so-called Great Moderation. In this post, we attempt to quantify the role the Great Moderation played in making the Great Recession appear nearly impossible in the eyes of macroeconomists.

In the twenty years that preceded the Great Recession, the U.S. economy had displayed remarkable stability—a phenomenon that James Stock of Harvard and Mark Watson of Princeton dubbed “the Great Moderation.” Most economists attributed this relatively sudden reduction in the volatility of macroeconomic variables, starting around 1984, to a combination of “good luck”—in the form of less severe external shocks hitting the economy—and “good policy,” especially in the form of greater Fed vigilance on inflation, as well as to other forms of structural change (see this 2004 speech by then Fed Governor Ben Bernanke for an overview).

Their conclusion:

In sum, our calculations suggest that the Great Recession was indeed entirely off the radar of a standard macroeconomic model estimated with data drawn exclusively from the Great Moderation. By contrast, the extreme events of 2008-09 are seen as far from impossible—if unlikely—by the same model when the shocks hitting the economy are gauged using data from a longer period (third-quarter 1954 to fourth-quarter 2007). These results provide a simple quantitative illustration of the extent to which the Great Moderation and more specifically the assumption that the tranquil environment characterizing it was permanent, might have led economists to greatly underestimate the possibility of a Great Recession.

The chart depicts the volatility of real output (RGDP) over the 1954-12 period. Notice that the “longer period” contains “shocks” of magnitude matching the one that characterizes the recent “dramatic macroeconomic event”. And as he says: “the extreme events of 2008-09 are seen as far from impossible—if unlikely—by the same model when the shocks hitting the economy are gauged using data from a longer period (third-quarter 1954 to fourth-quarter 2007)”.

Note he says “unlikely”, because even taking account of the shocks over a longer period the size of the downfall was “way down the left side of the distribution”.

There´s a religious connotation here. It seems that we are on earth to “pay for sins” so that “tranquil environments” must be an “aberration”. It is said that people become complacent and undertake “excessive risks”, not taking into account the fact that people can do more stuff exactly because the macro environment became less risky!

I think the key phrase shows up in the intro to Scenario 1:

Scenario 1 assumes that “this time is different”—meaning that the Great Moderation permanently changed the structure of the U.S. economy and the nature of the shocks that buffet it.

I believe it was not the “nature” of the shocks that changed, but how “good policy” was “good” exactly because it was managed in such a way as to contain the propagation of the shocks, not because it showed “greater vigilance on inflation”. For example, no one can say that the Fed was not paying attention to inflation in the first half of 2008 (just read the statements). Things went sour exactly because the Fed was paying too much attention to “inflation”, letting monetary policy tighten so much that aggregate demand plunged. And so did inflation! The rest is history.

10 thoughts on “Please, less “technique” and more substance

  1. “It is said that people become complacent and undertake “excessive risks”, not taking into account the fact that people can do more stuff exactly because the macro environment became less risky!”

    The underlying perspective seems to be that the Fed is the vigilant guardian of the economy against external (to Fed policy) shocks, instead of the simpler brute tasked with keeping spending balanced atop its shoulders. It’s the result of a failure to define monetary policy itself as the stabilization of NGDP expectations – if Scott can win that part of his crusade, he’s won the war. You’d think it was a simple deduction from NK Mishkin’s three principles, but no…

    “Things went sour exactly because the Fed was paying too much attention to “inflation””

    The Fed is locked into its own communications strategy, unable to communicate its role to the public and now to itself in terms of anything other than inflation. So if something did go wrong with “monetary policy” – it can only have been insufficient vigilance on inflation. They are still trying to escape the shadow of their Dinosaur Keynesian past – the last thing they would want is to reassociate themselves with “demand management” and the resulting inflationary cycles of the ’60s and ’70s, even though that is precisely what the optimal policy of NGDP level targeting is. As I just said on Scott’s blog, central banks are and have always been fundamentally political creatures, make no mistake about that.

  2. Initially the 2008 recession seemed impossibly severe. However, upon renormalizing the distribution, a 1 in 100 year recession has a probability of 1%.

    • “Once in a century, a once in a century event occurs” – Bryan Caplan.
      However in this case the “tail event” was really the spectacular collapse of the prevailing Neo-Wicksellian central banking paradigm, after an ill-fated rate hike just as the banking system was starting to feel the heat from the sub-prime crisis.

  3. Saturos:

    I think you are looking in the right direction here.

    A 1-100 year event where modest changes in short term intererest rates engineered by the Fed fail to slowly close the output gap while keeping inflation close to target.

    The possibility (and liklihood) that a anternative approach to monetary policy could have weathered these changes with only a modest growth recession and increase in inflation is outside the paradigm.

    • Well, according to Scott, the “dominant paradigm” would still have survived had Bernanke been proactive in mid-2008 and targeted the forecast. There was still room to cut rates then. Instead he raised them.

      • Of course, rate cuts only work by signaling intentions for future NGDP growth. But point is, the normal mechanism would still have operated then had it been used effectively.

  4. one cannot find a smoking gun on how the Fed reaction function changed when bernanke took the chair, but I strongly suspect that the regime switched from soft ngdp targeting under Greenspan to inflation targeting under Bernanke. Conversely, before Volcker I think they were unemployment targeting.

    The fact that nominal expectations remained anchored during the 86-2006 period also suggests this – that the great moderation was policy driven, and that the great recession was also policy driven by a regime shift.

    • And that’s exactly what Scott just said about the Great Depression – it was caused by a regime shift.

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