Views on Business Cycles in the heyday of The “Great Moderation”

In 1997, the Boston Fed hosted a Conference on “Causes of Business Cycles. An overview can be found here:

In assessing the causes of the four largest downturns of the century— the Great Depression, and the recessions of 1920, 1929, and 1937—Temin concludes first that no single cause explains all four downturns. Three of the four possible causes in Temin’s taxonomy appear as causes of the downturns. Second, three of the four recessions appear to be responses to domestic shocks. Most often, we cannot blame our downturns on foreign causes. Taking all of the cycles studied into consideration, Temin offers the following conclusions: (1) “It is not possible to identify a single type of instability as the source of American business cycles.” Thus, Dornbusch’s statement, “None of the U.S. expansions of the past 40 years died in bed of old age; every one was murdered by the Federal Reserve,” is not supported by Temin’s analysis. (2) Domestic real shocks—ranging from inventory adjustments to changes in expectations—were the most fre quent source of fluctuations. (3) Other than the two oil shocks of 1973 and 1979, foreign real shocks were not an important source of U.S. cycles. (4) Monetary shocks have decreased in importance over time. (5) When measured by the loss of output, domestic sources have loomed larger than foreign sources; real sources have caused about the same losses as monetary sources.

Christina Romer takes issue both with Temin’s classification scheme and with his interpretation of the literature on the causes of recessions. She suggests that an improved classification scheme and a different reading of the literature would yield a more critical role for domestic monetary shocks, particularly in the inter- and postwar periods. Romer suggests that Temin’s methodology is biased toward finding very few monetary causes of recessions. Whereas Temin classifies most Fed behavior as a fairly typical response to prevailing conditions and therefore not the ultimate cause of the recession, Romer would prefer a more practical classification of monetary policy actions. If the monetary policy action was the inevitable or highly likely result of a trigger, then we should consider the policy action endogenous and therefore not a cause. If, however, “a conscious choice was made” or if “alternative policies were . . . discussed at the time,” then the policy should be considered at least partly exogenous, and monetary policy should get some blame for the recession.

Romer shows that, using this criterion, many more of the twentieth century recessions have an important monetary policy aspect. Monetary factors would likely be given an important causal role in the 1931 recession, for example, as “reasonable men at the time were urging the Fed to intervene” in the face of financial panics. Thus, the choice not to intervene but to raise the discount rate was not inevitable or even most likely. Romer also questions the extent of the constraint imposed by the gold standard, as U.S. gold reserves in 1931 were probably adequate to have allowed the Fed to pursue expansionary open market operations while maintaining the gold value of the dollar, as in fact it did in 1932.


As Romer sees it, “the key change has not been from monetary to real shocks or vice versa, but from random shocks from various sources to governmental shocks.” Since the Second World War, the government has been more effective at counteracting most shocks, accounting for the diminished frequency of cycles. However, the combination of a tendency toward overexpansion and a few large supply shocks caused inflation to get out of hand. In sum, Romer would agree with the thrust of Dornbusch’s statement, which is that monetary policy has played a vital role in postwar recessions. She might re-cast the role of the Fed, however, as “more like a doctor imposing a painful cure on a patient with an illness than a murderer.”

In my view, what monetary policy managed to achieve in the early 1980s, giving rise to the “Great Moderation”, was contain the propagation of real shocks (through managing to keep nominal spending evolving close to a trend level path). Unfortunately, in 2007 the Fed turned into a “serial killer”!


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