Demythologizing Central Bankers and the Great Moderation

It is often said that the winners get to write history, which matters because the way we tell history frames our understandings. What is true for general history also holds for economic history, and the way we tell economic history affects our expectations and aspirations for the economy.

The last twenty-five years have witnessed a boom in the reputation of central bankers. This boom is based on an account of recent economic history that reflects the views of the winners. Now, with the U.S. economy entering troubled waters that reputation may get dented. More importantly, there is an opportunity to tell an alternative account of recent history.

The raised standing of central bankers rests on a phenomenon that economists have termed the “Great Moderation.” This phenomenon refers to the smoothing of the business cycle over the last two decades, during which expansions have become longer, recessions shorter, and inflation has fallen.

Many economists attribute this smoothing to improved monetary policy by central banks, and hence the boom in central banker reputations. This explanation is popular with economists since it implicitly applauds the economics profession by attributing improved policy to advances in economics and increased influence of economists within central banks. For instance, the Fed’s Chairman is a former academic economist, as are many of the Fed’s board of governors and many Presidents of the regional Federal Reserve banks.

That said, there are other less celebratory accounts of the Great Moderation that view it as a transitional phenomenon, and one that has also come at a high cost. One reason for the changed business cycle is retreat from policy commitment to full employment. The great Polish economist Michal Kalecki observed that full employment would likely cause inflation because job security would prompt workers to demand higher wages. That is what happened in the 1960s and 1970s. However, rather than solving this political problem, economic policy retreated from full employment and assisted in the evisceration of unions. That lowered inflation, but it came at the high cost of two decades of wage stagnation and a rupturing of the link between wage and productivity growth.

Disinflation also lowered interest rates, particularly during downturns. This contributed to successive waves of mortgage refinancing and also reduced cash outflows on new mortgages. That improved household finances and supported consumer spending, thereby keeping recessions short and shallow.

With regard to lengthened economic expansions, the great moderation has been driven by asset price inflation and financial innovation, which have financed consumer spending. Higher asset prices have provided collateral to borrow against, while financial innovation has increased the volume and ease of access to credit. Together, that created a dynamic in which rising asset prices have supported increased debt-financed spending, thereby making for longer expansions. This dynamic is exemplified by the housing bubble of the last eight years.

The important implication is that the Great Moderation is the result of a retreat from full employment combined with the transitional factors of disinflation, asset price inflation, and increased consumer borrowing. Those factors now appear exhausted. Further disinflation will produce disruptive deflation. Asset prices (particularly real estate) seem above levels warranted by fundamentals, making for the danger of asset price deflation. And many consumers have exhausted their access to credit and now pose significant default risks.

Given this, the Great Moderation could easily come to a grinding halt. Though high inflation is unlikely to return, recessions are likely to deepen and linger. If that happens the reputations of central bankers will sully, and the real foundation and hidden costs of the Great Moderation may surface. That could prompt a re-writing of history that restores demands for a return to true full employment with diminished income inequality. How we tell history really does matter.

Copyright Thomas I. Palley

5 Responses to “Demythologizing Central Bankers and the Great Moderation”

  1. kio Says:

    I agree. Central Banks have privatized all “success” of the past 20-25 years. Moreover they will be very reluctant to be assocaited with any failure in the future. Such failures wll be “nationalized” or “internationalized”.

    The problem is who and how can prove that these banks are not real driving force of economy as expressed by real economic growth, inflation, unemployment?

    I guess that no quantitative explanation would be accepted, even a 100% right one. Economics is a political science, i.e. a play of political powers, not a scientific consideration.

  2. j Says:

    The Argentines, Indonesians, Japanese, Russians, Thais, Koreans, et al might beg to differ as to whether there has been any great moderation. It could be argued that US dollar hegemony provided a nifty way to dump painful adjustments onto others. Stability is easier to maintain when you can borrow unlimited amounts in a currency you can devalue. Also there have been no serious resource crises since the 70’s. No crop failures, energy crises, or world wars. The mettle of our central bankers is yet to be tested, IMHO.

  3. Lifeguard Says:

    What do you mean when you write: “That could prompt a re-writing of history that restores demands for a return to true full employment with diminished income inequality.”?

    Are you saying that an intelligent, educated, diligent worker who makes six figures should be paid as much as someone who is less intelligent, not educated, and who puts in the minimum due at their job? Of course not. Yet the diligent worker is the one who is more likely to have a higher income which establishes an “income inequality”.

    Or are you arguing that salaries of the “rich” have rapidly outpaced the gains (or losses) of the “middle class”? Then you would need to define the “rich” and the “middle class” or “poor”.

    Charlie Gibson defined the “middle class” as those making $200,000 per year. I would disagree with that. The median income of U.S. households is about $48,000 (plus or minus a bit). There is my starting point for defining “middle class”.

    In short, your article fails to persuade me to your cause since it offers no definition or data on which to base a judgment. I suspect that if it did, we might actually agree.

  4. Alex Says:

    you said:” economic policy retreated from full employment and assisted in the evisceration of unions. That lowered inflation, but it came at the high cost of two decades of wage stagnation and a rupturing of the link between wage and productivity growth.”
    How can unemployment and the evisceration of the unions cause wage stagnation and a wedge between the wage and productivity? the reduction in the wage should reduce unemployment, especially with weaker unions, and the de-unionization should reduce the wedge between productivity of labor and the wages.

  5. Thomas Palley on “The Great Moderation” « … And the cow goes moo Says:

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