Back to the Great Moderation?
Following the largest financial shock since the Great Depression, modern industrial countries appear to be coming back to a moderate growth trajectory, as was the case for the last three decades.
By Stéphane Lhuissier
Post
Following the collapse of Lehman Brothers in 2008, many observers became convinced that OECD countries had entered a phase of economic instability, putting a definite and abrupt end to the so-called « great moderation », a term referring to the period of macroeconomic stability that had prevailed since the mid-1980s. Yet, many macroeconomic indicators show that moderation has recently returned. Very good news for world economy!
To convince ourselves of the return to a low volatility environment, let us look at the data. Figure 1 shows the five-year rolling standard deviations of quarterly GDP growth rates for several developed countries (France (FR), Germany (GE), Italy (IT), Canada (CA), United Kingdom (UK), G7, OECD, and the United States (U.S.) since 1975. This measure highlights the variability of real GDP growth rates over time. As such, it is a good proxy of economic instability, or more generally, the level of economic uncertainty confronting households and firms.
Zooming on the pre-crisis years reveals that the standard deviations of GDP growth significantly and continuously declined during the past three decades in all countries. For each of them, the degree of economic instability in 1970s and 1980s was more than twice as high as the levels indicated in the 1990s. Still, firms and households managed to make investment and consumption decisions in a way that was still conducive to (some) economic growth.
The period of growth moderation (1985-2008) did not exclude the possibility of recessions. Rather, economic contractions turned out less frequent and less severe, on average, than those observed in the period of macroeconomic instability. This is very well illustrated by the American recessions in 1990-1991 and 2001, whose intensity was lower and their duration was shorter than those observed in the 1970s and 1980s.
More recently, the severity of the financial crisis in 2008, which was followed by the sovereign debt crisis in the euro area, triggered a rise in the amplitude of business cycles fluctuations – in fact bringing us back to the level that prevailed prior the Great Moderation. However, this regime remained short-lived. By contrast, the volatility experienced since the end of 2014 has been low, just like before the crisis.
Other measures of volatility indicate our claim that low volatility has returned. For example, uncertainty can also be proxied by the VIX, a financial index of expected future price volatility in stock markets. This index, shown in Figure 2, confirms the trend observed in the first figure, namely a large reduction of financial asset price volatility.
The million dollar question is then: will this low volatility regime be persistent? If so, it would certainly help the economy to grow.
First, a low-volatility macroeconomic regime spurs new investment projects. In his seminal 2009 paper [1], Nicholas Bloom, Professor at Stanford University, highlights that “increased uncertainty is depressing investment by fostering an increasingly widespread wait-and-see attitude about undertaking new investment expenditures”. Along the same line of argument, the Chief Economist of the IMF, Olivier Blanchard, explains the lack of demand since the Great Recession by uncertainty: “Uncertainty is largely behind the dramatic collapse in demand. Given the uncertainty, why build a new plant, or introduce a new product now? Better to pause until the smoke clears”. Clearly, the recent decrease of uncertainty over several months should foster investment and economic activity.
Second, the reduction of macroeconomic volatility boosts domestic demand by improving consumer confidence, which in turn stimulates consumption. Just like investors, households can put off their decisions regarding the purchases of consumption durable goods (cars, houses, …) as soon as uncertainty is raised. When faced with high uncertainty, workers tend to build precautionary savings, to the detriment of consumption, in order to guard against – for example - the risks of losing his/her job.
Third, reduced uncertainty improves the effectiveness of fiscal and monetary policies, by making economic agents (households, firms, investors, …) more inclined to make decisions. A recent empirical study on the United States, Canada, United Kingdom, and Norway by economists at Norges Bank [2], shows that a decrease in nominal interest rates, in period of low uncertainty, would increase investment, consumption and GDP by more than twice as much as in a period of very high uncertainty.
The same applies to tax reliefs to both taxpayers and businesses: they are likely to have a greater impact when uncertainty is low. Seen from this angle, the “big” European investment plan, under the supervision of the President the European Commission, Jean-Claude Juncker, was extremely timely, as it is being implemented at a time of low volatility.
From a macroeconomic point of view, the return of moderation is a very positive signal. There are, however, grey areas, which could rapidly bring volatility back. First and foremost, the unconventional monetary policy conducted by the ECB, the so-called “Quantitative Easing” started this past March, differs dramatically from the traditional implementation of monetary policy, namely the steering of interest rates through the injection of liquidity via refinancing operations. Due to their innovative and experimental nature in most developed countries, non-standard monetary measures could trigger waves of uncertainty. Each monetary policy announcement by ECB could generate unprecedented and unexpected reactions from financial markets. Enough to fear that in the end, volatility might be around the corner and the recent macroeconomic stability could end up being short lived…
To convince ourselves of the return to a low volatility environment, let us look at the data. Figure 1 shows the five-year rolling standard deviations of quarterly GDP growth rates for several developed countries (France (FR), Germany (GE), Italy (IT), Canada (CA), United Kingdom (UK), G7, OECD, and the United States (U.S.) since 1975. This measure highlights the variability of real GDP growth rates over time. As such, it is a good proxy of economic instability, or more generally, the level of economic uncertainty confronting households and firms.
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Figure 1 - Volatility of quarterly GDP growth rates in OECD countries 
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Zooming on the pre-crisis years reveals that the standard deviations of GDP growth significantly and continuously declined during the past three decades in all countries. For each of them, the degree of economic instability in 1970s and 1980s was more than twice as high as the levels indicated in the 1990s. Still, firms and households managed to make investment and consumption decisions in a way that was still conducive to (some) economic growth.
The period of growth moderation (1985-2008) did not exclude the possibility of recessions. Rather, economic contractions turned out less frequent and less severe, on average, than those observed in the period of macroeconomic instability. This is very well illustrated by the American recessions in 1990-1991 and 2001, whose intensity was lower and their duration was shorter than those observed in the 1970s and 1980s.
More recently, the severity of the financial crisis in 2008, which was followed by the sovereign debt crisis in the euro area, triggered a rise in the amplitude of business cycles fluctuations – in fact bringing us back to the level that prevailed prior the Great Moderation. However, this regime remained short-lived. By contrast, the volatility experienced since the end of 2014 has been low, just like before the crisis.
Other measures of volatility indicate our claim that low volatility has returned. For example, uncertainty can also be proxied by the VIX, a financial index of expected future price volatility in stock markets. This index, shown in Figure 2, confirms the trend observed in the first figure, namely a large reduction of financial asset price volatility.
|
Figure 2 - VIX: financial index of expected future price volatility in stock markets .bmp) |
The million dollar question is then: will this low volatility regime be persistent? If so, it would certainly help the economy to grow.
First, a low-volatility macroeconomic regime spurs new investment projects. In his seminal 2009 paper [1], Nicholas Bloom, Professor at Stanford University, highlights that “increased uncertainty is depressing investment by fostering an increasingly widespread wait-and-see attitude about undertaking new investment expenditures”. Along the same line of argument, the Chief Economist of the IMF, Olivier Blanchard, explains the lack of demand since the Great Recession by uncertainty: “Uncertainty is largely behind the dramatic collapse in demand. Given the uncertainty, why build a new plant, or introduce a new product now? Better to pause until the smoke clears”. Clearly, the recent decrease of uncertainty over several months should foster investment and economic activity.
Second, the reduction of macroeconomic volatility boosts domestic demand by improving consumer confidence, which in turn stimulates consumption. Just like investors, households can put off their decisions regarding the purchases of consumption durable goods (cars, houses, …) as soon as uncertainty is raised. When faced with high uncertainty, workers tend to build precautionary savings, to the detriment of consumption, in order to guard against – for example - the risks of losing his/her job.
Third, reduced uncertainty improves the effectiveness of fiscal and monetary policies, by making economic agents (households, firms, investors, …) more inclined to make decisions. A recent empirical study on the United States, Canada, United Kingdom, and Norway by economists at Norges Bank [2], shows that a decrease in nominal interest rates, in period of low uncertainty, would increase investment, consumption and GDP by more than twice as much as in a period of very high uncertainty.
The same applies to tax reliefs to both taxpayers and businesses: they are likely to have a greater impact when uncertainty is low. Seen from this angle, the “big” European investment plan, under the supervision of the President the European Commission, Jean-Claude Juncker, was extremely timely, as it is being implemented at a time of low volatility.
From a macroeconomic point of view, the return of moderation is a very positive signal. There are, however, grey areas, which could rapidly bring volatility back. First and foremost, the unconventional monetary policy conducted by the ECB, the so-called “Quantitative Easing” started this past March, differs dramatically from the traditional implementation of monetary policy, namely the steering of interest rates through the injection of liquidity via refinancing operations. Due to their innovative and experimental nature in most developed countries, non-standard monetary measures could trigger waves of uncertainty. Each monetary policy announcement by ECB could generate unprecedented and unexpected reactions from financial markets. Enough to fear that in the end, volatility might be around the corner and the recent macroeconomic stability could end up being short lived…
[1] Nicholas Bloom, 2009. "The Impact of Uncertainty Shocks," Econometrica, Econometric Society, vol. 77(3), pages 623-685, 05.
[2] Aastveit, Knut Are, Natvik, Gisle James and Sola, Sergio, 2013. "Economic Uncertainty and the Effectiveness of Monetary Policy," Norges Bank Working Paper 17.
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