from Follow the Money

So long, “Great Moderation”

December 7, 2008

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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The great moderation – a theory that become quite popular once the big financial party of this decade really got going after 2004 (see the New York Times graphic on LBOs) – had two components.

One: Macroeconomic volatility was a historical relic. Downturns were not going to be as severe as in the past – in part because of the success of counter-cyclical monetary policy.

Two: Financial volatility also was a thing of the past. The combination of reduced macroeconomic policy and the credibility of monetary policy meant that financial markets weren’t as subject to wild gyrations.

The implication of course was that leverage was safe. Financial firms could enhance their returns by borrowing more and taking bigger bets. And everyone else could increase take on more debt too – whether firms or households.

I guess it is now time to go back to the drawing boards.

Financial volatility has come back, with vengeance. And not just in the equity markets. After a period of (relative) stability, there have been a series of sharp moves in the foreign exchange market. The yield on the thirty year bond has swung wildly. The pros are amazed at some of the strange permutations that derivatives markets have churned up under stress.

And Friday’s employment data leaves little doubt that macroeconomic volatility is back with a vengeance. The pace of contraction in economic activity in the US – and probably globally – this quarter is likely to be brutal. Wall Street economists are increasingly starting to sound like Dr. Doom.

Alas, adjusted to a more volatile world won’t be easy. Belief in the great moderation meant that the US economy was operating with a smaller buffer of capital and liquidity than it had in the past. And here at least much of the world seems to have emulated the US. The easy way to increase equity returns over the last few years was to take on more debt. That in turn is likely to augment the amount of volatility in the economy.

The risk, obviously, is that firms that borrowed to buy back their stock – or hadn’t run down their cash reserves – won’t be able to avoid Chapter 11. Or Chapter 7. And financial firms won’t be able to support their existing balance sheets with their now-depleted capital and will have to scale back (even after government capital injections), adding to the downturn.

Ideas have consequences. Big bets on the “great moderation” throughout the economy helped to create the financial basis for a potentially big slump.

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