Wednesday, November 12, 2008

Did the "Great Moderation" Contribute to the Financial Crisis?

Since the early-to-mid 1980s there has been a pronounced drop in macroeconomic volatility. This development has been called the "Great Moderation" and can be seen in the figure below. This figure shows the rolling 10-year average real GDP growth rate along with one-standard deviation bands. These standard deviation bands provide a sense of how much variation or volatility there has been around the 10-year average real GDP growth rate. The figure shows a marked decline in the real GDP volatility beginning around 1983. (Click on figure to enlarge)

Solid line = 10 year real GDP growth rate rolling average
Dashed line = 1 standard deviation

Something I have been wondering lately is whether this "Great Moderation" contributed to the financial crisis by creating complacency about macroeconomic conditions. Is it possible that policymakers, investors, and others came to believe that improvements in macroeconomic stability were a given and, as a result, let their guard down? Thomas Cooley believes this may be the case:
There is another, deeper possible link between the Great Moderation and the financial crisis that is worth thinking about, because it may help to inform the financial regulation of the future. The idea is simply that the decline in volatility led financial institutions to underestimate the amount of risk they faced and overestimate the amount of leverage they could handle, thus essentially (though unintentionally) reintroducing a large measure of volatility into the market.

Financial institutions typically manage their risk using what they call value at risk or VaR. Without getting into the technicalities of VaR (and there is a very long story to be told about the misuse of these methods), it is highly likely that the Great Moderation led many risk managers to drastically underestimate the aggregate risk in the economy. A 50% decline in aggregate risk is huge, and after 20 years, people come to count on things being the same.

Risk managers are supposed to address these problems with stress testing--computing their value at risk assuming extreme events--but they often don't. The result was that firms vastly overestimated the amount of leverage they could assume, and put themselves at great risk. Of course, the desperate search for yield had something to do with it as well, but I have a hard time believing that the managers of Lehman, Bear Stearns and others knowingly bet the firm on a systematic basis. They thought the world was less risky than it is. And so, the Great Moderation became fuel for the fire.
So as much as the Great Moderation has been praised, it may turn out to be a key contributor to the biggest financial crisis since the Great Depression.


  1. What about the 1987 market crash? It didn't have much fallout on GDP, but it certainly had to make financial institutions more risk averse into the late 80s.

  2. Not wanting to sound like a broken record, but this is exactly the point Taleb makes in the "Black Swan". His metaphor for the Great Moderation is the case of a turkey that is fed for 1000 days, each day providing more statistical confirmation that the kind human will always look after the turkey. But on the 1001st day......