Global Nominal Spending History

As someone who believes that stabilizing nominal spending rather than inflation is key to macroeconomic stability, I have taken the liberty in the past to reframe U.S. macroeconomic history according to this perspective. Thus, I renamed (1) the "Great Inflation" that started in the mid-1960s and ended in the early-1980s as the "Great Nominal Spending Spree" and (2) the "Great Moderation" of 25 years or so preceding the current crisis the "Great Moderation in Nominal Spending." I also labeled the late-2008, early 2009 period as the "Great Nominal Spending Crash". Below was the figure I used to summarize this reframing of U.S. macroeconomic history (Click on figure to enlarge):


Recently, I learned the OECD has a quarterly nominal GDP measure (PPP-adjusted basis) aggregated across 25 of its member countries going back to 1960:Q1. The countries are as follows: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Japan, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, United Kingdom and United States. The combined economies of these counties make up over half the world economy and thus, provide some sense of global nominal spending. So in the spirit of reframing global macroeconomic history according to a nominal spending perspective I created the following figure (click on figure to enlarge):



I suspect the similarities between these two figures speak to the size and influence of the U.S. economy. I think it also speaks to the influence of U.S. monetary policy on global liquidity conditions and, thus, it influence on global nominal spending.

Obstfeld and Rogoff's New Paper

Mark Thoma directs us to a new paper by Maurice Obstfeld and Kenneth Rogoff titled Global Imbalances and the Financial Crisis: Products of Common Causes. In this paper the authors acknowledge that highly accommodative U.S. monetary policy in the early-to-mid 2000s in conjunction with other developments played an important role in the build up of global economic imbalances. In their discussion of U.S monetary policy, interest rates, and global liquidity conditions they miss, however, some important points on the issues of (1) productivity growth and (2) the monetary superpower status of the Federal Reserve. Let me take each point in turn.

The first point comes up when Obstfeld and Rogoff criticize the saving glut explanation for the decline in long-term interest rates that began in the early 2000s. They rightly expose the holes in the saving glut story but then turn to a less-than-convincing explanation for the decline in the long-term interest rates. Here are the key excerpts:

[T]he data do not support a claim that the proximate cause of the fall in global real interest rates starting in 2000 was a contemporaneous increase in desired global saving (an outward shift of the world saving schedule)... according to IMF data, global saving (like global investment, of course), fell between 2000 and 2002 by about 1.8 percent of world GDP... [A]n end to the sharp productivity boom of the 1990s, rather than the global saving glut of the 2000s, is a much more likely explanation of the general level of low [long-term] real interest rates.

So their story is that the productivity surge of the 1990s ended and pulled down long-term interest rates. This is a plausible story since productivity growth is a key determinant of interest rates, but the data does not fit the story. Below is a figure showing the year-on-year growth rate of quarterly total factor productivity (TFP) for the United States. The data comes John Fernald of the San Francisco Fed (Click on figure to enlarge):


This figure shows the TFP growth rate did slow town temporarily in 2001 but resumed and even picked up its torrent pace for several years. Rather than pushing interest rates down this indicates they should have gone up. That still leaves the question of why long-term interest rates declined during this time. My tentative answer is that it was some combination of (1) a drop in the term premium that itself was the result of a false sense of security created by the Great Moderation and (2) and expectations of future short-term interest rates being low because of accommodative monetary policy.

The productivity point, however, does not end there. It becomes important in understanding why the Fed continued to keep interest rates so low for so long. As the authors note in the paper:

In early 2003 concern over economic uncertainties related to the Iraq war played a dominant role in the FOMC’s thinking, whereas in August, the FOMC stated for the first time that “the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.” Deflation was viewed as a real threat, especially in view of Japan’s concurrent struggle with actual deflation, and the Fed intended to fight it by promising to maintain interest rates at low levels over a long period. The Fed did not increase its target rate until nearly a year later.

In other words, the fear of deflation is what motivated Fed officials to keep interest rate low for so long. As I have noted many times before, though, the Fed's fear of deflation at this time was misplaced. Deflationary pressures emerged not because the economy was weak, but because TFP growth was surging as shown above. The Fed saw deflationary pressures and thought weak aggregate demand when in it fact it meant surging aggregate supply. Making this distinction is important if monetary policy wishes to fulfill its mandate of maintaining full employment. Not making this distinction in 2003-2004 meant an economy already buffeted by positive aggregate supply shocks (i.e. productivity surge) got simultaneously juiced-up with positive aggregate demand shocks (i.e. historically low interest rate policy). This was a sure recipe for economic imbalances to emerge somewhere.

The second point with the Obsteld and Rogoff's paper is that it fails to appreciate how important is the Fed's monetary superpower status. As I have explained before

the Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Obstfeld and Rogoff actually hint at this possibility briefly when they say the following:

the dollar’s vehicle-currency role in the world economy makes it plausible that U.S. monetary ease had an effect on global credit conditions more than proportionate to the U.S. economy’s size.

But then they go on to say

While we do not disagree entirely with Taylor [who believes the Fed was too accommodative in the early 2000s], we argue below that it was the interaction among the Fed’s monetary stance, global real interest rates, credit market distortions, and financial innovation that created the toxic mix of conditions making the U.S. the epicenter of the global financial crisis.

I agree that there were many factors at work, but if you accept that the Fed is a monetary super power and therefore helped generate the global liquidity glut then it could have also tightened global liquidity conditions and helped pushed the global interest rates toward a more neutral stance. And without the global liquidity glut it seems that many of the other credit market distortions that arose at the time would have been far less pronounced.

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.

The "Great Moderation" at the State Level

Michael Owyang, Jeremy Piger, and Howard Wall have a paper that takes a fresh look at the "Great Moderation", the reduction in aggregate macroeconomic volatility since the early 1980s. This Great Moderation has received a lot of attention--including from this blog(here and here)--with a lot of it directed to explaining why the volatility has declined . These authors make a novel contribution to this literature by looking at this issue from the state level. Their paper, titled "A State-Level Analysis of the Great Moderation", points to better monetary policy as a key factor behind the reduced macroeconomic volatility. Here are the authors in their own words:

This paper documented the Great Moderation at the state level and found significant heterogeneity in the timing and magnitude of states’ structural breaks. Specifically, we found that 38 states experienced a structural break and that 14 states had breaks that occurred at least three years before or after the aggregate break, which we place at September 1984. The states for which we found weak or little evidence of a break tended to be along the Atlantic coast.

Typically, when macroeconomists are looking for explanations for the Great Moderation, they have only the single aggregate occurrence with which to work. As a result, severalhypotheses have gained support on the basis of temporal coincidence between various events or trends and this single volatility reduction. Unfortunately for this approach, however, a surfeit of events occurred alongside the Great Moderation, so it is difficult to sort out the many theoretically plausible explanations. Our set of state-level great moderations might, therefore, be useful in sorting through the various hypotheses.

Of the five main hypotheses that have been put forth, our results suggest that four of them—the inventory, good-luck, banking deregulation, and demography hypotheses—are implausible because they are statistically inconsistent with the state-level pattern of structural breaks. On the other hand, we found that the monetary hypothesis remains a plausible explanation of the Great Moderation in that it is not inconsistent with the state-level experience.

You can read the rest of their paper here.

The Great Moderation vs. Rising Household Income Volatility

Just last week I revisited the question of how to reconcile the findings from the "Great Moderation" literature that shows a significant decline in aggregate economic volatility since the early-to-mid 1980s with the findings of Jacob Hacker and others that show there has been a marked increase in household income volatility over this same period. One would think some of the decreased macroeconomic volatility would be experienced and observed at the household level. The data, however, says otherwise. How is this possible? A new paper on the "Great Moderation" by Steven Davis and James Kahn attempts, among other things, to answer this question.

From their paper, Interpreting the Great Moderation: Changes in the Volatility of Economic Activity at the Macro and Micro Levels, we get the following discussion of this issue:

[A] puzzle that research on the Great Moderation has yet to confront: Why has the dramatic decline in the volatility of aggregate real activity, and the roughly coincident decline in firm-level volatility and job-loss rates, not translated into sizable reductions in earnings uncertainty and consumption volatility facing individuals and households?

We do not know the answer to this question, but we conjecture that greater flexibility in pay setting for workers played a role, possibly a major one. Greater pay flexibility is consistent with the rise in wage and earnings inequality in U.S. labor markets since 1980 and with increases in individual income volatility and earnings uncertainty. If these developments involve a rise in the variance of idiosyncratic permanent income shocks to households, then household consumption volatility also rises according to permanent income theory. Greater wage (and hours) flexibility also leads to smaller firm-level employment responses to idiosyncratic shocks and smaller aggregate responses to common shocks, because firms can respond by adjusting compensation rather than relying entirely on layoffs and hires. By the same logic, wage adjustments can substitute for unwanted job loss. So, at least in principle, greater wage flexibility offers a unified explanation for the rise in wage and earnings inequality, flat or rising volatility in household consumption, a decline in job-loss rates, and declines in firm-level and aggregate volatility measures.

In short, their argument is that greater wage volatility has been traded for reduced output and employment volatility. If true, this interpretation has two implications: (1) labor markets are working better since the price of labor is now more flexible; (2) more economic risk has been shifted to labor.

Read the rest of the article.

Update I: See further discussion of this posting here.

A Question for Jacob Hacker

Jacob Hacker is back with revised estimates on family income volatility (ht Mark Thoma). In his earlier work he found a marked increase in the volatility of family income between 1973 and 2004. These conclusions were later challenged by findings from the CBO. In turn, Hacker responded to CBO here. Now, if Hacker could be so kind as to respond to another question, one that I raised earlier:

[W]hat role does the 'Great Moderation' play in this debate? A well documented fact is that there has been less volatility in aggregate economic activity since the early 1980s and this development is called the 'Great Moderation.' One study has found real economic activity volatility has fallen 50% over this time. Would not some of this decline in aggregate economic volatility be felt at the household or individual level? Is not the low U.S. household saving rates one indication of this development?

Some observers may look at the low U.S. saving rate and say it is the result of the global saving glut or the U.S. asset price booms. I am not convinced, though, these answers can provide the full explanation for the sustained downward trend in U.S. household savings. A more complete answer has to account for the possibility of improved household expectations arising from the long economic expansions of the past two decades that were interrupted by only mild economic downturns (i.e. the 'Great Moderation').

Clearly, this question reflects my macro background. But it is the question that keeps coming up in my mind when I read this family income volatility debate.

Labor Market Dynamics

In a recent paper, Robert Hall makes two interesting assertions about employment over the business cycle. First, the "Great Moderation"--the reduction in U.S. macroeconomic volatility since 1984--is only a feature of output, not employment. Second, employment falls during a recession not because of increased job losses, but because new jobs are harder to find. Both of these claims were news to me so I decided to dig into the data myself.

Regarding the first assertion, Hall provides a figure (Figure 1 in the paper) that shows the percentage deviation of employment from trend does not noticeably change since 1948. It is not clear how he constructed the figure, but here is a graph from the Fred database at the St. Louis Fed that shows the monthly percentage change in employment over the same period:

Visual inspection of this figure indicates that employment volatility has diminished since 1984. Hall, in fact, does concede there does appear to be some reduction using this approach, but he goes on to claim that it has not declined as much as with output. Here is what I found looking at the standard deviation of the quarterly growth rate for both real GDP and employment (data from Fred database again):

The reduction of the standard deviation is of similar magnitude for both real GDP and employment. I fail to see, then, how the "Great Moderation" is more a feature of output than employment.

Regarding the second assertion, Hall provides a figure (Figure 2) that shows percent of workers laid off since 2000 has been relatively stable. This table was constructed using data from the BLS's Job Opportunity and Labor Turnover Survey (JOLTS). Digging into this data I was able to get numbers on layoffs and other separations, as well as new hires. I have graphed the data below:

This figure supports Hall's second assertion that employment falls during a recession not because of increased job losses, but because new jobs are harder to find, at least for the period 2000-2007 (unfortunately the data only begins in 2000). The impact of 2001 recession, for example, is visible in hires but not in the layoffs and other separations. The economic weakening that began late last year shows a similar pattern. Again, this is not what I expected.

If these patterns hold up going forward, then any good macro theory should be able to explain them. This was the whole point of Hall's paper.

The 'Great Moderation' and the Income Volatility Question

Over at the CBO Director's Blog we read that based on the CBO's own research "household income is much less volatile than individual worker’s earnings, and that household income volatility has not increased over time — and perhaps even declined slightly." The period being studied here is from the early 1980s to the present. These results run contrary to the work of Jacob Hacker of Yale University who finds that the volatility of family income doubled between 1973 and 2004. Professor Hacker's response to the CBO Directors Blog can be found here.

A question: what role does the 'Great Moderation' play in this debate? A well documented fact is that there has been less volatility in aggregate economic activity since the early 1980s and this development is called the 'Great Moderation.' One study has found real economic activity volatility has fallen 50% over this time. Would not some of this decline in aggregate economic volatility be felt at the household or individual level? Is not the low U.S. household saving rates one indication of this development?

Some observers may look at the low U.S. saving rate and say it is the result of the global saving glut or the U.S. asset price booms. I am not convinced, though, these answers can provide the full explanation for the sustained downward trend in U.S. household savings. A more complete answer has to account for the possibility of improved household expectations arising from the long economic expansions of the past two decades that were interrupted by only mild economic downturns (i.e. the 'Great Moderation'). Any thoughts?