The Great Moderation of Money and Banking in Output - Essay Example

Money and Banking Money and Banking Thi work find that The Great Moderation Money and Banking in output - the decline in the volatility of output in the mid 1980 - i due to declining variability in invetment and conumer durable purchae, a reult that ugget that better inventory management and financial innovation are at leat part of the declining volatility tory. It alo find that for undertanding wing in GDP growth, "Tracking hift in invetment pending remain critical, but change in houehold pending on nondurable good are now more important than movement in conumer durable. Meanwhile, the fraction of job growth volatility attributable to firm in profeional and buine ervice ha rien to the point where thi ector ha become the larget contributor to hort-run wing in aggregate job growth.": (Damato, 77-99) The 'Great Moderation' in Output and Employment Volatility: An Update, by Evan F. Koenig and Nicole Ball , Economic Letter, FRB Dalla: Volatility can wreak havoc on economie. udden, harp up and down in buine activity can make it difficult for conumer to plan their pending, worker to feel ecure in their job and companie to determine their future invetment. Becaue of their impact on expectation and buine and conumer confidence, wing in the economy can become elf-reinforcing. Volatility can alo pill over into real and financial aet market, where evere price movement can produce eemingly arbitrary reditribution of wealth. It' good new, then, that the U.. economy ha become much more table. On average, the five receion from 1959 to 1983 were 47 month apart, lingered 12 month and were aociated with a 2.17 percent peak-to-trough decline in real gro dometic product. By contrat, the 1990 downturn came after 92 month of expanion, lated eight month and involved a 1.26 percent decline in GDP. The 2001 lump ended a record 120 month of uninterrupted growth, lated eight month and entailed a GDP decline of only 0.35 percent. More generally, quarterly growth in both real GDP and job became markedly le volatile after 1983. (Damato, 77-99) Explanation for thi "Great Moderation," a it' called, include tructural change in the economy, improved monetary policy and imple good luck. Potentially important tructural change include the elimination of ceiling on depoit interet rate, broader acce to credit market through financial innovation like home equity loan, tighter inventory control facilitated by technology, and the globalization of output and labor market. By improved monetary policy, analyt typically have in mind central bank action that repond more quickly and forcefully to emerging inflation preure, o that medium- to long-term price expectation remain contained. Bernanke' approach to looking at the variou reaon for low long-term rate i more rational and reaonable than any I've een in the dozen of article and paper I've read on the yield curve. There wa one point I did diagree with, however. Bernanke aid, "I have argued elewhere that improved policie, which tabilized inflation and better anchored inflation expectation, are an important reaon for thi poitive development; no doubt, tructural change in the economy uch a deregulation, improved inventory control method, and better rik-haring in the financial market alo contributed." I think it hould be the other way around and read like thi, "tructural change in the economy uch a deregulation, improved inventory control method, and better rik-haring in the financial market, which tabilized inflation and better anchored inflation expectation, are an important reaon for thi poitive development; no doubt, improved policie alo contributed. He' referring to the "Great Moderation" in which volatility in the GDP and inflation ha declined. By improved policie he' talking about the monetary policy. o he' giving the Fed the credit for getting the economy under control. He' dead wrong on that point and I hope he come to hi ene and realize the truth on thi very important matter. The Fed, whether they realize it or not, ha more o been driven by economic factor, than been a driver of economic factor. (Barron' , 442-456) Globalization i the "Great Moderator". That' what' changed. Monetary policy ha only changed becaue it could, becaue the economy let it change, becaue the economy inited on it. In the 1970 the Fed took rate extremely high, but it did o in reaction to run away inflation. They had to completely kill the economy to get inflation back under control. Why wa there o much inflation Becaue the Fed grew the money upply too much Not really. It wa primarily becaue our then iolationit, protectionit, non-free trading economy wa hyperenitive for the reaon I wrote about in Keep On, Keepin' On. Globalization ha dramatically inulated the economy from the extreme gyration we once had. And to the bet of my knowledge none of the pat great economit or other great thinker really aw thi coming. Thu, we're only jut now beginning to undertand it. Globalization i taking over for the fed and doing a much better job. The Fed i going to find increaingly that it monetary policy will have little impact on the economy and many of the old guy, the old Fed watcher, won't ee thi coming. They will continue to blame or credit the Fed for thi, that, and the other. The Fed may be overreactive trying to control the economy, a they have in the pat, to their chagrin, and the old Fed watcher will predict all ort of bad thing to come out of the Fed' overreaction, which won't come true. (Barron' , 442-456) The bet bet on the economy i for to keep on being moderate and table. When the conenu get too excited either optimitically or peimitically it will be profitable to bet on the ide of moderation and more of the ame. The tock market coming down the way it did between 2000 and 2003 hould have put u in Great Depreion II, but it didn't. Commoditie price climbing the way they have for the pat two year hould have caued run away inflation, but it didn't. The proof i right in front of u. The Fed didn't do anything more than it' ever done. In the 1970 the ame kind of price pike in energy caued inflation to get out of control in a matter of only a few month and the Fed reacted by raiing rate quickly. Where would Fed rate be now if month after month the core CPI kept riing The Fed would have been reactive and done the ame thing it did in the 70. Do you think that the Fed teeny tiny quarter point hike kept the core CPI down The Fed would like to think it did. But it' not the truth. Wal-Mart ha more control over inflation than the Fed doe. That ound cary, but it' really not becaue Wal-Mart i a generalization for all the merchant importing relatively cheap good. Globalization ha gotten inflation under control, not the Fed. Merchant and bank have alway controlled inflation. The Fed ha only reacted to the action of merchant and bank. It' jut that now becaue of diverification through globalization, merchant and bank aren't a hyperenitive a they once were. Wal-Mart doen't raie price when energy cot go up becaue cheap Chinee labor and the Chinee communit government aborb the cot of higher energy price intead of Wal-Mart. Wal-Mart ha contract for the delivery of good at certain price. Wal-Mart doen't take the hit it would have in the pat. (Barron' , 442-456) imilarly, Citigroup increaingly generate banking, brokering, and lending revenue from all over the world. o it' le enitive to interet rate fluctuation in the U.. than it once wa. If Citigroup doen't raie rate, then other maller regional bank can't either, or ele they will loe buine to Citigroup. o the mall bank take the hit. If U.. interet rate fluctuate enough mall bank will tart to go out of buine. Only intead of cauing a banking crii, big bank aborb the cutomer and often buy out the little bank. The economy i forcing thi globalization on u whether we want it or not. We forcing it on ourelve, becaue it' more efficient. Bernanke talked about one reaon for long-term interet rate being low being poibly becaue borrower are now expecting lower premium for their rik. Greenpan believed thi wa the dominant reaon for low long-term rate and believed thi wa a danger to the economy. But what Greenpan wa miing i the fact that prime lending rate are normal. The current rate i 7.5%, compared to a hitorical average of 7.1% going back to 1949, and that' with a prime rate of 20% in the early 80 pulling the average up. Take out the extreme rate of 1980 and 81 and the average i 6.7%. It' only long-term treaurie and corporate debt that i hitorically low and unreponive to change in hort-term rate. But why houldn't invetor be willing to accept low yield on treaurie After all, ha the U.. treaury ever defaulted on a loan The anwer i no. There baically i nearly zero rik and therefore logically there hould be little to no rik premium for U.. treaurie. High rated corporate bond alo have extremely low real default rik. o that leave demand for debt a the primary driver of price, not rik. Premium aren't low becaue people ee bond a being le riky than before. Premium are low becaue more people want to own nearly zero rik ecuritie. Thi i the aving glut Bernanke i talking about. From the conumer' perpective we're paying the ame rate on loan a we alway have. It' only the buyer of Treaurie and corporate debt that are paying more for a lower yield. o it' not the bank at rik. Really no one i at rik, becaue the buyer are penion and foreign government that want to hold the debt for a long period of time, rather than trade it actively. Thu again we have a ituation where the economic gyration are being dampened. Rate are going to be held table o long a the majority buyer are locking up their bond to collect the income and not actively trading them. o the "Great Moderation", that ha driven down GDP and inflation volatility, i alo moderating interet rate and the buine cycle, which will in turn moderate corporate earning, and tock price once invetor realize thi economic truth. Therefore, I expect that PE ratio will climb for tock in general, a invetor will demand le rik premium for tock. That' a trend that tarted in the 90, but got carried away for a while. I expect that trend to continue more moderately and deliberately going forward, which mean tock will likely continue to do well for the next everal year. And if tock do well, then o will income and the houing market and the trong income will circularly help tock to do well. Once upon a time, not too long ago, policymaker of every tripe were literally dilocating their houlder patting themelve on the back for having tamed the beat that afflict economie from time to time. The phenomenon known a the "Great Moderation" wa thought to have become the new economic paradigm promiing a world of near contant growth in which central banker and political operative would quickly extinguih any deviation from the deired mean. (Deventer, Kenji , Mark and Meler, 23) ource and caue of the Great Moderation were much debated and it birth and ucce had many inventor. No le a luminary than Ben Bernanke in a 2004 peech validated the exitence and benefit of it. Mr. Bernanke did not attempt to quetion it reality, taying power or implication, rather he pent hi time trying to argue that monetary policy wa a major reaon for the Great Moderation: Explanation of complicated phenomena are rarely clear cut and imple, and each of the three clae of explanation I have decribed probably contain element of truth. Neverthele, orting out the relative importance of thee explanation i of more than purely hitorical interet. Notably, if the Great Moderation wa largely the reult of good luck rather than a more table economy or better policie, then we have no particular reaon to expect the relatively benign economic environment of the pat twenty year to continue. Indeed, if the good-luck hypothei i true, it i entirely poible that the variability of output growth and inflation in the United tate may, at ome point, return to the level of the 1970. If intead the Great Moderation wa the reult of tructural change or improved policymaking, then the increae in tability hould be more likely to perit, auming of coure that policymaker do not forget the leon of hitory. My view i that improvement in monetary policy, though certainly not the only factor, have probably been an important ource of the Great Moderation. In particular, I am not convinced that the decline in macroeconomic volatility of the pat two decade wa primarily the reult of good luck, a ome have argued, though I am ure good luck had it part to play a well. In the remainder of my remark, I will provide ome upport for the "improved-monetary-policy" explanation for the Great Moderation. I will not pend much time on the other two clae of explanation, not becaue they are unintereting or unimportant, but becaue my time i limited and the tructural change and good-luck hypothee have been extenively dicued elewhere. Before proceeding, I hould note that my view are not necearily thoe of my colleague on the Board of Governor or the Federal Open Market Committee. Ah, hubri. A we now know, the Great Moderation wa not meant to lat. In fact it ha turned to ahe before our eye in uch a blur of peed that one i left to wonder if it ever exited. Indeed it did exit and it may well have been the wort thing that ever happened to u. ince the Great Depreion the economie of the world tended to go through boom and but phae. Depite downturn, ometime evere, growth continued on an upward trend line. ometime in the mid-80 the U.. and the world in general embarked on a growth phae eldom witneed before. Though downturn, evere enough to be claified a receion in a couple of cae, occurred they tended to be horter and inflict far fewer caualtie than wa previouly the cae. Each downturn wa met with aggreive monetary and fical policy repone. Each time the medicine wa well tolerated by the patient and a remarkable recovery enued. The problem wan't o much that the patient urvived but that the patient urvived-almot all of them. For an economy i a collection of economic unit and not all are meant to live forever. Pat downturn exacted a toll. The weaket economic unit fell by the wayide and the pain of their demie wa tolerable; uncomfortable, but tolerable. When we began aggreively controlling economic contraction, we alo began paring thoe that probably hould have paed into hitory. A thi great wave of growth and properity rolled on and on it carried the weak with it and alo infued men and women with a certain ene of omnipotence. Failure wa aumed to no longer be an operative outcome and with no fear of failure, fear of rik diminihed to the vanihing point. Both trong and weak alike embraced rik with a fervor. Then the muic topped. Not only did it top but all of the pent up weakne and rik that the Great Moderation had fotered or hidden were expoed obcenely. The economy which ha for o long protected thoe that did not deerve protection crumbled and the terminally ill, tripped of their life upport, have begun to exhibit end of life ymptom. "Creative detruction" i once again trying to have it way with the economy. Unfortunately, unleahing that ueful weapon might not work thi time. For the Great Moderation ha kept o many alive and inpired o much exceive rik taking that the normal purge eem not to be an acceptable outcome. Auto companie in the U.., marginal mall exporter in China, bank that forgot the baic hould all probably be left to their own device and fail when neceary. Yet the cope of the danger poed by what ome are beginning to call the Great Receion make ignificant failure unacceptable. Politically, the propect of maive buine failure in the midt of uch a downturn i not tolerable. Economically, thoe buine failure could eaily turn a naty receion into a full fledged depreion. o the neceary cleaning take a back eat to economic urvival. Recovery will come but dragged along will be thoe who hould not have urvived. The auto companie will be back in probably a hort period of time for more help, Citibank will line up at omeone' window for another bailout and thoe Chinee exporter will continue a ward of the tate. It i hard to argue in favor of receion. Maybe it' more appropriate to argue that we need to take le heroic action to tave them off, admit that there i ome good that come from culling the weak from the herd, protect the mot vulnerable and accept a little bit of dicomfort. The Great Moderation wa a hell of a ride but the end of that ride i eemingly dangerou. It probably wan't worth it. Work Cited Damato,Karen. Doing the Math: Tech Invetor' Road to Recovery i Long. Wall treet Journal, pp.C1-C19, May 18, 2001 Barron' Finance, 4th Edition. New York. 2000. pp.pp 442-456. IBN 0-7641-1275-9. ingh Wahla, Ramnik. AICPA committee on Terminology. Accounting Termonology Bulletin No. 1 Review and Reume. Gray R.H., D.L. Owen & C.Adam (1996) Accounting and Accountability: Change and Challenge in Corporate ocial and Environmental Reporting (London: Prentice Hall), Ch 1 Crockford, Neil (1986). An Introduction to Rik Management (2nd ed.), Woodhead-Faulkner. 0-85941-332-2. Charle, Tapiero (2004). Rik and Financial Management: Mathematical and Computational Method, John Wiley & on. IBN 0-470-84908-8. Lam, Jame (2003). Enterprie Rik Management: From Incentive to Control, John Wiley. IBN-13 978-0471430001. van Deventer, Donald R., Kenji Imai and Mark Meler (2004). Advanced Financial Rik Management: Tool and Technique for Integrated Credit Rik and Interet Rate Rik Management, John Wiley. IBN-13: 978-0470821268. Read More