What Caused the ‘Great Moderation’ and How is it Related to the 2008 Crisis?


Today most mainstream economists, even those who call themselves Keynesians, hold to the idea that something like a ‘Great Moderation’ existed between the mid-1980s and 2008. This period, characterised by low inflation and moderate GDP growth, was then and is now generally interpreted as being due to the perfection of the use of monetary policy as a macroeconomic stabilisation tool. It is this rather unusual specter of an argument that lies behind the assumption that once we exit our present so-called ‘liquidity trap’ we will be back to business as usual.

Why do I call this a specter of an argument? Simply for the reason that it is never made clear what the link between the crisis of 2008 and the supposed Great Moderation actually was. What I mean by this is that it is impossible for any serious economist to avoid the fact that the Great Moderation must be viewed, retrospectively, in light of the 2008 crash and the stagnation that followed. To avoid doing this, as it seems to me most commentators today have done, is to show oneself to have a blind spot so massive that I do not believe such people should be taken at all seriously.

The Post-Keynesian community, of course, have a perfectly clear answer to this question. They always said that the 1990s and 2000s were characterised by a chronic lack of demand due to, in the cases of the US and the UK, large trade deficits, tight government budgets and stagnant real wages. This lack of demand was then papered over by the growth of a financial sector that expanded private sector debt enormously and generated bubbles — first in the stock market, then in the housing market. When these bubbles ran their course the plaster was ripped off the wound and the effects of the underlying demand shortage became known.

Such dynamics too should be seen as the cause of the low inflation of that era. In a 2003 paper entitled Are These Trade-Offs Necessary? in the book Reinventing Functional Finance the Old Keynesian economist James Duesenberry noted how, in the case of the US, it was the underlying causes of these dynamics that accounted for the low inflation of the period.

In my opinion, the changes in personnel management, the increasing role of foreign competition and the weakening of trade union bargaining power noted earlier have played an important role in limiting inflation. (p132)

These changes are, of course, the result of what is usually referred to as ‘globalisation’ and they tend to hold wages in check. This even in the case of the low levels of unemployment that we saw in the 1990s — levels which had the NAIRU theorists, who assumed some rigid relationship between unemployment and inflation, scratching their heads.

So why don’t the mainstream economists who realise that what economies are suffering from is a chronic lack of demand recognise these obvious truths? After all, heterodox economists were making these arguments rather vocally in the 1990s and 2000s and I am fairly confident that at least some of those economists that I am referring to are aware of them. I would say that this is for two reasons; both of which are interlinked.

On the one hand these theorists continue today to cling to the notion of a ‘natural rate of interest’ that implies that central banks can overcome any structural issues in the economy (which, according to these theorists,basically cannot exist in the long-run anyway) and create a full employment savings-investment equilibrium. On the other, and tied to this theoretical stubbornness, it was these theorists who pushed for many of the ‘reforms’ that led to sluggish wage growth, deregulated financial markets and widened trade deficits throughout the so-called Great Moderation.

In short: to recognise the real causes of the Great Moderation would be, for many established commentators, to basically discredit their life’s work. And that is a hard cross for any man to bear.


About pilkingtonphil

Philip Pilkington is a London-based economist and member of the Political Economy Research Group (PERG) at Kingston University. You can follow him on Twitter at @pilkingtonphil.
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4 Responses to What Caused the ‘Great Moderation’ and How is it Related to the 2008 Crisis?

  1. Geoffrey Gardiner says:

    The low inflation was the effect of gigantic capital expenditure in China and other countries. It lowered costs and prices of their exports. Take out this effect from the inflation figures so that only domestic inflation in US, UK and others is measured and one will find the ‘moderation’ was an illusion. I pointed this out to Randy Wray over ten years ago during one of his stints at Jerome Levy. He queried my remark so I suggested he check it out with Wynne Godley who was also at Levy. Godley confirmed my view and put a figure on UK domestic inflation which was twice the RPI.

  2. NeilW says:

    Export led growth is a complex way of injecting your own money into your own economy.

    You sell your goods to foreigners and then provide a way of them using their foreign currency to buy your goods, while ensuring you get the local currency so you can pay your workers, etc.

    The result is colossal forced saving in foreign currencies.

    The trick in import led countries would be to accommodate that forced saving. Make sure everybody has the money to buy the imports as well as all the domestic output, and don’t bother paying any interest.

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