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The End of the Great Moderation?

Barnett, William A. and Chauvet, Marcelle (2008): The End of the Great Moderation?

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Abstract

The current financial crisis followed the “great moderation,” according to which some commentators and economists believed that the world’s central banks had gotten so good at countercyclical policy that the business cycle volatility had declined to low levels. As more and more economists and media people became convinced that the risk of recessions had moderated, lenders and investors became willing to increase their leverage and risk-taking activities. Mortgage lenders, insurance companies, investment banking firms, and home buyers increasingly engaged in activities that would have been considered unreasonably risky, prior to the great moderation that was viewed as having lowered systemic risk. It is the position of this paper that the great moderation did not reflect improved monetary policy, and the perceptions that systemic risk had decreased and that the business cycle had ended were based on other phenomena, such as improved technology and communications. Contributing to the misperceptions about monetary policy solutions was low quality data provided by central banks.

Since monetary assets began yielding interest, the simple sum monetary aggregates have had no foundations in economic theory and have sequentially produced one source of misunderstanding after another. The bad data produced by simple sum aggregation have contaminated research in monetary economics, have resulted in needless “paradoxes,” have produced decades of misunderstandings in economic research and policy, and contributed to the widely held views about decreased systemic risk. While better data, based correctly on index number theory and aggregation theory, now exist, the usual official central bank data are not based on that better approach. While aggregation-theoretic monetary aggregates exist for internal use at the European Central Bank, the Bank of Japan, and many other central banks throughout the world, the only central banks that currently make aggregation-theoretic monetary aggregates available to the public are the Bank of England and the St. Louis Federal Reserve Bank. Dual to the aggregation-theoretic monetary aggregates are the aggregation-theoretic user-cost and interest rate aggregates, which similarly are not in official use by central banks.

The failure to use aggregation-theoretic quantity, user-cost price, and interest-rate index numbers as official data by central banks often is connected with the misstatement that expenditure share weights move in a predictable manner, when interest rates change. In fact the direction in which a share will change when an interest rate changes depends upon whether or not the price elasticity of demand is greater than or less than -1. No other area of economics has been so seriously damaged by data unrelated to valid index-number and aggregation theory. We provide evidence supporting the view that misperceptions based upon poor data were responsible for excess risk taking by financial firms and borrowers, and by regulators at central banks. We also provide evidence indicating the poor data may have induced the Federal Reserve to underestimate the rate of growth of monetary services and hence to have fed the bubbles with excess liquidity unintentionally. We also provide evidence indicating that a similar misperception produced an excessively contractionary policy that finally burst the bubble.

Many commentators have been quick to blame insolvent financial firms for their “greed” and their presumed self-destructive, reckless risk taking. Perhaps some of those commentators should look more carefully at their own role in propagating the misperceptions that induced those firms to be willing to take such risks. While there are many considerations relevant to the misguided actions of private firms, individuals, and central banks during the period leading up to the current financial crisis, there is one common thread associated with all of them: misperceptions induced by poor data disconnected from the relevant economic aggregation theory.

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