Did Central Banks Engineer the 'Great Moderation'?

Did Central Banks Engineer the 'Great Moderation'?
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The idea of a Great “Moderation” had been around in various pieces for some time before the 21st century.  The US and even the global economy had experienced a sharp and sustained reduction in volatility across all sorts of metrics. From inflation and employment to general output (GDP), from the mid-1980’s forward it seemed as if a new golden economic age had somehow been achieved. Since it had happened and because it was by contemporary accounts an unqualified positive, a great amount of scholarly effort was put forth to identify who might claim authorship of the accomplishment.

The actual term Great “Moderation” was coined at the Annual NBER conference in April 2002. James Stock of Harvard and Mark Watson of Princeton had presented their findings (published officially in January 2003) trying to answer the question, Has the Business Cycle Changed and Why? Unsurprisingly, they found that it had and used their considerable mathematics skills to figure it all out, including who the world might thank for the service. 

The term Great “Moderation” itself would receive its mainstream arrival with a speech given by Ben Bernanke a year after Stock and Watson published. In February 2004, Bernanke was invited to give his thoughts on the economy to the Eastern Economic Association in Washington, which he did by the very title he chose – The Great Moderation.  Despite the dot-coms, little had actually changed in terms of variation in inflation (consumer) and output.  The recession which had followed the stock bust was the mildest so far recorded, and by early 2004 the economy outwardly appeared right back on track. 

Of the possible explanations for this uniquely stable period, Stock and Watson statistically tested several candidates put forth separately over the years by other writers.  These fell into three broad categories. The first was the class related to several structural changes, including a more service oriented economy, as well as more effective and efficient inventory management.  The third was, to use their words, pure good luck.  The authors meant by that simply what appeared to be a distinct lack of “exogenous shocks.”  The second, and the one that is mostly remembered, at one time in the form of the media’s obsession with even Alan Greenspan’s briefcase, “improved policy, in particular improved monetary policy.”

Bernanke in early 2004 actually claimed that the Federal Reserve was notgetting enough acclaim for the economy’s stable results.  Saying, “I have put my case for better monetary policy rather forcefully today, because I think it likely that the policy explanation for the Great Moderation deserves more credit than it has received in the literature,” apparently the future Fed Chairman did not want to share praise with other possible explanations, particularly “good luck.”  He wanted it to be known that the Fed made it, and would keep making it:

“Lower volatility of output tends to imply more stable employment and a reduction in the extent of economic uncertainty confronting households and firms. The reduction in the volatility of output is also closely associated with the fact that recessions have become less frequent and less severe.”

It is the fatal conceit of all statistics used often inappropriately in the “soft sciences” that correlations made today will still be valid tomorrow.  For economists in particular, interpreting events by these statistics makes for the same weakness of argument, if not more so.  Stock and Watson even cautioned as much in their paper:

“But because most of the reduction seems to be due to good luck in the form of smaller economic disturbances, we are left with the unsettling conclusion that the quiescence of the past fifteen years could well be a hiatus before a return to more turbulent economic times.”

Was it really a Great “Moderation” in the first place, or just a temporary window of depressed volatility as the authors reluctantly contemplated?  What might account for this long period of “good luck?”

As to the first question, central bankers have mostly fallen silent.  Whenever the Great “Moderation” has been mentioned over the past decade it was more so to invoke a lost glory that with each new QE or monetary “stimulus” economists were sure they would reclaim.  One central banker who tried to make that case early on was the Bank of England’s Charles Bean.  As BoE’s Deputy Governor for Monetary Policy, Bean was about as inside as any insider could possibly be, and at a speech in Barcelona in August 2009 his point was that, essentially, everyone was fooled.

“Now if the Great Moderation was down to ‘good luck’, then improved macroeconomic performance was more likely to be ephemeral. But if it was down to structural changes or better policy, there was more chance of it proving permanent. Moreover, if it was permanent, then part of the ‘dividend’ from this reduced macroeconomic volatility should be a greater willingness to take on risk.”

To follow his reasoning, the Great “Moderation” was real and the crash the consequences of it being real.  All policymakers would have to do to get back to it, then, is to go forth much the wiser making sure the same mistakes would be avoided.  No reason to fret that central bank luck might have run out.

There are a great many misconceptions at root in this contrary notion of randomness, particularly as derived about what really happened in the 1990’s.  Alan Greenspan’s early tenure at the Fed was one marked by almost constant crisis, events that policymakers at the time were deathly afraid might repeat the circumstances of the early 1930’s.  He started as Chairman in August 1987 and two months later the stock market suddenly and violently crashed.  It was even called Black Monday in the media, intentionally evoking October 1929 as if monetary officials around the world weren’t already thinking it (particularly as it started in Hong Kong).

Though the crash would almost immediately start to fade, the S&L crisis would keep attention on monetary policy as it would only deepen to where the early Greenspan Fed was facing it thought almost exactly the 1930’s scenario – a stock crash followed by a banking crisis with an inordinate number of failures and uncertainty about ultimate depositor losses.  The great problems in the thrift industry, those closest to the traditional definition of a bank and what most people think of when they hear the word, would intensify in 1989 and would not be resolved for several years after.

And yet, for all the worry and effort, in the economy all that came out of it was the mild 1990-91 recession.  Total lending, however, in the US which had been steady at double digit rates from 1984 through 1987 had by the middle of 1991 ground completely to a halt.  For an entire year, US lending was essentially zero (growth, which is what truly matters).

The federal funds rate, which had been raised to nearly 10% in June of 1989, was lowered as the S&L crisis (and then Saddam Hussein’s effects on oil prices in the middle of 1990) began to scar the economic landscape.  When the recession ended in early 1991, the federal funds rate was still 6.25%.  Greenspan’s Fed would reduce it a further 325 bps over the next eighteen months so by September 1992 the target rate was just 3%, the lowest in decades. He was applauded cautiously at first for his powerful intervention.

Lending growth would resume thereafter, to which was added to Greenspan’s side of the ledger.  That burgeoning reputation would be further cemented in 1994 and 1995 when the Fed removed so much “accommodation” through rate hikes and though sparking a bond market “massacre” created what economists called a “soft landing”, perfectly consistent with the Great “Moderation.”  However, the lending activity that would follow the early 1990’s was not at all the same as had been produced before that time.

The loan stoppage was due entirely to the savings industry.  Before Gramm-Leach-Bliley, this was a distinction that meant something.  There were savings banks and there were commercial banks, today which might seem redundant classifications.  Indeed, the Federal Reserve’s statistics have recently acted on that thought, for what were separate categories in the Financial Accounts of the United States (formerly Flow of Funds) have been after 2013 combined into a single bank line.  You have to go back into the discontinued data to actually relate these differences.

In 1988, credit market growth achieved by savings institutions was just about 10% year-over-year.  By the third quarter of 1989, around the time when the Fed started lowering the fed funds target, it was -1.3%; two years later, in mid-1991, it was -15%.  In terms of total credit market assets, savings banks saw their peak at the end of 1988 with about $1.4 trillion in mostly loans.  They would never recover from the S&L crisis, as it would take sixteen years before the thrift industry would revisit just that level.

But while savings banks were almost absent from 1990’s growth, other forms of credit channels were steadily taking their place.  Before 1983, the Fed’s Z1 statistics record nothing from Issuers of ABS Securities.  By 1990, these new forms of debt packaging and volume maintenance had created a more than $200 billion credit market footprint, and in the middle of 1998 ABS Issuers had surpassed the savings industry in debt assets.  Just prior to the 2007 crash, these shadowy conduits were holding an estimated $4.4 trillion in credit assets compared to just $1.6 trillion in the former savings and loan industry.  The commercial banking segment had exploded to more than $7 trillion by then.

The whole idea of bank and the funding model which supported it was vastly different in ABS than savings institutions, with commercial banks somewhere in the middle but more and more like the former as the Great “Moderation” progressed.  There seemed to be a vast reservoir of exogenous funding pools, money even, and increasingly that was derived literally outside the Fed’s jurisdiction or definitions (in the shadows). 

In September 1992, the UK was forced to remove the pound from the ERM, the EU’s Exchange Rate Mechanism. The precursor to the euro, the ERM was meant to foster stability and low variation in currency exchange values, therefore inflation and employment, and therefore output and economy – exactly the qualities described of the Great “Moderation.”  The proximate cause of the sterling crisis was Bundesbank’s (Germany’s central bank) unwillingness to sell D-marks and buy pounds, leaving the Bank of England to defend its currency alone without credibility.  In truth, however, despite the politics of the ERM and the nature of the narrowly fixed exchange system, something else was going on.

As Allen Myerson wrote in the New York Times in mid-September 1992:

“The world's currency markets, it seems, are no longer governed by central bankers in Washington and Bonn, but by traders and investors in Tokyo, London and New York, as the chaos in the currency markets this past week has shown…

“As of February 1990, the daily worldwide volume of currency trading had reached $650 billion, more than the market value of the 10 largest American companies, according to the most recent figures from the Bank for International Settlements in Basel, Switzerland. Improved technology, new financial instruments and the growth of international investment have combined to make the currency markets ever more fluid.”

Here’s Thomas Jaffe and Dyan Machan writing in Forbes in November that year:

“In former times, powerful central banks could usually frustrate speculators.  They did so by simply buying massive amounts of the weaker currency and flooding the market with the stronger currency.  But times are changing.  While the central banks can mobilize tens of billions of dollars, trading in foreign currency markets now runs to a trillion dollars a day.”

Where did all that currency and therefore power come from? It wasn’t printed by central bankers, and it wasn’t even in the form of physical anything. This was pure balance sheet capacity that throughout the 1980’s was experiencing evolutions unlike anything ever seen before.  Massive quantities of bank liabilities of all kinds could be electronically debited into existence and then transferred anywhere in the world in a matter of seconds.  The format of ABS Issuers was tailor-made for this world, and it left far behind what we used to call banks (even the S&L Crisis itself had its origins in thrifts that dabbled too far into wholesale for their own good). 

Alan Greenspan, in his rush to avoid a repeat of 1930-33, actually aided in the transference.  In December 1990 and January 1991, Regulation D was altered so that eurodollar liabilities would be fully non-reservable, eurodollar reserves perfect substitutes for federal funds.  Banks in the US could borrow dollars, really “dollars”, freely from their foreign subsidiaries operating in the eurodollar market without incurring any capital or reserve requirement.  From the conditions of the time and the enormously worried disposition of policymakers you can understand why they did it (without agreeing with their premise).  Greenspan wanted loan growth and truly didn’t care where it came from or how it was funded. 

The effect was immediate and permanent.  According to the BIS, the moment Regulation D was changed gross borrowings in federal funds was surpassed by gross borrowings due to foreign related offices (eurodollars).  The federal funds gross had been $200 billion in 1985 to $100 billion eurodollar, but by the end of the 1990’s, the height of the dot-com bubble, reported eurodollar liabilities ($700 billion) were by then nearly double the same derived from domestic federal funds. 

But that was only the tip of the currency iceberg, as the sterling crisis in 1992 but briefly illuminated. Unreported was all the other forms of offshore funding, as well as exclusively offshore transactions (both sides borrowing and lending), balance sheet capacity that allowed banks to overwhelm central banks in what seemed to be, contra the Great “Moderation” ideal, a regular occurrence. From the tequila crisis of the mid-1990’s to the Asian flu several years later, central bank after central bank fell victim to deep monetary resources none of them seemed to be aware of and of which they certainly didn’t understand.

Yet, the US economy hardly noticed, as if it was shielded somehow by luck or other from these exogenous potential shocks.  Unlike 1991 and 1992, credit growth was more than steady to a level way, way beyond all characterization of moderate.  The dot-com recession was, again, unusually mild even though stock market crash, slow motion as it was, took on eventually massive proportions.  These were not even the biggest inconsistencies of the Great “Moderation” era.

Those would come a few years later in the form of a housing bubble that at the height of academic talk about the Great “Moderation” glaringly contradicted it – especially the fact that the mania of the mid-2000’s was a eurodollar funded and offshore one (as well as off-balance sheet). US statistics recorded massive credit growth but somehow nothing like it in money. They should have paid attention to the means of that credit growth and the lack of participation from traditional banks as an answer to what was a disparity of philosophy alone.  Monetary growth had exploded outside of the US and only partially leaked back inside in the form of unrestrained mortgage creation (the rest went into corporate debt to finance EM “miracles”).

But the Great “Moderation” was more than an academic mischaracterization of what had happened.  It was an overestimation of what monetary policy had achieved, and therefore what monetary policy could achieve or could even do on a technical level (the role of bank reserves is very different in the savings industry than in the shadows). I noted last week as on uncountable prior occasions this enormous disparity laid bare at least in the middle 2000’s when Alan Greenspan’s last major act as Fed Chairman was to “tighten” monetary policy without any such effect being felt anywhere.  The most powerful and well-regarded central banker since Bagehot could not despite 17 rate hikes affect anything other than the nominal frame of reference of those rate hikes. 

As if those weren’t enough, Ben Bernanke’s first major act as Fed Chairman was to reverse Greenspan with sharper “accommodation”, only to find like Greenspan exactly the reverse characteristics in the monetary system (Greenspan tightens, explosive money and credit results; Bernanke loosens, money and credit instead implode). It was as if monetary policy just wasn’t what they thought it was, and was at best a reactionary indication of what was happening elsewhere unrelated to monetary policy.

We have to consider, if not only consider, the unappreciated wisdom of Stock and Watson’s 2002 “unsettling” alternate, where “the quiescence of the past fifteen years could well be a hiatus before a return to more turbulent economic times.”  Perhaps the whole thing about “good luck” was no luck at all, but rather a vast and misunderstood (indeed often purposefully ignored) radical change in global monetary dynamics.  There was no hiatus in volatility that wasn’t the eurodollar system (which wasn’t and isn’t limited to just eurodollars, but all forms of wholesale funding formats including FX derivatives in all major denominations, however bank balance sheets might consider expansion or contraction) building up. 

Without that positive monetary momentum what looked like a Great “Moderation” with Alan Greenspan’s its chief genius has become instead a globally synchronized nightmare from which central banks have proved they can do nothing; not for lack of trying. This week, the Federal Reserve has come full circle again, an almost perfectly polar opposite monetary policy to Alan Greenspan’s early 1990’s (false) reputation-staking maneuvers.  Unwittingly, current Fed Chairman Janet Yellen admitted as much when at her press conference following Wednesday’s “rate hike” vote she said:

“If one averages through several quarters, I would describe our economy as one that has been growing around two percent per year. And as you can see from our projections, we -- that's something we expect to continue over the next couple of years.”

She was asked, for once, why the Fed seems to be hiking interest rates when the economy is still so terrible let alone unrecovered; current projections for GDP in the US call for just +0.9% in the first quarter.  If that prediction holds, it would mean the sixth quarter out of the past seven less than 2%, and fourth of the last six below 1.5%.  It hardly expresses what most people think of where the Fed might need to be “tightening”, as “rate hikes” are presumed to be.

“Our -- you know, as you said, the data have not notably strengthened. I -- there's noise always in the data from quarter to quarter. But we haven't changed our view of the outlook. We think we're on the same path, not -- we haven't boosted the outlook, projected faster growth. We think we're moving along the same course we've been on, but it is one that involves gradual tightening in the labor market.”

The “same course” is a damning indictment. What she is saying, confessing, is profoundly different than what is being described in the mainstream about the economy (nothing new for the last ten years).  It is the anti-Greenspan.  The economy has not yet recovered from the massive contraction in 2008 and Yellen here declares that she doesn’t expect that it ever will (in what may be her first pronouncement she has ever gotten right).  No matter how bad it is here or globally, there is nothing the Fed can do about it now. 

And that is true, so far as the Fed currently operates and is constructed. It was never monetary policy that created the Great “Moderation”, and outside of the narrow confines of orthodox definitions that period was never so moderate to begin with.  As the eurodollar system built up, it only appeared that way because output was stable so long as what was hidden far out of view remained drastically immoderate.  Now that is no longer the case, where the eurodollar system reverses, decays, and acts as an anchor upon global output, there is no stability anywhere.  Suddenly exogenous shocks (like “global turmoil”) are the rule rather than the exception where even the US economy is concerned. 

It was never policy or luck, and is certainly not now bad luck.  

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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