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The Great Moderation?

The policies of demand management through monetary manipulation and government spending produced a period that has been called the Great Moderation by economists. This moniker refers to the alleged moderation of the business cycle. The policy of demand management is based on the idea that there is a simple positive correlation between total spending or aggregate demand and employment and for the last three decades it appeared that the relationship was real and that modern policymakers had mastered the tools of managing demand. It seems more likely that the Great Moderation was an illusion produced by periodic inflation. GDP measured in nominal US dollars appears to grow fairly steadily:

But this steady rise in GDP depends critically on how GDP is measured. If we use Swiss Francs instead, the economy looks a lot more volatile:

Measuring output in British pounds also produces a more volatile picture:

Since we produce in order to consume, maybe we should measure GDP in terms of something real. GDP measured in barrels of oil:

GDP in terms of gold:

Seen in this light, the Great Moderation is nothing of the sort. GDP has been incredibly volatile over the last 40 years compared to the post WWII period of stable value for the dollar (in terms of gold). Here’s what GDP looked like in the Bretton Woods era (1946-1970):

Bretton Woods eventually failed because US politicians could not abide by the rules of the arrangement. There were other reasons as well, but one cannot dispute that growth in the period of stable exchange rates was less volatile than the period labeled the Great Moderation. After 24 years of Bretton Woods exchange rate stability, US GDP had grown nearly 5 fold. After 39 years of floating exchange rates, US GDP in terms of gold is actually less now than it was at the beginning of the period. Obviously other policies influence GDP but the change in volatility is immediate when the link of the dollar to gold is severed in 1971. It should also be of interest that the most steady period of growth after the link was severed occurred from 1980 to 2000, a period of fairly stable gold prices.

For most of that period gold stayed in a fairly narrow range of $300 to $400 per ounce. In addition, it should not escape one’s notice that the two periods when gold moved significantly out of that range, 1987 and 1999, both culminated with the biggest financial events of the period, the stock market crash of 1987 and the bursting of the dot com market. Extreme monetary changes engender extreme financial events. Inflation and deflation are just two sides of the same coin and neither is desirable.

The lesson of these two periods is that real growth requires a stable monetary environment. A stable monetary environment is also necessary if the benefits of growth are to be shared more equally among those who produce it. Inflationary periods such as the post Bretton Woods era produce larger disparities in wealth and income because those who own more assets at the beginning of the inflation benefit as the value of their assets rises with the inflation. While it isn’t definitive evidence, the large differences in wealth and income in South America where inflation has historically been more prevalent would seem to support this contention. During these inflationary periods it is the owners of capital that benefit the most while labor tends to suffer as inflation adjusted wages stagnate. Differences in wealth and income in and of themselves are not bad but when they reach extremes the result is social strife.

The obvious course of action is to enact policies that stabilize the value of the dollar. The problem we face currently if we take that action is that our debt remains onerous in terms of our current nominal dollar income. There are plenty of economists who believe that a further devaluation of the dollar is required to lessen the burden of our debts and allow for a higher rate of growth. That “solution” is not a solution at all since it favors debtors over creditors and savers when it is the creditors and savers who will supply the capital for future expansion. The debts need to be restructured so that neither debtors nor creditors are favored and the pain is shared equally. Most important is that the restructuring should not force those who were not party to these transactions to contribute to repayment of debts they were smart or lucky enough to avoid. Debtors who borrowed money they cannot repay and the creditors who funded them must be allowed – forced – to suffer the consequences of their actions.

Unfortunately, the prospects for comprehensive monetary reform seem remote at best. The Federal Reserve is a powerful institution that enjoys vast political support from both parties. And no wonder since it is the Fed that allows Congress to run persistent deficits; a gold standard may have some drawbacks but a major advantage is that persistent deficits are impossible. There is no political support for a return to a gold standard and recent efforts at reform such as Ron Paul’s bill to audit the Fed’s activities have been defeated in Congress.

What this means for citizens and investors is that regardless of the new agencies, rule makers and regulators legislated into existence with the financial regulatory reform bill, the policies that caused our current economic problems will continue. We shouldn’t expect significantly different results.