From the April 2008 issue of Wealth Manager Web • Subscribe!

Steady As She Goes

Recessions are inevitable. It's the timing and depth of economic contractions that keep everyone guessing.

Since 1857, the U.S. has endured 32 recessions, according to the National Bureau of Economic Research (NBER). The good news is that, of late, the slumps have been fairly modest compared with their predecessors. Economic researchers have dubbed the trend toward kinder, gentler downturns the Great Moderation, a reference to the sharp fall in the volatility of quarterly changes in gross domestic product (GDP).The fading of macroeconomic risk dates to the mid-1980s, when GDP volatility fell dramatically. Chart 1 shows that quarterly GDP fluctuations in the early 1980s were running at standard deviations of roughly 5 to 6, based on rolling cycles composed of 12 quarters. Midway through the decade, volatility suddenly tumbled. Twenty years later, business cycle fluctuations, so far, remain relatively calm.

The Great Moderation is visible in absolute terms, too. Examples include real (inflation-adjusted) declines in the quarterly GDP ranging from -0.5 percent to -1.5 percent during the recession of 2001, and -2 percent to -3 percent in the 1990-91 slump. That compares with quarterly dives of nearly -8 percent at one point in the early 1980s contraction and a 10 percent-plus loss in the 1957-1958 downturn.

Business slowdowns are also shorter. The last two recessions lasted just eight months, or less than half as long as the average for all previous recessions going back to the mid-19th century. Fewer recessions necessarily translate into longer expansions. The growth periods leading up to the last two economic contractions lasted 92 and 120 months--considerably longer than the average 33-month expansion that prevailed from the mid-19th century through 1981, NBER reports.

Additional evidence that the Great Moderation reflects fundamental economic change includes measures of labor growth, wage inflation and industrial output. All have become notably smoother and less volatile in recent years relative to history, reports a 2002 study by the National Bureau of Economics Research ("Has the Business Cycle Changed and Why?" by James. H. Stock and Mark. W. Watson, NBER Macroeconomics Annual: 2002).

Consider the jobless rate, which has been swinging in a smaller and lower band compared to decades past. Between 1948 and 1983, U.S. unemployment varied from 2.5 percent to more than 10 percent--a spread of 750 basis points. But in the last 20 years, the jobless rate has fluctuated in a tighter, lower range of roughly 4.0 percent to 7.5 percent.

Another striking feature of the Great Moderation is that the smoother macroeconomic ride is a global phenomenon among the developed nations. Echoing the American experience, GDP volatility in Europe, Japan and other mature economies dropped sharply in the 1980s, and has stayed low ever since.

What's behind all the calm? Several theories have been circulating, including improved inventory management, globalization and financial innovation that spreads risk. Another explanation is that the world economy has just been lucky. But the view favored in the academic literature is that central banks have learned a thing or two about keeping inflation under control. In turn, the enlightened supervision over the money supply has fertilized a strain of economic growth that's more stable and enduring.

Central bankers, unsurprisingly, aren't shy about taking some of the credit. In a speech a few years ago, Federal Reserve Chairman Ben Bernanke (then a Fed governor) said that "improvements in monetary policy, though certainly not the only factor, have probably been an important source of the Great Moderation." In fact, the Great Moderation was directly preceded by a sharp fall in the rate and volatility of inflation in the 1980s. A number of economists see a connection. "By achieving low and stable inflation, many analysts argue, monetary policy provides a favorable environment for economic activity generally," advised a 2005 article in Economic Review, a journal published by the Kansas City Federal Reserve Bank.

In addition to economic benefits, the Great Moderation has been cited as a catalyst for higher valuations in the stock market. The rise in equity market valuation in the 1990s and--to a lesser extent--the 2000s is a response to the fall in macroeconomic risk, says a forthcoming study in The Review of Financial Studies ("The Declining Equity Premium: What Role Does Macroeconomic Risk Play," by Martin Lettau, et. al.). The reasoning is that investors accept a lower prospective equity risk premium (i.e., prices are higher) when economic risk declines. As the paper observes, "It would be surprising if asset prices were not affected by this fundamental change in the structure of the macroeconomy."

Indeed, the U.S. stock market's price-earnings ratio as of this past January was still in the mid-20s, which is generally the highest in the past 150 years, save for the bubble peaks of 1929 and 2000, according to Yale professor Robert Schiller's Web site ( Meanwhile, long-term interest rates are hovering near 40-year lows.

Now the obvious question: If lower economic risk rationalizes a lower equity risk premium, might the reverse apply at some point? Answering "yes" seems reasonable. But if GDP volatility scaled its old heights, last seen in the early 1980s, investors may demand a higher premium on stocks as compensation, implying that equity prices would have to fall and perhaps stay low for an extended period.

The idea that economic tranquility eventually gives way to a more perilous environment isn't new. Economist Hyman Minsky, for example, famously observed that stability is unstable. The seeds of higher risk are planted in periods of calm, he advised, because investors pursue higher risk in good times to the point of excess. Eventually the cycle turns, risk is repriced and the lure of easy money is replaced by a fear of loss, a reversal that lays the foundation for the next boom.

On that note, consider that inflation volatility--a key factor associated with the Great Moderation--has been rising recently. Chart 2 shows that inflation volatility recently jumped to levels last seen in the early 1980s, when economic volatility was much higher. Is the rise in inflation risk a harbinger of higher macroeconomic risk, too?

The Great Moderation may come under attack from other corners, warns Robert Dieli, an economist who heads the consultancy By his reckoning, much of the smoothing in the U.S. business cycle is linked with growth in the foreign outsourcing of the manufacturing sector, which suffers relatively volatile boom-bust swings compared with the calmer services sector that now dominates the American economy. "In the old days, recessions were nothing more than giant inventory cycles," he explains. Thanks to the growing use of industrial capacity in the developing world, "we've been reducing the size and importance of manufacturing," Dieli says. That, in turn, has smoothed the economic cycles.

Along the way, the American economy has become more entwined with the economies of China, India and the developing world generally. The relationship has proven mutually beneficial so far, although the short history of the new world order of globalization only reflects the good times.

A study by the International Monetary Fund last October noted that last year, China was the single-biggest contributor to world growth, followed by India in second place and the U.S. in third. Indeed, China's economy grew more than 11 percent last year--roughly four-times faster than that of the U.S. and Euro region. When growth is robust, it's easy to overlook the fact that emerging market economies are more volatile compared with the developed world. Upside economic volatility, after all, pleases everyone. But the volatility may not moderate when the cycle turns, as it inevitably must.

The challenge, Dieli says, is that the increased dependence on emerging markets hasn't been stress-tested. The fear is that a sharp downturn in other emerging markets may transmit economic shock into the developed world, effectively ending the Great Moderation in the process.

The notion that the emerging markets have decoupled from the U.S. is just a theory, of course, and an unproven one. It's also a theory on which the Great Moderation's fate rests, says Quincy Crosby, chief investment strategist at The Hartford. "One of the things we're going to find out, over the next year or so," she predicts, "is whether the decoupling thesis that would extend the Great Moderation is a viable thesis after all."

James Picerno ( is senior writer at Wealth Manager.

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