The Even-Keel Economy

Today sharp shocks in one sector, like housing, don't necessarily lead to broader downturns

It's the economic heavyweight fight to watch. In one corner: the slumping but still powerful housing market, where new starts have dropped by almost 50% with no bottom in sight.

Its opponent: the global phenomenon known to economists as the Great Moderation. In the U.S., and across much of the world, the ups and downs of output, inflation, and employment have become far less pronounced since the mid-1980s. Recessions have been fewer and milder.

For now, the Great Moderation is winning, since the housing contraction has not turned into a full-blown downturn. This good news, if sustained, implies that different sectors have become less tightly linked. Moreover, it implies that the traditional way of thinking about recessions may be outmoded. Rather than broad-based declines in economic activity, these days we are more likely to get "micro-recessions"--sharp downturns concentrated in one or two economic sectors.

The term "Great Moderation" is relatively new, dating to a 2002 paper by economists James H. Stock of Harvard and Mark W. Watson of Princeton. Since then, researchers have come up with plenty of potential explanations for the decline in economic fluctuations, including better monetary policy, improved inventory controls, the rise of globalization, and more flexible financial markets. It's still not clear which factor is the most important, though more economists are placing greater weight on improvements in the finance sector, which enable consumers and businesses to keep borrowing and spending even in tough times.

But no matter what the cause, the effect is that bad economic news now comes like a tornado rather than a hurricane. There's still devastation, but it's in a much narrower band. "We've had a lot of big shocks, and they seem to be having less of an effect," says Stock.

For example, the oil price spikes of recent years sent gasoline prices skyrocketing but didn't have much of an impact on overall inflation. The tech bust earlier this decade led to a record employment decline in the professional and business services sector, but the resulting recession only cut economic output by a piddling 0.3%.

One growing sector appears to be de-linked from everything else. The health care-education-social services-government complex--accounting for roughly 30% of the workforce--has not had a yearly drop in employment since 1982, cushioning the job market. In part, that's because governments, which ultimately provide much of the funding for these programs, have had easy access to credit.

The de-linking also means the economy is harder to predict than it used to be. Forecasters once could look at a slowdown in one sector--say, retail sales--and predict how fast it would spread to other sectors. But the predictive value added by a typical forecaster has "disappeared," according to research by Sean D. Campbell, a Federal Reserve economist. Except in the very short run, adds a paper published by the European Central Bank, "no forecast model has been better than tossing a coin."

How long will the Great Moderation last? No one can offer any guarantees against unanticipated shocks, of course, such as a massive political and economic crisis in China. But Stephen G. Cecchetti, an economist at Brandeis University, argues that less volatility will persist "as long as you don't blow up the financial system." From this perspective, the big danger is a financial crisis broad enough to cut off credit to most households and businesses--and so far that hasn't happened. With good policy and some luck, broad-based economic volatility will remain a thing of the past.

By Michael Mandel

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