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Can the economy be too stable?

Believe it or not, one of the most striking facts about the U.S. economy over the past 25 years has been the relative stability it has enjoyed — until all hell broke loose the last few months.

That may be difficult to believe today, given the severity of the strains on the financial system and the reigning panic in Washington and Wall Street. But until recently economists stood in wonder at the relative stability and prosperity of the American economy over the past couple of decades. 

Ever since Federal Reserve Chairman Paul Volcker wrung inflation out of the economy in the late ’70s and early ’80s, the United States and much of the Western world has enjoyed what most economists consider a golden age. Current Fed Chairman Ben Bernanke and other economists dubbed this age “The Great Moderation.”

What made this period unique was the combination of robust economic growth, tame inflation, short and mild recessions, and low unemployment. Periods of economic growth and decline during these 25 years were smoother and less disruptive than at any time in history, and the crises the economy faced were easier to contain and did less serious damage than in the past.

Several damaging crises
During this time, crisis after crisis hit the economy: the savings-and-loan crisis, the “Asian Flu,” the Russian default on their debt, the bursting of the dot com bubble, and even the Sept. 11 attacks. Each of these was damaging, but none of them tipped our economy into a 1982- or 1973-style recession, and certainly no threat of a crisis as severe as the Great Depression. In fact, the U.S. economy pretty much hummed along despite these crises. At no period in history had an economy been able to sustain such serial shocks without serious consequences such as soaring unemployment and declines in GDP.

It was this stability in the economy that earned former Federal Reserve Chairman Alan Greenspan the title “Maestro” — reflecting the common belief that after nearly a century the Federal Reserve had finally mastered the art of managing the economy’s ups and downs.

These days there is little talk of the great moderation, except perhaps to wonder what happened to it. A sense of crisis, perhaps panic, rules the day. The stock market has recently experienced declines comparable to the recession of 1937, and each government attempt to stem the bleeding seems to inspire more panic. Economists seem to agree that a painful recession will hit America’s economy, and are arguing more about how long and severe it will be rather than whether it will come.

What can explain such a sudden reversal of both our fortunes and of economic opinion?

Perhaps one answer is the “great moderation” itself.

The price of stability
History has shown that the price of economic stability is usually economic stagnation. The price for economic growth is allowing for “creative destruction,” which breeds a certain level of instability. Stability and predictability are the enemies of dynamism, and countries that seek them ultimately pay with slower economic growth. Until recently it seemed impossible to have both a dynamic economy with strong growth and a stable economy with relative predictability and security.

During the “great moderation” it seemed that we could have our cake and eat it too — dynamic economic growth and relative stability and predictability in the economy. It seemed that the Federal Reserve had found the magic formula for sustaining economic growth while avoiding serious dislocations in the economy. 

But now it seems that the very success of these policies imposed an unseen cost — the creation of a new kind of moral hazard. The very success of the Fed invited investors to assume that the economy could bear almost any shock and keep right on humming, as it had during the financial crises that hit during this 25-year period. The apparent success of the Fed in moderating economic swings seemed to mean reduced risk for investors. The apparent reduction in risk in turn fed an appetite for what in earlier times seemed to be high-risk investments.

People assumed Fed could handle crises
Risk, it appeared, had begun to disappear from the financial system. Everybody believed that the Fed knew how to keep the economy humming and ensure that crises could be turned into mere hiccups. Even a crisis as severe as the dot com bubble in which $5 trillion of wealth evaporated only triggered only a mild recession.

Viewed in this light, the seemingly successful policies of the past few decades helped set us up for the severity of the crisis we face today. The excessive risk-taking of the past decade was spurred on by the success of the Fed in moderating the costs to the economy of prior crises. The Fed’s earlier successes have led us to the current morass.

Unsurprisingly there turns out to be no magic bullet for eliminating the business cycle. Even a period of successful Fed management of the economy has its own potential dangers, the fruits of which we are seeing today. We can only hope that the tools the Federal Reserve and Treasury have at their disposal are up to the task of keeping our economy afloat as it works through the effects of the excessive risk-taking of the past quarter century.

David Strom is president of the Minnesota Free Market Institute.


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Comments (3)

  1. Submitted by Tom Poe on 10/09/2008 - 09:57 am.

    Quite a fantastical take on our economy for the last 30 years, I must say. Deregulation, some would posit, is but regulation that favors a corporate welfare state. There are those who understand the last 30 years as the evolution of our corporate welfare state in the guise of deregulation. If we look closely, your attribution of fed management as “moderating” is really nothing more than corporate welfare at work, driven by an all-consuming need to transfer as much wealth to as few individuals as possible.

    Anyone who continues to advocate the free market, corporate welfare approach to economics, today, is truly living in la la land. Personally, I look at the last eight years as little more than a marauding band of raping and pillaging republicans. Good luck, David, with your free market institute, an institute that needs to close its doors. Maybe you can stand in line with your victims to eat dinner, later, at your nearest soup kitchen.

  2. Submitted by Brian Simon on 10/13/2008 - 03:50 pm.

    I have a different theory. I think there is a correlation between the level of regulation and the amplitude of the business cycles. After the last big crash – the great depression – the unfettered market was tamped down and tightly regulated. Under tight regulation, the business cycle still occurred, but without excessive highs or lows. By the time the 80s rolled around, the deregulation argument came into vogue – which allowed for both higher highs and lower lows. We didn’t heed the warning inherent in the tech bubble crash in 2000 – and continued to restrict regulation. In an extremely unfettered market the innovaters created these bizarre financial instruments (credit default swaps, tranched mortgages, etc) that allowed for even larger gains, and …. now we know, extremely large losses. As this mess is sorted out, we’ll likely see a renewed interest in regulation, which will dampen the business cycle – promoting slow steady growth over large booms & busts.

  3. Submitted by Vonya Ereye on 10/13/2008 - 09:56 pm.

    What in the world does free markets have to do with corporate welfare? No one that understands and believes in free markets has any patience for corporate welfare. Tom is misguided and confused.

    This is a brilliant display of moderation and well put by Mr. Strom. However, when one goes into more in depth study to the downturns that did happen, you would learn that much of the fault will lie in pompous government thinking they know better and rather than simply protecting consumer end up punishing businesses to the point of harm, forcing downturns to last much longer than they would otherwise.

    This recent economic crisis does a pretty good job of debunking the more liberal assertion of trickle down economics being a fallacy. If you haven’t figured out through this crisis that economics trickles down, then you really have a screw loose.

    The money will always get into the hands of those smart enough and valuable enough to deserve it. Thanks to those people, our economy will always have investment, expansion, more prosperity for everyone (and not through income redistribution), jobs, the need and desire for goods and services beyond food and shelter and the quality of life that comes with it.

    Prosperity is not a government program. And it never will be.

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