The “Great Moderation” in the Financial Markets and the Economy
Team Latte
January 24, 2008
Yesterday, as the Hang Seng Index (for Hong Kong stocks) surged about 11% after dropping almost 10% the previous day the Hang Seng Index volatility* touched 80%. The Nikkei, Taiwan Stock index and the Australian stock index, all crossed the 50% volatility levels on last Monday when we saw the great decline of the markets. Such gigantic levels of volatility across all major Asian stock markets have never ever been witnessed before in history.
And the rising levels of stock volatility in Asia, including Japan, were a growing pessimism of the investing public about the health of the U.S. economy and fears of a recession. Even in the U.S., the stock markets have been very volatile over the last couple of months and have been steadily falling. Once again, the investors are doubtful about the health of the economy. Economic growth, at least in the United States, no longer seems certain. And if stock markets are efficient (that’s a big assumption, though) and a leading indicator for economic growth then all this portends to rising volatility in the output and inflation.
In Feb 2004, Ben Bernanke, then a Fed Governor, was quite upbeat about the prospects of the U.S. economy and the global economy in general. On February 20, 2004, in a speech at the meetings of the Eastern Economic Association in Washington, DC he mused that perhaps the notion, or the theory, of "Great Moderation", has finally taken shape and the economic possibilities of our children and grandchildren, to borrow a phrase from Lord Keynes, might after all look a lot rosier than ours.
Governor Bernanke was alluding to a research paper published in 2001 which was authored by Oliver Blanchard of MIT and John Simon of the Reserve Bank of Australia. In that paper, titled, "The Long and Large Decline in the U.S. Output Volatility", Messers Blanchard and Simon had argued that the volatility of the U.S. economic output as well as the volatility of inflation were steadily declining over the past twenty years starting from the early 1980s. And this decline in volatility was due to several factors, notable amongst them, structural changes in the economy, increased productivity, improved monetary policy and perhaps a bit of good fortune. They were thus laying the groundwork for the theory or the notion of "Great Moderation".
In the same speech Gov Bernanke referred to the term "Great Moderation" in the same context as above and henceforth the term found great usage amongst practitioners and academicians. Quite a few believers of the theory were born.
The term "Great Moderation" was coined by the Harvard economist James Stock in a research paper titled "Has the Business Cycle Peaked" which he co-authored with Mark Watson of Princeton in August 2002. Here again, Messers Stock and Watson, were reiterating what Blanchard and Simon had said that the volatility of the output and the inflation have greatly declined in the United States over the last two decades.
Great moderation implied moderate volatility of output and inflation. In other words, it means low volatility of output and inflation. Regardless of the causes of such low volatility, of which there is no consensus even amongst its chief proponents, it implies an increasing general level of prosperity for all people (at least in the United States) and reduced uncertainty in the growth of the economy.
Therefore, has the notion of great moderation run into trouble waters? Or is the notion inherently fraught with flaws. For, even though there is a general belief, at least within the mainstream Federal Reserve ranks and practicing economists within the banking sector, that great moderation in the volatility of output and inflation in the United States have happened since early eighties, there is no unified explanation for why this has happened. Is it because of the structural changes in the economy? Is it because of better money supply by the Federal Reserve? Or is it simply a stroke of good luck, something like a statistical fluke?
Volatility, as measured by the economists is purely a statistical concept. It is simply another name for the dispersion (standard deviation) of an economic variable (GDP, CPI, etc.) around a mean value. And like any other concept in statistics it is fraught with flaws. Data analysis using statistical tools is in fact a challenging and daunting task, and to ascribe economic rationale to that data is even more challenging, especially when the markets, the real economy and its agents are all highly irrational.
Volatility, as measured by the market practitioners and investors is not always a statistical concept. Implied volatility, and the volatility indices which are derived from it, is guage of investors´ fear and their take on the future movement of assets. And implied volatility for all major asset classes has hardly been moderate in the last two and half decades (1987 market crash, 1994 bond market crisis, 1992 crisis in the FX markets, 1997 Asian Financial crisis, 1998 LTCM and subsequent bust of the dot com bubble in 2000 and now the mini-crash of the Asian markets this week). Even if you measure asset volatilities by the standard deviation of the realized log prices, volatilities have hardly been secularly moderate or declining.
And yet despite all this until very recently the U.S output and inflation, and indeed the output and inflation of the G7 economies have displayed low and secularly declining volatility. Great Moderation has indeed worked as far as the real economy is concerned.
What happens now? Will the theory be made to stand on its head?
* Note: This article is inspired by a front page article, written by David Leonhardt that appeared in the International Hearald Tribune on January 24, 2008.
*measured by Risk Latte’s volatility index, BRiXX™ based on the implied vols in the market)
**http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2004/20040220/default.htm
http://economistsview.typepad.com/economistsview/2007/09/the-great-moder.html
http://artsci.wustl.edu/~econ502/0.pdf
http://ksghome.harvard.edu/~JStock/pdf/stock&watson_macroannual.pdf
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