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April 7, 2002
David Warsh, Proprietor

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Something Happened

With the US apparently emerging from a downturn so shallow it doesn’t seem to meet the standard test — two consecutive quarters of declining output — it has been twenty years since the United States endured a recession worthy of the name.

It was in July 1981, that an inflation-wracked and thoroughly-overheated economy stalled and began to plummet, following a dramatic tightening by the Federal Reserve Board. By autumn of that year business activity was falling at an annual rate of 5 percent. Trade diminished, factories closed, unemployment soared, bankruptcies skyrocketed. With the yield on 30-year government bonds still hovering at around 14 percent in the summer of 1982, banks went broke like so many rivets popping on a diving submarine — Drysdale Government Securities, Penn Square Bank, Continental Illinois National Bank and Trust Co. The Dow Jones Industrial Averaged dipped below 800. Mexico prepared in August to default on debt payments to US banks.

That led Federal Reserve Board Chairman Paul Volcker and New York Federal Reserve Bank president Gerald Corrigan to cut short a Wyoming fishing trip to return to Washington and New York to adjust the monetary throttle. A week later, the stock and bond markets began their massive rallies. The Fed eased decisively in October. And after 16 painful months of decline, the economy finally began to grow again in November.

There have been plenty of nervous moments since. The market break in October 1987, when the Dow lost a quarter of its value in a single day. The recession of 1991, following the Gulf War, as eerie as it was short and mild. The Asian financial crisis of 1997-98, culminating in liquidation of Long Term Capital Management, an event that threatened briefly to paralyze the foreign exchange markets. The day the New York markets re-opened after 9/11.

But nothing has recurred resembling the wrenching recessions of 1980-82 and 1974-75, when whole industries received death threats and seemingly strong companies were lost. The most recent expansions have lasted 92 months and 120 months respectively. Now another period of growth seems to have begun.

Economists have been asking themselves for years whether something has happened to the business cycle. Last week at the annual Macroeconomics Conference of the National Bureau of Economic Research, James Stock of Harvard University and Mark Watson of Princeton took the most careful look yet at the evidence and concluded the answer was yes. Volatility definitely had declined, they said. There could be no precise dating of a moment in time when a break occurred, though 1984 seemed to stand out as something of a watershed. But what had changed? And why?


Four major explanations have been advanced since central bank economists Margaret McConnell and Gabriel Perez-Quiros first took the question of the “taming” of the business cycle over from the business press in 1998 and put it firmly on economists’ agenda. Perhaps the relatively greater stability owed to the greater role of less-cyclical services in the economy relative to durable goods. Or else recent improvements in corporate management techniques, mainly involving computers, have made inventory swings less severe. Wal-Mart’s just-in-time location, restocking and delivery system is the example usually given, since it has vaulted that once-tiny Arkansas retailer to the top spot on the Fortune 500 as the biggest American corporation. Then again perhaps we merely have been lucky, with fewer of those destabilizing shocks — oil, taxes, money, productivity — that made the ’70s seem so exciting.

Or, just possibly, the conduct of macroeconomic policy has improved.

Harvard’s Stock and Princeton’s Watson are as statistically sophisticated as they are voluble. They subjected the four explanations to every conceivable test. Shifts in the composition of output seemed to account for only a little of the improved performance .The diminution of the intensity of external shocks contributed only a little more. Something was missing, they said.

And when they tuned up their high-dimensional time-series models and vector auto-regressions, the answer seemed to be that the improvement stemmed from monetary policy in the era of Paul Volcker and Alan Greenspan. Whether tested against recently-adopted formulas for inflation-targeting, changes in the shape of the yield curve, or the predictions of an old-fashioned Phillips Curve, the evidence was that someplace between 15 percent and 25 percent of the improvement in performance owed to a more stable hand on the monetary tiller.

That’s good news, for economists think that they understand pretty well the “inflation targeting” policy that Greenspan and other central bankers have pursued during these last fifteen years. It amounts to a feedback system, now often described as following a Taylor Rule, after economist John B. Taylor who wrote down a formula for periodically adjusting short-term interest rates in response to deviations in actual inflation and output rates from previously announced targets. It seemed to resemble what Greenspan had done.

Everybody recognizes that Wal-Mart, like McDonald’s, computer manufacturers, credit card companies and a host of others, have made great strides in delivering better quality products and services for less. Wouldn’t it be grand if the same turned out to be true of central bankers? What would it be worth to grow steadily for another twenty years with no more than an occasional pause? All the more reason to pay close attention to the person who is selected to replace Alan Greenspan. The 76-year-old’s appointment as chairman expires in 2004.

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