Did you like this post? Subscribe to my Substack now for additional insights and content.
When Ben Bernanke detailed his thoughts about the various causes of the “Great Moderation” to the Eastern Economic Association in 2004 (as a Federal Reserve Governor before becoming Chairman), he had no idea that, ironically, we were on the brink of the beginning of the end of this unique period.
The “Great Moderation” is generally defined as a period of reduced volatility during which businesses, households, and institutions could rely on a more stable and predictable macroeconomic environment, and is generally accepted to have begun in 1984 after the Federal Reserve successfully overcame the pervasive stagflation period of the 1970s.
Bernanke said:
“In particular, U.S. output volatility, which was high in the immediate postwar period, fell substantially between 1955 and 1970, when inflation volatility was low. Both output volatility and inflation volatility rose substantially during the 1970s and early 1980s and, as I have noted, both fell sharply after 1984. Economists generally agree that the 1970s, when both output and inflation volatility were at their highest, also marked a period when monetary policy was much less effective than either the previous or subsequent periods. Few would dispute that monetary policy has played a major role in stabilizing inflation. Thus, the fact that output volatility has fallen in tandem with inflation volatility, both in the United States and abroad, suggests that monetary policy may have also helped to mitigate output volatility.”
Bernanke then goes on to detail various possible causes for this period of stability, digressing into extensive explanations of the Taylor Curve before concluding with the broad conclusion that “improved performance of macroeconomic policies, especially monetary policy,” was likely the main factor.
“I have argued today that improved monetary policy is likely to have made an important contribution not only to reduced inflation volatility (which is not particularly controversial) but also to reduced output volatility. I have further suggested that because changes in monetary policy regimes have far-reaching effects, some of the effects of improved monetary policy may have been misinterpreted as exogenous changes in the structure of the economy or the distribution of economic shocks. This conclusion makes me optimistic about the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s.”
But Bernanke's assessment completely misses important instances where the Fed itself took specific steps to mitigate volatility, thereby disrupting normal market functioning in the name of the Fed's new, implicit mandate of “economic stability,” and, in the longer term, perhaps setting the stage for a new era of uncontrollable volatility and turmoil.
In the wake of the “Great Crash of 1987,” then-Federal Reserve Chairman Alan Greenspan, just two months after taking office, took action by directing the Fed to act as a “lender of last resort” to provide liquidity through open market operations and issuing a statement outlining the Fed's position on the issue in clear and unequivocal terms.
“Consistent with its responsibilities as the nation's central bank, the Federal Reserve Board affirmed today its readiness to serve as a source of liquidity to support the economy and financial system.”
And with that statement, Greenspan singlehandedly created the “Fed put” (formerly known as the Greenspan put) — an implicit guarantee that the Fed would always try to set a floor for the stock market in order to maintain the stability of the financial system.
The “moral hazard” created by this single Fed policy change cannot be overstated.
Markets are nothing more than a risk discounting mechanism, and by intervening on the downside of the risk calculation, the Fed severely disrupted normal market functioning, distorted investors' perceptions of risk, and especially thwarted the process of creative destruction.
From that point on, the Fed took on a new, implicit mission of maintaining “economic stability” in addition to its existing primary functions of maintaining “price stability” and “maximum employment.”
But Greenspan didn't stop there, and the Fed's new implicit “economic stability” mission was expanded in 1989 from simply covering systemic shocks resulting from stock market losses to providing relief for losses suffered by the banking and finance industry, particularly savings and loans, in the “savings and loan crisis” of the late 1980s, in an effort to limit the impact of a large number of failed financial institutions on the financial system.
“Arrangements have been established for the provision of liquidity support by the Federal Reserve and the Federal Home Loan Banks to savings and loan associations,” Mr. Greenspan said in a February 1989 joint statement with M. Danny Wall, chairman of the Bank of America's Board of Governors.
Extending this implicit mission further, in 1998 Greenspan brokered a $3.6 billion private bailout of several financial institutions as part of an effort to contain a potential systemic shock resulting from the sudden collapse of Long-Term Capital Management, a highly leveraged hedge fund.
“If LTCM's failure had caused market turmoil, it could have caused significant harm to many market participants, including those without direct ties to the company, and could have adversely affected the economies of many countries, including our own,” Greenspan said.
Yet in his 2004 speech, Chairman Bernanke's analysis of the causes of the decline in volatility during the “Great Moderation” did not once mention any obviously significant Fed policy shifts, and not surprisingly, when faced with the same kind of systemically harmful situation that Chairman Greenspan faced, Chairman Bernanke was blinded by fears of the impact of the great housing bubble burst in 2008 and imposed support, backup and bailouts on the Fed on a scale that Chairman Greenspan could probably scarcely have imagined.
Now, more than a decade later, in response to the COVID-19 panic, current Fed Chairman Powell responded in a similar manner, with the Fed immediately slashing its key policy interest rate to zero and resuming the quantitative easing policy devised by Bernanke in an effort to prevent economic instability from the outsized exogenous shock.
But now, after 35 years of bailouts and support, and building up levels of currency printing, inflation is finally raging and the real costs of this “easing” are going to have to be paid.
The Era of the “Great Moderation” has finally given way to an entirely new and opposite era, the Era of the “Great Disturbance,” in which the Fed will not only not have the ability to mitigate volatility, but will instead be forced to create it by imposing “tight” monetary policy.
Many believe that the Fed will eventually have to abandon its goal of controlling inflation and continue to expand the monetary base in order to support the stability of the economic system and the solvency of the federal government, but I believe this view is mistaken.
With inflation running rampant and inflationary theory completely out of control, if the Fed were to continue to try to expand the monetary base, it would be a ploy to end the system. With no vestiges of a legitimate economic system left to protect, further monetary easing would no longer be necessary.
What to expect from the “unrest” over the next few years should be fairly predictable, since instability typically leads to anxiety, resentment, and social unrest, and while it's entirely possible that there will be positive outcomes from this reckoning, clearly the pain will be widely felt and the stakes are very high.