Risk Latte - The Great Depression, the Great Inflation and the Great Moderation – and now what?

The Great Depression, the Great Inflation and the Great Moderation – and now what?

Rahul Bhattacharya
April 29, 2009


First we had the Great Depression.

It was a worldwide economic downturn, but most highly documented in the U.S. and Western Europe, starting from the stock market crash of 1929 and ending in late 1930s or early 1940s, depending on the countries which got affected. It was the severest economic depression that mankind has so far experienced when the international trade fell by around 50% to 75% and peoples and there was a general and dramatic fall in peoples income, corporate profits and prices of goods. It was a time of great misery and hardship, the collective memory of which still haunts us.

The world eventually emerged out of those depths of economic misery, thanks partly to the New Deal, the various Keynesian policy measures in the U.S. and the U.K., the World War II, and perhaps a thousand other factors of which no living economist today, including the God of the Federal Reserve, would have a clue or understanding. The New Industrial Society was born thanks to the Organization Man.

Then we had the Great Inflation.

Robert Samuelson, the veteran columnist for Newsweek and Washington Post and the economic commentator, in his book, “The Great Inflation and Its Aftermath: The Past and Future of American Affluence” talks about it. To the best of our knowledge, it seems that Samuelson has coined the term “the Great Inflation”. This is the period from mid 1960s to early 1980s when the inflation in the United States rose from around 1% in 1960 to almost 14% by 1980.

One of Samuelson’s core arguments in this rather fascinating book seems that this period of almost twenty years from early 1960s until 1981 in American history sowed doubts in the minds of people both within and outside America about the supremacy of the American civilization. This was a period of stagnation in lives of millions within the United States. Then there was the stock market crash of 1973-74, the first oil crisis of 1973. It was a time when Wall Street was a dull and boring place and for almost ten years, from late 1973 to 1981 the stock market in America was almost dead. In a recent Wall Street Journal article titled Flashbacks of the 1970s for Stock-Market Vets Jeffrey Saut, the chief market strategist at Raymond James Financial, reminisces, “The summer of 1974 was so bad that we used to go out to the bars at lunch and not go back to the office. It felt like stocks were never going to go up.” However, it was the stagflation, the combination of high inflation and high unemployment that almost came to destroy the economic fabric of the American society. It would take one man, Paul Volcker, the then Chairman of Federal Reserve, to blow a hole through this inflation bubble and through a brutal recession of 1981-82 bring the inflation down to low single digit levels.

Finally, after the Great Inflation came the Great Moderation.

Just as Business Week published its cover story entitled Death of Equities on August 13th 1979 and just as, a couple of years later, Paul Volcker took the inflation monster by the horns, something was simmering underneath the otherwise stagnant American economy. It was almost that the economy was preparing for what physicists call a “phase transition”. Water was about to become vapour and the boiling point was approaching. Beginning 1982, the stock market in the United States began its long, upward climb. And suddenly the world changed. Thus, in the U.S. and in the U.K. there began a long period of growth and prosperity, that would forever change not only how economists look at and understand their theories of growth but also how ordinary people in these two countries, and perhaps in most of the developed world, look upon their lifestyle and their value system.

The period from 1982 to early 2008 would be the golden period in American economic history, if not the economic history of the entire Western world. Of course, along the way there would be hiccups, short recessions and market crashes, but nothing to warrant a paradigm shift. For two and a half decades there would be a significant jump in peoples income and purchasing power and a humongous rise in the wealth of the society. This would be the era of Alan Greenspan, the one time miracle man. This would be the era of economic growth, high employment and minimal inflation something that went by the otherwise dubious theory of productivity growth.

In a paper published in August 2002, James Stock of Harvard University and Mark Watson of Princeton University coined the term the “great moderation” to describe the phenomenon of the moderation of business growth, in other words, the sudden break and the decline in the volatility of the U.S. GDP growth in and around 1984 and the greatly reduced volatility in the U.S. GDP growth ever since then.

Ben Bernanke, the Chairman of Federal Reserve Bank in the U.S. would take this term and run with it. Moreover, in 2004, in an important speech, he would come up with an explanation of this phenomenon which has come to be known, in some economic circles, as the “Bernanke conjecture”.

In the winter of 2008, our world would change once again. And some say, it has changed forever. The Great Moderation is over and Alan Greenspan has retired. Ben Bernanke has become best friends forever with Hank Paulson and his conjecture is up in the air.

As for the others, a great many are invoking the ghost of John Maynard Keynes, while a few others on the right – a truly diminishing creed – are still sticking with Milton Friedman. Each one of us is lost for direction and incapacitated by a dysfunctional economy. Our societies, wherever we live in this world, are lying prostrate.

Therefore, dear readers, what now? Will the next ten or twenty years be the age of Great Confusion?


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