GREAT MODERATION AND GREAT RECESSION: FROM PLAIN SAILING TO STORMY SEAS?

• Author: Gabriel Pérez‐Quirós,María Dolores Gadea,Ana Gómez‐Loscos
• Date: 01 November 2018
• Published date: 01 November 2018
• DOI: http://doi.org/10.1111/iere.12337

INTERNATIONAL ECONOMIC REVIEW

Vol. 59, No. 4, November 2018 DOI: 10.1111/iere.12337

GREAT MODERATION AND GREAT RECESSION: FROM PLAIN SAILING TO

STORMY SEAS?∗

BYMAR´

IA DOLORES GADEA,ANA G´

OMEZ-LOSCOS,AND GABRIEL P´

EREZ-QUIR ´

OS 1

University of Zaragoza, Spain; Banco de Espa˜

na, Spain; Banco de Espa˜

na, Spain, and CEPR,

U.K.

Many have argued that the Great Recession of 2008 marks the end of the reduction in output volatility

known as the Great Moderation. This article shows that this is not the case through an empirical analysis.

Output volatility remains subdued despite the output loss of the Great Recession. This finding has important

implications for policymaking because we also find that a lower volatility of output is associated with slower

recoveries.

1. INTRODUCTION

The period of unusually stable macroeconomic activity experienced in the United States

during the last decades of the 20th century is known as the Great Moderation. Kim and Nelson

(1999) and McConnell and Perez-Quiros (2000) are the first to document the substantial de-

cline in U.S. output volatility in the early 1980s.2The literature on the Great Moderation has

been and still is very prolific. This phenomenon of volatility reduction has been documented

internationally3and has generated a considerable amount of debate about its causes.4

One basic macroeconomic consensus before the recent economic crisis was that the volatility

reduction of the Great Moderation was a virtually permanent phenomenon. For instance,

Blanchard and Simon (2001) conclude that a major reversal of the volatility decrease was

unlikely, which implies a much smaller likelihood of recessions; Lucas (2003) considers that the

central problem of depression prevention was solved; and Bernanke (2004) suggests that the

reduction in the volatility of output was closely associated with less frequent and less severe

recessions. In fact, according to the National Bureau of Economic Research (NBER), after 1984,

the United States experienced only two relatively mild recessions until the Great Recession.

The Great Recession was of unprecedented severity and duration in the postwar U.S. business

cycle and led many economists to conclude that there had been a major breakdown in the GDP-

generating process, meaning that the late-2000s economic and financial crisis may have brought

the Great Moderation period to an end.

∗Manuscript received May 2016; revised December 2017.

1We are very grateful to J. Gali, O. Jorda, and P. Perron for their useful comments. We also thank participants

at Banco de Espa ˜

na seminars, IIIt Workshop in Time Series Econometrics 2013, IEA World Congress 2014, GSE

Summer Forum 2014, SNDE Conference 2015, IAAE Annual Conference 2015 and ESEM 2015, and the editor and

three anonymous referees for their helpful comments and suggestions. M. Dolores Gadea acknowledges financial

support from the Ministerio de Ciencia y Tecnolog´

ıa under grant ECO2011-30260-C03-02. The views expressed in this

article are those of the authors and do not necessarily represent those of the Banco de Espa˜

na or the Eurosystem.

Please address correspondence to: Gabriel Perez-Quiros, Banco de Espa˜

na, Alcal´

a, 48, 28014 Madrid, Spain. Phone:

+34 91 3385333. Fax: +34 915310059. E-mail: gperezquiros@gmail.com.

2They date the increased stability in the economy in the first quarter of 1984.

3See Blanchard and Simon (2001), Summers (2005), and Stock and Watson (2005).

4Although no consensus has yet been reached, three main explanations of the decline in volatility have been

proposed, namely, changes in the structure of production, improved policy, and good luck. For a debate on their

relative importance, see Stock and Watson (2002), Ahmed et al. (2004), Giannone et al. (2008), Canova (2009), Gali

and Gambetti (2009), and Canova and Gambetti (2010).

2297

C

(2018) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social

and Economic Research Association

2298 GADEA,GOMEZ-LOSCOS,AND PEREZ-QUIROS

Against this background, the contribution of this article is twofold; first, to formally show for

the first time in the literature, and contrary to the opinion of many authors, that the reduction

in the volatility of GDP growth associated with the Great Moderation continues to hold despite

the Great Recession, and, second, to find that the decline in volatility of the Great Moderation

is consistent with the absence of high-growth recovery periods. Sluggish recoveries are the price

paid for low volatility.

Regarding the first contribution, it is not banal to devote statistical efforts to address the

question of whether the Great Moderation still holds given that many papers, such as Taylor

(2012), Blanchard (2014), and Stock and Watson (2017), have declared the end of the Great

Moderation. Moreover, the fact that we find that the Great Moderation holds even though we

have suffered a strong recession (and we show that it would hold even if this pattern of recession

recovery continued for a long time) should make us reconsider the explanations proposed in

the literature about the causes of the Great Moderation.

Several authors have called for a reassessment of the Great Moderation hypothesis. For

instance, Taylor (2012) states that the beginning of the Great Recession was the end of the

Great Moderation. Blanchard (2014) claims that the crisis made it necessary to carry out a

profound revision of the benign view of economic fluctuations in mainstream macroeconomics

until then.

Very valuable theoretical work supports the end of the Great Moderation. Most of the papers

that consider that the Great Recession meant the end of the Great Moderation agree that it

was actually the consequence of the disequilibria accumulated during the Great Moderation,

for instance, the “balance sheet recessions” argument in Brunnermeier and Sannikov (2014)

and Brunnermeier et al. (2013). Bean (2010) relates the end of the Great Moderation with a

misperception of risk. Williams and Taylor (2009) and Taylor (2011, 2012) claim that the Great

Moderation ended because of a set of measures implemented by the Fed between 2003 and

2010 that contradicted the standard monetary policy rules.5

Against the arguments in favor of the end of the Great Moderation, Clark (2009) simply

computes standard deviations and finds that, although the variability of the U.S. economy rose

significantly after the Great Recession, low volatility is the norm. A theoretical paper by Coibion

and Gorodnichenko (2011) also supports that the Great Moderation is not over, assuming good

policy has played an important role in the Great Moderation.

The implications for academics and policymakers of whether the Great Moderation has

ended or continues are as important as the original discovery of the Great Moderation. For the

academic literature, if the Great Moderation still holds, the break in volatility has important

implications for theoretical and empirical techniques, such as in the estimation of models of

business cycle fluctuations, model calibration exercises, and the estimation of structural vector

autoregression models. For policymakers, it is key to identify the features of future expansionary

periods, to examine the likelihood of having a sluggish recovery, to deal with jobless recoveries,

to be aware of whether there is any change in business cycle characteristics, and to examine the

international transmission of business cycles.6

Regarding the second contribution, we investigate whether the Great Moderation is the result

of having fewer recessions, shallower recessions, or more moderate growth after each recession.

Although the Great Moderation is originally associated with a decrease in output volatility and

considered a great achievement in terms of reducing risk and of decreasing the frequency and

depth of recessions, we show that it is linked to the disappearance of high-growth recoveries.

The remainder of the article is organized as follows: In Section 2, we apply several econometric

techniques to test for the presence of structural breaks in mean and volatility of the GDP series

and find that the decline in volatility of the Great Moderation still holds. We confirm the validity

5Although empirically oriented papers do not focus on analyzing whether the Great Moderation ended as a result

of the Great Recession, some of the results would infer it has ended, for instance, Carvalho and Gabaix (2013) or Ng

and Wright (2013).

6SeeCamacho et al. (2011), Stock and Watson (2012), Ng and Wright (2013), and Gali and Backus (1999), respectively.