October 29, 2007


The Even-Keel Economy: Today sharp shocks in one sector, like housing, don't necessarily lead to broader downturns

It's the economic heavyweight fight to watch. In one corner: the slumping but still powerful housing market, where new starts have dropped by almost 50% with no bottom in sight.

Its opponent: the global phenomenon known to economists as the Great Moderation. In the U.S., and across much of the world, the ups and downs of output, inflation, and employment have become far less pronounced since the mid-1980s. Recessions have been fewer and milder.

For now, the Great Moderation is winning, since the housing contraction has not turned into a full-blown downturn. This good news, if sustained, implies that different sectors have become less tightly linked. Moreover, it implies that the traditional way of thinking about recessions may be outmoded. Rather than broad-based declines in economic activity, these days we are more likely to get "micro-recessions"--sharp downturns concentrated in one or two economic sectors.

The term "Great Moderation" is relatively new, dating to a 2002 paper by economists James H. Stock of Harvard and Mark W. Watson of Princeton. Since then, researchers have come up with plenty of potential explanations for the decline in economic fluctuations, including better monetary policy, improved inventory controls, the rise of globalization, and more flexible financial markets. It's still not clear which factor is the most important, though more economists are placing greater weight on improvements in the finance sector, which enable consumers and businesses to keep borrowing and spending even in tough times.

But no matter what the cause, the effect is that bad economic news now comes like a tornado rather than a hurricane. There's still devastation, but it's in a much narrower band. "We've had a lot of big shocks, and they seem to be having less of an effect," says Stock.

Posted by Orrin Judd at October 29, 2007 7:51 AM
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