We need to sustain the 'great moderation'
Stephen Cecchetti | Thursday, 26 June 2008
The US housing market has collapsed, placing severe strains on the financial system and, as a direct consequence, workers and companies are suffering. But the real concern is not that there will be a few quarters with below average real growth - it is that the period of the great moderation may be over.
The past 20 years have brought extraordinary prosperity. Growth has risen the world over and this higher growth has come with a remarkable stability. Comparing the 1970s with the most recent decade reveals that the volatility of real growth in the industrialised world has reduced - the standard deviation of real gross domestic product (GDP) growth has roughly halved.
There are a variety of possible explanations for this unprecedented stability. It could be that a modern monetary policy, with its focus on price stability, is less destabilising. Alternatively, information technology has increased the flexibility of companies to adjust production and employment quickly to changes in the business environment. Or, it could be we have been lucky and faced fewer disruptive shocks. There is something to each of these but the one that I put most weight behind is that financial innovation has allowed companies and individuals to smooth consumption and investment in the face of fluctuations in income and revenue.
Elementary economics teaches us that smooth consumption paths yield higher welfare than volatile ones. Intermediate economics notes that, in reality, for households to keep purchases smooth from month to month they need savings or access to loans, which many of them do not have. As a result of this constraint, consumption follows income more closely than the simple theory says it should. Advanced economics teaches that financial markets should provide consumption insurance, allowing individuals to borrow and lend, reducing the dependence of current expenditure on current income.
There is a parallel logic for business. Growth should be smooth, even as revenue waxes and wanes. But in reality, cash-strapped companies are forced to curtail investment plans, while cash-rich ones can splurge. Again, borrowing and lending through financial intermediaries should cut this tie, leaving investment and growth smooth.
Over the last 20 years we have seen exactly this sort of financial innovation. Securitisation and the ability to separate risk and payment streams have been the keys to the revolution in finance. Active secondary markets for home mortgages, car loans, consumer credit and business lending enable both collateralised and uncollateralised borrowing. This dramatically weakens the link between income and expenditure for households and businesses.
It is hard to overstate the importance of these innovations. Looking at data for the US economy, in 1985 just over $500bn of the $1,600bn in home mortgages was in pools used to create asset-backed securities. By 2005, total mortgage debt was $9,500bn, of which $7,500bn was used for securities.
Mortgage-backed securities went from representing one-third of a small number to more than three-quarters of a large number. Securitisation of consumer credit also went from zero in 1985 to 10 per cent at the start of this decade.
Not only has the overall quantity of financing increased, but also these innovations have allowed high-risk borrowers access to financing. After all, pricing a security requires an accurate assessment of the default probability regardless of what that probability may be. Once something can be priced, it can be traded. While we have less data for other countries, there is a clear sense that financial innovation has been responsible for reducing the previously direct relationship between consumption and income. With smoother growth in household expenditure comes less volatile real growth.
This brings us to the long-run risks posed by the financial crisis. There was a failure to provide sufficient information about borrowers or align the incentives of the loan originators with the investors in the resulting securities. By separating financial instruments into their fundamental pieces the system allowed risk to be bought and sold, allocating it to those willing to take it on for the lowest price.
The result of the last 20 years of financial innovation is that we can insure virtually anything and engage in activities we would not have undertaken in the past. As a result growth has been more stable and business cycles have been less frequent and severe.
While we need to clean up the present mess - aligning the incentives of securities issuers and ultimate investors and providing the information they need to price the risks they face - the fundamental innovations should remain. As we think about how to adjust the financial regulatory system, it is important that we do not stop what is going on, just that we do it better. Otherwise, I fear the great moderation will be over.
(The writer is the Barbara and Richard M. Rosenberg professor of global finance at Brandeis International Business School.)
..........................................
The past 20 years have brought extraordinary prosperity. Growth has risen the world over and this higher growth has come with a remarkable stability. Comparing the 1970s with the most recent decade reveals that the volatility of real growth in the industrialised world has reduced - the standard deviation of real gross domestic product (GDP) growth has roughly halved.
There are a variety of possible explanations for this unprecedented stability. It could be that a modern monetary policy, with its focus on price stability, is less destabilising. Alternatively, information technology has increased the flexibility of companies to adjust production and employment quickly to changes in the business environment. Or, it could be we have been lucky and faced fewer disruptive shocks. There is something to each of these but the one that I put most weight behind is that financial innovation has allowed companies and individuals to smooth consumption and investment in the face of fluctuations in income and revenue.
Elementary economics teaches us that smooth consumption paths yield higher welfare than volatile ones. Intermediate economics notes that, in reality, for households to keep purchases smooth from month to month they need savings or access to loans, which many of them do not have. As a result of this constraint, consumption follows income more closely than the simple theory says it should. Advanced economics teaches that financial markets should provide consumption insurance, allowing individuals to borrow and lend, reducing the dependence of current expenditure on current income.
There is a parallel logic for business. Growth should be smooth, even as revenue waxes and wanes. But in reality, cash-strapped companies are forced to curtail investment plans, while cash-rich ones can splurge. Again, borrowing and lending through financial intermediaries should cut this tie, leaving investment and growth smooth.
Over the last 20 years we have seen exactly this sort of financial innovation. Securitisation and the ability to separate risk and payment streams have been the keys to the revolution in finance. Active secondary markets for home mortgages, car loans, consumer credit and business lending enable both collateralised and uncollateralised borrowing. This dramatically weakens the link between income and expenditure for households and businesses.
It is hard to overstate the importance of these innovations. Looking at data for the US economy, in 1985 just over $500bn of the $1,600bn in home mortgages was in pools used to create asset-backed securities. By 2005, total mortgage debt was $9,500bn, of which $7,500bn was used for securities.
Mortgage-backed securities went from representing one-third of a small number to more than three-quarters of a large number. Securitisation of consumer credit also went from zero in 1985 to 10 per cent at the start of this decade.
Not only has the overall quantity of financing increased, but also these innovations have allowed high-risk borrowers access to financing. After all, pricing a security requires an accurate assessment of the default probability regardless of what that probability may be. Once something can be priced, it can be traded. While we have less data for other countries, there is a clear sense that financial innovation has been responsible for reducing the previously direct relationship between consumption and income. With smoother growth in household expenditure comes less volatile real growth.
This brings us to the long-run risks posed by the financial crisis. There was a failure to provide sufficient information about borrowers or align the incentives of the loan originators with the investors in the resulting securities. By separating financial instruments into their fundamental pieces the system allowed risk to be bought and sold, allocating it to those willing to take it on for the lowest price.
The result of the last 20 years of financial innovation is that we can insure virtually anything and engage in activities we would not have undertaken in the past. As a result growth has been more stable and business cycles have been less frequent and severe.
While we need to clean up the present mess - aligning the incentives of securities issuers and ultimate investors and providing the information they need to price the risks they face - the fundamental innovations should remain. As we think about how to adjust the financial regulatory system, it is important that we do not stop what is going on, just that we do it better. Otherwise, I fear the great moderation will be over.
(The writer is the Barbara and Richard M. Rosenberg professor of global finance at Brandeis International Business School.)
..........................................