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The End of the Great Moderation: “We told you so.”

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  • Barnett, William A.
  • Chauvet, Marcelle

Abstract

The current financial crisis followed the “great moderation,” according to which the world’s central banks had gotten so good at countercyclical policy that the business cycle no longer existed. As more and more economists and media people became convinced that the risk of recessions had moderated or ended, lenders and investors became willing to increase their leverage and risk-taking activities. Mortgage lenders, insurance companies, investment banking firms, and home buyers increasingly engaged in activities that would have been considered unreasonably risky, prior to the great moderation that was viewed as having lowered systemic risk. It is the position of this paper that the great moderation did not reflect improved monetary policy, and the perceptions that systemic risk had decreased and that the business cycle had ended were false. Contributing to those misperception was low quality data provided by central banks. Since monetary assets began yielding interest, the simple sum monetary aggregates have had no foundations in economic theory and have sequentially produced one source of misunderstanding after another. The bad data produced by simple sum aggregation have contaminated research in monetary economics, have resulted in needless “paradoxes,” have produced decades of misunderstandings in economic research and policy, and contributed to the widely held views about decreased systemic risk. While better data, based correctly on index number theory and aggregation theory, now exist, the usual official central bank data are not based on that better approach. While aggregation-theoretic monetary aggregates exist for internal use at the European Central Bank, the Bank of Japan, and many other central banks throughout the world, the only central banks that currently make aggregation-theoretic monetary aggregates available to the public are the Bank of England and the St. Louis Federal Reserve Bank. Dual to the aggregation-theoretic monetary aggregates are the aggregation-theoretic user cost and interest rate aggregates, which similarly are not in official use by central banks. No other area of economics has been so seriously damaged by data unrelated to valid index-number and aggregation theory. Many commentators have been quick to blame insolvent financial firms for their “greed” and their presumed self-destructive, reckless risk taking. Perhaps some of those commentators should look more carefully at their own role in propagating the misperceptions of the great moderation that induced those firms to be willing to take such risks.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 11642.

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Date of creation: 14 Nov 2008
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Handle: RePEc:pra:mprapa:11642

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Keywords: Measurement error; monetary aggregation; Divisia index; aggregation; monetary policy; index number theory; financial crisis; great moderation; Federal Reserve;

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References

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  1. William Barnett & John Keating & Unja Chae, 2006. "The Discounted Economic Stock of Money with VAR Forecasting," Annals of Finance, Springer, Springer, vol. 2(3), pages 229-258, July.
  2. Barnett, William A. & Chauvet, Marcelle & Tierney, Heather L. R., 2008. "Measurement Error in Monetary Aggregates: A Markov Switching Factor Approach," MPRA Paper 10179, University Library of Munich, Germany.
  3. Barnett, William A. & Chauvet, Marcelle, 2008. "International Financial Aggregation and Index Number Theory: A Chronological Half-Century Empirical Overview," MPRA Paper 10242, University Library of Munich, Germany.
  4. P.A.V.B. Swamy & P.A. Tinsley, 1976. "Linear prediction and estimation methods for regression models with stationary stochastic coefficients," Special Studies Papers, Board of Governors of the Federal Reserve System (U.S.) 78, Board of Governors of the Federal Reserve System (U.S.).
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  12. Diewert, W. E., 1976. "Exact and superlative index numbers," Journal of Econometrics, Elsevier, Elsevier, vol. 4(2), pages 115-145, May.
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  14. Chauvet, Marcelle, 1998. "An Econometric Characterization of Business Cycle Dynamics with Factor Structure and Regime Switching," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 969-96, November.
  15. Belongia, Michael T, 1996. "Measurement Matters: Recent Results from Monetary Economics Reexamined," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 104(5), pages 1065-83, October.
  16. Schunk, Donald L, 2001. "The Relative Forecasting Performance of the Divisia and Simple Sum Monetary Aggregates," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 33(2), pages 272-83, May.
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