If the new order represents an improvement, its most redeeming feature is the Great Moderation, or the taming of the business cycle. Since the 1981-82 recession, the economy has expanded most of the time. It has created jobs most of the time. It has fostered higher living standards most of the time. All this has acted as a social shock absorber, lessening discontent from greater inequality and shakier job security. The new order is in part hostage to the Great Moderation. A resurgent business cycle—harsher and more frequent slumps—could transform public opinion. It could fan hostility toward business and heighten pressures for government intervention. Considering this, it would be helpful to know whether the Great Moderation is a permanent blessing or a passing phase. Unfortunately, we don't know.

The Great Moderation does not lack for explanations. Business cycles stem from shifts in spending. Higher spending (on, say, housing or cars) promotes expansion. Weaker spending threatens recession. As already noted, inflation s decline abetted the Great Moderation by minimizing stop-go economic policies. But there were probably other causes. The historic shift away from manufacturing and farming, both susceptible to dramatic swings rooted in inventory and investment cycles as well as harvest conditions, may have promoted stability (the effects may also have occurred in the 1950s and 1960s before being overwhelmed by inflation). Bigger government may stabilize overall spending; except for war, its disbursements are not prone to dramatic fluctuations. Moreover, it provides "automatic stabilizers" (in recessions, unemployment insurance increases and the bite of progressive taxes moderates; the opposite occurs in expansions). Computerized inventory controls to match sales and orders, widely adopted in the 1980s and 1990s, may have prevented businesses from overstocking. The greater availability of consumer credit may have helped families smooth their spending.

The fact that the economy has been fairly stable for the past two decades does not guarantee that it will stay stable. A capitalist system that constantly reinvents itself can also breed new sources of disorder. The prime candidate these days is the financial system. Finance is the means by which a society mediates between savings and investment. Some people and companies save; others invest—in businesses, homes, factories, new products. Banks and financial markets (for stocks, bonds and other securities) connect the two. A partial or complete breakdown of the financial system could severely harm the rest of the economy. It could cripple the normal borrowing and lending processes on which both businesses and consumers rely; and financial setbacks translate into major wealth losses for individuals, businesses and nonprofit institutions (colleges, hospitals) that would affect their spending and investment. For much of 2008, the Federal Reserve struggled to prevent such a breakdown, as losses on securities backed by so-called "subprime mortgages" (loans to weaker borrowers) hurt banks and investment banks. This preoccupation with the financial system exposed a huge gap in modern economics.

Anyone who took introductory college economics in the 1960s (as I did), or for many years later, was barely exposed to finance. It was considered a backwater. The standard approach to business cycles was to separate the economy's spending into four broad categories. Private consumption—everything from furniture to fast food—was the biggest. The others were investment in businesses and housing; government spending, from defense to roads; and net exports (a trade surplus or deficit). Significant shifts in any of these spending streams could induce economic expansions and recessions. Professors with a historic bent might recall that there had once been bank panics—depositors demanding their money—that, by causing contractions of bank lending, had influenced business cycles. But those were the bad old days before the creation of deposit insurance in the 1930s prevented bank panics. (Federal deposit insurance, now generally $100,000 per account, protects individuals against loss even if the bank fails.) The role of finance was mostly passive. Finance responded to events. It didn't initiate them. If consumers or companies needed to borrow, they went to banks or sold bonds. Similarly, the stock market was mainly a barometer of how well or poorly companies were doing. Few firms raised capital by selling new shares.

But it turned out that what I and many others were taught was wrong or, at least, has become dated and incomplete. In the past quarter century, finance has been a driver of events—causing both expansions and, through "bubbles," recessions. High stock and home values persuaded millions of Americans to spend more of their incomes, borrow more money, or both. People felt wealthier and so they spent more; indeed, economists called this "the wealth effect." Consumer spending rose from 63 percent of GDP in 1980 to 70 percent in 2004, and that steady gain buttressed living standards and the economy's growth. Then the same run-up in stock prices and home values reversed and brought the economy down. The greater availability of venture capital (from $18 billion in 1997 to $107 billion in 2000) initially fed the boom in Internet and computer startups, many of which subsequently collapsed along with sky-high stock prices in the "tech bubble." The pattern was similar in real estate. Greater availability of mortgage loans pushed up home prices, which made anxious buyers more frantic to purchase homes; that led to more lending, buying and higher prices. The boom fed on itself until the "bubble" popped and home prices—no longer supported by credulous credit—started to drop. In both cases, the initial rise in prices—triggered by falling inflation and interest rates— fostered a false belief in the inevitability of ascending values.

The crucial point is that these rhythms of spending were dictated by the financial system, which had changed dramatically from the bank and S&L dominance of thirty years earlier. Their losses in the 1980s—many S&Ls and banks failed, and others had their lending limited by depleted capital—left a void that was filled by "securitization": the packaging of mortgages, auto loans, credit card debt and other loans into bondlike securities that were sold to institutional investors (insurance companies, pension funds, college endowments, mutual funds). Computerization led to faster trading and more complex investment strategies. Even in the early 1970s, as writer Martin Mayer has recalled, most major securities firms had "cages" that handled the physical transfer of stock certificates and cash that settled daily trading. Now, virtually all transfers occur electronically. From 1980 to 2006, average trading volume on the New York Stock Exchange rose from 45 million shares to 1.8 billion. Many investment banks went from small, clubby partnerships to massive publicly traded firms. At the end of the 1950s, Morgan Stanley had one office and about one hundred employees; in 2007 it operated in thirty-three countries and had 47,000 employees. The breakdown of global capital controls meant that money also moved increasingly among different countries.20

The college texts—and mainstream economics—need to be revised to incorporate the benefits and dangers of a complex financial system that is highly interconnected internationally. Finance seems susceptible, notes Josh Lerner of the Harvard Business School, to regular cycles of productive invention and reckless speculation. The cycle usually starts with some worthwhile innovation, say "securitization," venture capital or LBOs. This leads to imitation, which is generally good because it creates competition and improvement. Finally, there's a speculative binge. Crowd psychology takes charge; the quest for quick profits overwhelms underlying economics. Prices get stretched, dubious deals and trades multiply, and the process ends with a "crash" of artificial values. If the "crashes" only made some rich people poorer, they wouldn't matter much. But the conse quence can also include widespread wealth losses, depressed confidence and constricted credit. In my college days, the connections between the financial system and the rest of the economy were thought to be straightforward and modest. Now they're larger and less predictable.21

The fate of the Great Moderation may hinge on their influence. Hardly anyone now believes that business cycles can be completely abolished. Swings in spending inevitably result from human miscalculation, whether in financial market or elsewhere. Sometimes these errors stem from new technologies, products and business practices that inspire unsustainable surges of buying or investment. Sometimes they reflect shifts in popular psychology—periods of mass euphoria or gloom. Still, it's tempting to think that the business cycle has been purged of its worst excesses and that the Great Moderation will endure. Unburdened by inflation's destructive effects, the economy expands with only infrequent and mild interruptions. Though plausible, this pleasing prospect cannot be taken for granted. We simply do not know whether the economy is self-stabilizing—and, if not, whether government can always stabilize it. This is a great unsettled issue in economics and will probably stay unsettled.

History suggests some optimism. Since the Great Depression, only a few recessions have been exceptionally harsh. In theory, economic downturns could feed on themselves. Slumping sales could lead to higher joblessness, which could lead to lower sales, more joblessness and so on. But in practice, the economy has many self-correcting mechanisms. Interest rates and prices abate; surplus inventories are sold. Government also has tools (tax cuts, spending increases, interest-rate changes) to promote stability. The caveat is that, in a fast-changing world, what worked yesterday might not work today. In 2008, the Federal Reserve struggled to defuse a new type of financial crisis. The classic response to bank panics, as conceptualized by Walter Bagehot (1826—1877), editor of The Economist, was for central banks to lend cash to solvent banks suffering depositor runs. But by 2008, much lending occurred outside of banks (aka "securitization"), and losses on "subprime" mortgages mounted. Financial institutions grew leery of lending to one another, because no one knew which institutions had suffered losses. To offset this credit stinginess, the Fed lent liberally to both banks and nonbanks. Its actions may have averted a panic, but the long-run consequences remain unclear.

As the "full employment" obsession made clear, overambitious policies can do more harm than good. But just because some interventions fail doesn't mean that all are doomed. The practical questions are what, when, how much and by whom. The answers are usually a matter of judgment. History's other lesson is that economies are usually most vulnerable when they're changing rapidly. Recall the Great Depression. When it struck, there was a political and intellectual vacuum. Britain, which had been the global leader, could no longer continue; America wouldn't step in. The gold standard, once the linchpin of the world financial system, was besieged. No one was in charge, and no one knew what to do. There are parallels today. The global financial system is changing swifdy. America's leading political and economic role is waning before the advance of other powers (Europe, Japan, China, India, Russia). We understand less and control less. With so much change, could the Great Moderation itself become a victim?

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