Question

Robert Samuelson, a columnist for the Washington Post, argued that the Great Moderation actually caused the Great Recession. During the Great Moderation, he wrote, "consumers could assume more debt- and lenders could lend more freely." Why might consumers have been willing to assume more debt and banks and other lenders have been willing to make loans more freely during the Great Moderation? Why might these actions have made the severe recession of \(2007-2009\) more likely?

Short answer

During the Great Moderation, lower economic volatility might have encouraged consumers to assume more debt and lenders to lend more freely, due to increased confidence in economic stability. However, this could create a credit bubble that could collapse when economic conditions changed, making the severe recession of 2007-2009 more likely.

Step-by-step solution

Define the Great Moderation

The Great Moderation refers to a period of decreased macroeconomic volatility in the United States that occurred from the mid-1980s to the financial crisis in 2007. During this time, many economic indicators such as GDP, inflation, and unemployment exhibited reduced variability.

Analyze Consumers' Behavior

Consumers could have been willing to assume more debt during the Great Moderation because the decreased economic volatility made them more confident in their future earning potential and job security. In essence, they felt safer to borrow money, whether for consumption or investment, because the financial risks seemed to lessen.

Assume the Lenders' Perspective

On the other hand, banks and other lenders could have been more willing to make loans during this period because macroeconomic stability reduced risk. Additionally, the competition among financial institutions might have encouraged them to extend credit more freely in an effort to maintain or increase their market share.

Identify the relationship to the Great Recession

The combination of consumers taking more debt and banks more willing to lend could create a credit bubble. If the positive conditions of the Great Moderation changed, like they did with the financial crisis, it could lead to a situation where debt became unsustainable. Many consumers might not be able to repay their debt while banks could face insolvency due to the bad loans, which could make a recession more likely.

Key concepts

Macroeconomic Volatility

The term 'Macroeconomic volatility' refers to the fluctuations in economic activity within a country, usually represented by changes in indicators such as GDP growth rates, unemployment, and inflation. A period of low macroeconomic volatility indicates a stable economy where these indicators do not exhibit sharp ups and downs.

During the Great Moderation, a remarkable period of stability from the mid-1980s to 2007, the United States enjoyed less frequent and less severe economic downturns. This era was characterized by the implementation of better monetary policies, advancements in technology, and globalization, all of which contributed to the reduced volatility in economic activity. People began to have unwavering faith in the ongoing stability of the economy, and this belief system ultimately affected their financial behaviors.

Consumer Debt

Consumer debt is the amount of money that individuals owe, primarily as a result of purchasing goods and services on credit. This can include credit card debt, loans for vehicles, student debt, and mortgages. During stable economic times, consumers may feel more confident in their ability to pay back debt in the future, leading to an increase in personal borrowing.

Under the impression of the Great Moderation, job security seemed assured, and continuous economic growth appeared to be a given. With the view that the good times would roll on indefinitely, consumers took on more debt with the expectation that they could manage it with their future incomes. This practice was widespread and, in hindsight, concerning because it supercharged consumer spending but also set the stage for potential financial instability.

Credit Bubble

A credit bubble arises when there is excessive borrowing based on the assumption that continuing economic prosperity will allow for easy debt repayment. However, these bubbles are typically unsustainable and risk a severe correction when economic conditions change.

The Great Moderation saw a time of expansive credit availability. Banks, competing for market share, eased credit conditions and lowered the bar for creditworthiness. These lax lending practices, combined with consumers' heightened appetite for debt, inflated a credit bubble. When the underlying assumptions of ever-increasing property values and uninterrupted employment faltered, the bubble burst. The widespread inability to service these debts contributed directly to the financial crisis, evidencing how a credit bubble can eventually lead to a catastrophic economic downturn.

Great Recession

The Great Recession refers to the severe economic downturn that took place from 2007 to 2009, following the burst of the housing and credit bubble. It was the most significant global recession since the Great Depression of the 1930s. Unemployment rates skyrocketed while consumer spending plunged, leading to a vicious cycle of economic contraction.

What began as a crisis in the housing market quickly spread to financial markets and then to the general economy, demonstrating the interconnectedness of various sectors. It serves as an essential reminder that the risks associated with macroeconomic imbalances, such as excessive consumer debt and the creation of a credit bubble, can trigger far-reaching consequences when they come to a head, as they did during the Great Recession.