Economic stability could be here to stay

Economies are still vulnerable to 1970s-style shocks, but the response has changed

For the past 10 years, the US and British economies have been unusually tranquil. Activity has continued to fluctuate, but less violently; severe recessions have been avoided; and inflation has remained low and stable. The same is true of many other economies, although Japan and Germany have performed relatively poorly.

Some believe stability is the result of good luck - with the implication that instability could easily return. I disagree. With present-day monetary policies, and assuming the world is spared cataclysmic events, I believe economic stability will last.

Since the Great Inflation of the 1970s, economic stability has been fostered by improved monetary policy and by associated changes in the behaviour of inflation, which has become less self-feeding. Economic shocks and surprises have become less volatile for the same reason.

Mervyn King, the Governor of the Bank of England, has argued that the past decade was an exceptional period, unlikely to be repeated.

I am inclined to agree, but our projections show most economies continuing to enjoy an unusual degree of stability judged by historical standards.

The history of business cycles over the past 50 years can be conveniently summarised using a measure of volatility of economic growth and inflation. We divided the past 50 years into four periods. The first was the 20 years from the end of the Korean War to the growth climacteric of 1973, a period often referred to as a "Golden Age". Then there was the turbulent decade of large oil price and other shocks, followed by the next decade of marked disinflation and, lastly, the benign decade ending in 2003.

Comparing the past decade with the Golden Age, growth volatility has fallen by between 40 per cent and 60 per cent in the major economies except France, and all of them are less volatile compared with the decade ending in 1983.

The changes in inflation volatility are more dramatic still. Compared with the Golden Age - which includes the period of sharply rising inflation from the late 1960s onwards - inflation volatility in the major economies has fallen by 60 to 80 per cent in the past decade.

The improvement has been so marked that the record in most European countries now matches Golden Age conditions. Of the 11 European economies in our set of data, three have a worse record compared with the 1954-1973 period, three have a better record and for others the record is the same.

America has gone further and bettered its Golden Age performance, escaping severe recession in any of the past 10 years. In Japan, however, the benefit of the reduction in growth volatility has been offset by the impact of a markedly lower average rate of growth of less than 1.5 per cent a year.

What, then, explains the outbreak of stability? One way to ascertain the relative importance of forces that may have contributed is to conduct counterfactual exercises. These involve imagining how today's economies would have coped with yesterday's shocks, and vice versa.

Adding together the contributions of changed inflation and interest rate behaviour suggests that monetary policy made a significant contribution not only to the reduction in the level and volatility of inflation but also to the reduction in growth volatility.

Despite the importance of policy, the counterfactual exercises still identify shocks as a key source of lower growth variability in the US and UK, and lower inflation variability in the UK and Japan. The most obvious cause of the changed volatility of shocks is inflation. During the 1970s, expectations of inflation were probably highly volatile.

The defeat of inflation has itself led to a reduction in inflation shocks that predominantly account for the decline in inflation volatility in the UK and Japan. In addition, lower inflation has fostered smaller output shocks that account for most of the decline in US and UK growth volatility.

If policy makers continue to target low inflation, and do so credibly, there is much less reason to fear a return of 1970s-style output and inflation shocks.

On this basis, we construct a base case scenario of economic volatility over the next decade using the experience of the past 20 years as a guide.

The range of shocks during this period is wide and varied enough to represent the uncertainties of a future that today is at risk from US budget and other global imbalances.

To build the scenario, we pepper our low-inflation-era depiction of economies with 150 sets of pretend shocks to output, inflation, interest rates and the budget deficit. On average, these shocks have the same characteristics as those of the past two decades - the same volatility and the same correlation, one with another.

Compared with the past decade, the projections show a modest increase in growth volatility in the US, euro area and UK, with no change in Japan; small increases in the volatility of inflation in the US and UK and little or no change in the Euro area or Japan.

These projections support Mervyn King's contention that the past decade was an exceptional period, unlikely to be repeated. But in a wider context, the results show most economies enjoying an unusual degree of macroeconomic stability, at least equal to that experienced in the post-war Golden Age of the 1950s and 1960s.

In general, the base case paints a fairly benign picture. It points to the continuation of historically low inflation volatility - albeit rising in the UK - and limited chance of severe recession outside Japan. Growth volatility rises in the US and UK but not to "turbulent" levels.

A return to 1970s style shocks would disturb all the major regions and materially increase severe recession risk. In such circumstances, prospective output and inflation volatilities would be generally lower than in the 1970s, thanks to better policy and lower inflation persistence.

But this would be cold comfort. Compared with the past decade, output and inflation volatilities would be much higher in all regions except perhaps the euro area, where shock variance increases least.

These unpleasant outcomes cannot be wholly dismissed. But subject to the continuation of sound counter-inflation policy and an absence of extreme geo-political or natural disasters, our inclination is to believe stability will last.

Bill Martin is an economic consultant who until recently was chief economist at UBS Global Asset Management. This piece is based on research carried out with Bob Rowthorn, Professor of Economics at Cambridge University.