I rarely post about macro papers here, but I came across this interesting result by Carvalho and Gabaix in the new AER. Particularly in the mid-2000s, it was fashionable to talk about a “Great Moderation” – many measures of economic volatility fell sharply right around 1983 and stayed low. Many authors studied the potential causes. Was it a result of better monetary policy (as seemed to be the general belief when I working at the Fed) or merely good luck? Ben Bernanke summarized the rough outline of this debate in a 2004 speech.
The last few years have been disheartening for promoters of good policy, since many measures of economic volatility have again soared since the start of the financial crisis. So now we have two facts to explain: why did volatility decline, and why did it rise again? Dupor, among others, has pointed out the difficulty of generating aggregate fluctuations from sectoral shocks: as the number of sectors increase, then independence of shocks will generate little aggregate volatility as the number of sectors grows large. Recent work by the authors of the present paper get around that concern by noting the granularity of important sectors (Gabaix), or the network structure of economic linkages (Carvalho).
In this paper, the authors show theoretically that a measure of “fundamental volatility” in total factor productivity should be linked to volatility in GDP, and that that measure of volatility is essentially composed of three factors: the ratio of sectoral gross output to value added, a diversification effect where volatility declines if the economy where value-added shares of the economy are spread across more sectors, and a compositional effect, where the economy contains fewer sectors with high gross output to GDP. They then compare their measure of fundamental volatility, constructed using data on 88 sectors, to overall GDP volatility, and find that it fits the data well, both in the US and overseas.
What, then, caused the shifts in fundamental volatility? The decline in the early 1980s appears to be heavily driven by a declining share of the economy in machinery, primary metals and the like. These sectors are heavily integrated into other areas of the economy as users and producers of intermediate inputs, so it is no surprise that a decline in their share of the economy will reduce overall volatility. The rise in the 2000s appears to result almost wholly from the increasing importance of the financial sector, an individually volatile sector. Given that the importance of this sector had been rising since the late 1990s, a measure of fundamental volatility (or, better, a firm-level measure, which is difficult to do given currently existing data) could have provided an “early warning” that the Great Moderation would soon come to an end.