How the Great Moderation Became a (Contained) Depression and What to Do About It

By Barry Z. Cynamon, Steven M. Fazzari & Mark Setterfield

The Great Recession was deep and the subsequent recovery has been slower than most economists predicted. This article summarizes the message of a recent book that presents perspectives from a group of Keynesian economists, who warned prior to 2007 of dangerous trends that could lead to these unfavorable outcomes. The authors discuss how the debt-fueled consumer boom leading up to the Great Recession was unsustainable and how rising inequality has compromised demand generation during the feeble recovery. The article concludes by considering how public policy must respond in coming years.

In December of 2007, the U.S. economy entered a recession.1 Unemployment and financial instability worsened through the summer of 2008 and – following the dramatic collapse of Lehman Brothers (September 15, 2008) – the U.S. economy went into free fall. Job losses were the worst in generations, and the best that can be said five years since the onset of the Great Recession is that the threat of collapse has been replaced by that of stagnation.

The Great Recession caught most economists by surprise. Prior to its onset, thinking had converged to the idea that the U.S. (and other developed countries) were experiencing a “Great Moderation” – a marked reduction in the volatility of the aggregate economy as compared with the 1970s and early 1980s.2 While the mainstream applauded this accomplishment, a group of Keynesian macroeconomists repeatedly warned that gradual but strong forces were leading the U.S. economy toward a deep recession. These economists emphasized the central roles played by aggregate demand, uncertainty about the future, and finance in determining the path of the economy through time. They argued that robust and stable growth would not continue indefinitely under the prevailing conditions and attributed the relatively strong performance of the U.S. since the deep recession of the early 1980s to unique historical circumstances – most prominently, a high rate of demand growth financed by unprecedented household borrowing. The consumption-led and debt-financed engine of aggregate demand growth has since ground to a halt. Indeed, it was the breakdown of this mechanism that led to the Great Recession, and concern about where sustainable demand formation will come from is the most pressing issue the U.S. faces going forward. If policy is to address this situation, it will require significant intervention to create demand growth. A true recovery may be possible only with deep structural change, particularly in the distribution of income, that induces healthy demand growth without unsustainable borrowing by American families.

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