Great Moderation Provides Insight Into

¶ … Great Moderation provides insight into the macroeconomic environment of the past couple of decades, and perhaps also some insight into the recent changes in the environment. This should provide insight into how firms and investors can react to the new environment. The Great Moderation case points out that prior to the onset of recession in 2008 there was a period from the mid-1980s onward where macroeconomic output was relatively free from volatility.

Businesses and investors alike became accustomed to this stability, but the recession might presage the end of that era, which was dubbed the Great Moderation. There are many different theories as to why the Great Moderation occurred. One theory argues that the effects of more hands-on fiscal policy since Paul Volcker became Fed chairman in 1979, which ushered in an era of frequent and aggressive Fed responses to inflation changes. On a more structural level, another theory holds that globalization has helped to reduce macroeconomic volatility.

This theory rests on the concept of geographic diversification, wherein overseas production helps to allow countries to "smooth country-specific shocks." Creating value for the firm requires managers to understand the macroeconomic environment. If Clarida is correct and the current environment is different from the Great Moderation, then managers must adapt to conditions of higher volatility, not lower. Looking at the theories for contributing factors of the Great Moderation, those factors have been subject to change.

For example, where for a time geographic diversification enabled firms to "smooth" country-specific shocks, globalization today has progressed to such a point where there is a high degree of interdependency among nations. The recession began in the U.S., but spread to Europe and caused slowdowns -- albeit brief ones -- in Asia as well. The overhang of the European slowdown is now dragging on the U.S. economy, as will any slowdown in China.

Geographic diversification is more difficult to achieve today than it was ten years ago when globalization was just beginning to take hold. Today, the integration of real estate markets and banking systems in particular creates the potential for larger, not smaller, recessions. If Volcker-style interest rate management was responsible for creating conditions of greater macroeconomic stability, it is worth considering that the Fed has had limited ability in recent years to move interest rates, which have been pinned to the floor since 2008.

The central bank in Europe has a similar problem, as does the one in Japan. If central banks are experiencing reduced flexibility in the timing and intensity of monetary policy intervention, then again this will increase the volatility in the macroeconomic environment. For the firm to create value, it is essential that the firm understands the fundamental differences between the macroeconomic environment today and the conditions of the Great Moderation.

If there is a greater degree of volatility in the macroeconomic environment, the firm can extract value by undertaking strategies that help insulate the firm from this volatility, especially at the low end. The firm would seek greater diversification in terms of both geography and product, and is likely under these conditions to benefit from de-leveraging as well. Economic decisions are also subject to ethical and regulatory considerations. There are instances where a heavily-regulated industry is more successful under conditions of volatility.

This is because either the revenues are more stable due to protection, or because the firm is limited in terms of its ability to leverage, as was the case with Australian and Canadian banks during the 2000s. Ethically, managers have the imperative to maximize shareholder wealth, which in a Milton Friedman view of the firm is the only reason for being. Because this duty is in the long-term, managers need to ensure that assets and revenue streams are protected.

The duty implies that strategic actions on the part of the firm, if correctly oriented to the creation of long-term value, will have the objective of minimizing downside risk. There is also an ethical consideration that implies managers should attempt to time actions to position the firm for large gains during upward cycles. However, conservative value management would focus more on minimizing the damage during bust periods.

Managers during the Great Moderation were not oriented towards managing for high volatility, but managers today must take volatility into account in their strategic decision-making. Corporations also need to be acutely aware of their macroeconomic environment, in particular the key variables that act on their firm. Also, they need to understand the impact of other variables on their key variables. Corporate managers today need a much higher level of macroeconomic understanding than their counterparts during the Great Moderation did.

Managers during periods of macroeconomic stability can be forgiven for focusing on firm-specific volatility or industry-specific volatility as key variables. Today, more attention needs to be taken with respect to systemic risk, if the managers are to meet their objectives with respect to preserving and enhancing shareholder value. It will no longer be acceptable to simply explain away poor performance as the inevitable effect of systemic failure.

Managers instead will need to devise strategies and tactics that will minimize their exposure to systemic risk -- they will need to get their betas significantly lower than 1.0. The same can be said of the microeconomic environment. Managers today must first consideration that macroeconomic variables play a stronger role in the microeconomic processes of decision-making. During the 2008 recession, savings rates increased significantly.