Booms and busts will always be part of the economy, but they may come more frequently or less frequently, and they may be more severe or less severe. Let’s look at what’s likely in the next ten years.

We begin with history. Think back to December 1982 and visualize a business leader with 25 years of experience. That executive had managed through five recessions. Now fast forward to December 2007 and visualize the next generation business leader. In that person's 25 years of experience, he or she had managed through only two recessions. Five recessions or two recessions over the course of 25 years: it makes a difference to how one perceives the world.

The period from 1983 through 2007 - “The Great Moderation” - was the calmest era in all American economic history. Certainly we had political, technological, and social change. Yet in terms of business cycles, those years were the calmest ever in the United States. Recessions were much less frequent. When they came, which they did only twice, they were milder than average. Booms were less common as well, with fewer years of exceptionally strong economic growth. Mostly we had steady expansion.

The Great Moderation was a global event. Virtually every country in the world calmed down over this era.

Dr. Bill Conerly's calculations based on data from Bureau of Economic Analysis

Cyclicality of Economy

The chart shows how cyclical the U.S. economy is. When the line is high, there’s a great amount of change in the quarterly growth rates. When the line is low, we get pretty much the same growth rate quarter after quarter.

(The chart shows standard deviation, which is a statistical measure of variation. When a series of numbers includes many extreme values—high numbers are really high, and low numbers are really low—then the standard deviation is large. When all of the numbers are very close to each other, with few extremes, then the standard deviation is low. Note that this does not say whether the numbers themselves are high or low, just whether they are highly variable or highly consistent.)

The housing boom of the early 2000s was partly caused by the confidence that arose from a long era of steady economic growth. The Great Moderation helped fuel a sense of optimism about housing and most other industries.

What does the future hold for economic cyclicality? Will we return to stable times or will the economy resume the up-and-down pattern that characterized earlier economic history?

I expect a much more cyclical period in the decade to come. Five factors were identified by academic researchers as driving the Great Moderation. Let’s consider those factors and then project forward in time.

Better Technology

Technological change, by itself, can increase or decrease the economy’s cyclicality. In the recent experience, it almost certainly calmed the economy through better inventory management. Economists have long known that inventory changes are highly destabilizing to the economy. Businesses are surprised by sales changes and tend to leave target inventories static. After goods pile up (in a recession) or go out of stock (in a boom), the company adjusts new orders and also changes target inventory levels. In a recession, the reduction in orders is disproportionate to the decline in sales, pushing the economy downward. In a boom, the increase in orders is also disproportionate to the increase in sales, stimulating the economy further. Either way, slow inventory adjustments are destabilizing to the economy.

Technology will continue to stabilize inventories, though we probably won’t have further gains of great significance to business cycles. The next big improvement would be to predict sales changes more accurately, whereas past technology sped up reaction to sales changes. I’m skeptical that we’ll make much progress, given our difficulty in forecasting the economy, technological change, and social attitudes. However, we won’t lose the improvements that we have made, so this factor should be neutral for future economic stability.

Better Monetary Policy

After the acceleration of inflation in the late 1960s and through the end of the 1970s, the Federal Reserve pursued an on-again, off-again policy of fighting inflation. The Fed would raise interest rates to fight inflation, watch the economy turn down, either into a full-blown recession or into a milder “growth recession,” then decide to fight unemployment with low interest rates.

In 1979, Fed chairman Paul Volcker shifted monetary policy to a more anti-inflationary stance. The Fed’s move was bolstered by research arguing that the trade-off between inflation and unemployment disappears in the long run. That means we can have both low inflation and low unemployment, though we may have to put up with a temporary slump to achieve the desired goal. Volcker and his colleagues at the Fed were willing to put up with that slump.

Later, the Fed followed a much more stable policy which kept both inflation and unemployment low. The on-again, off-again monetary policy had switched to one of sure, steady gains for the economy without inflation.

But now things are different. The Federal Reserve has injected huge reserves into the banking system through three rounds of quantitative easing. This has translated into smaller changes in money supply and general spending than we would have expected from past experience. If the economy ever takes off, it’s likely that the fuel of bank reserves will ignite, leading to a flare up in total spending. Around that time, the Fed will have to drain reserves from the banking system at exactly the right time and in exactly the right magnitude. They have not been able to do this historically.

Financial Innovation

You may be surprised to hear that financial innovation was a calming influence on the economy. I’m not talking about credit default swaps and collateralized debt obligations. Instead, think back to 1990. The savings and loan industry was going bust, and those institutions had been originating most residential mortgages. How would the housing industry survive? How could the overall economy continue to expand if new housing construction collapsed due to lack of mortgages? Up jumped securitization, which saved the day.

Securitization is the procedure whereby a number of loans are bundled together, then sold off, typically in pieces based on the timing of the loan payment. Securitization of mortgages and other assets had taken place earlier, but in fairly small amounts. Thanks to the looser regulatory structure of that day, securitization increased rapidly. The home construction industry was saved due to financial innovation.

Financial innovation is unlikely to help us in the future. New regulations make it unlikely that any stoppage within financial markets would be quickly unclogged by innovative techniques by banks and other companies. We can hope that the new regulatory environment will prevent the excesses that led to the 2008-09 recession—but I’m doubtful given the government’s continued desire to get mortgages to people with poor credit.

Globalization

Rising volumes of foreign trade have been common around the world in the post-World War II period. Improvement in communications and falling ocean transportation costs enabled outsourcing. In the early stages of outsourcing, it appeared that we sent some of our most cyclical jobs overseas, which would tend to stabilize our own economy at the expense of other countries.

This theory fails, however, to account for the global nature of the Great Moderation. The economies of our major outsource targets, such as Mexico, China, and Taiwan, also became less cyclical. In the later years of the Great Moderation, we outsourced a number of fairly stable jobs, such as call center staff. Our most cyclical sector, construction, was never outsourced overseas. Globalization probably had a negligible impact on cyclicality, so I conclude that we cannot expect this factor to dampen future business cycles.

Good Luck

Yes, academic economists seriously wrote “… most of the reduction seems to be due to good luck….” In fact, they may have a point. Economic fluctuations come from a number of seemingly random factors, including droughts, wars, and shifts in consumption priorities. Perhaps we went through a period of few random events that would affect the economy. Perhaps, also, when these random events occurred, they often offset one another. For example, a hurricane in one location might be offset by an oil discovery somewhere else. One positive, one negative, and the overall economy was not much affected.

Will we be lucky again in the future? Certainly we will have good luck. We will also experience bad luck. That’s pretty much the fundamental character of luck. If you are feeling lucky, I recommend buying a lottery ticket over using business plans that depend on continued good luck.

The Future

Rolling all the factors together, I forecast a more cyclical economy in the coming decades. It probably won’t be as bad as the 1970s, but it will definitely be worse than during The Great Moderation. Let me emphasize that when I talk about more cycles, I don’t just mean more recessions. I think the booms will be boomier and the busts will be bustier. (I wasn’t sure if that last one was really a word. I looked it up on Google. Lost two hours of productivity). On average, we’ll do about as well, but there will be less time between the boom phase and the bust phase.

This conclusion means that the approach that business leaders learned in the era from 1983 through 2007 will not work as well in the coming years. Companies will need to think about business flexibility, to do more contingency planning, to speed up processes and to use diversification to test new markets.