Robert Samuelson, a columnist for the Washington Post,...

Robert Samuelson, a columnist for the Washington Post, argues that the Great Moderation actually caused the Great Recession. During the Great Moderation, "consumers could assume more debt $-$ and lenders could lend more freely." Why might consumers have been willing to assume more debt and banks and other lenders have been willing to make loans more freely during the Great Moderation? Why might these actions have made the severe recession of $2007-2009$ more likely?

Key Concepts

Leverage and Systemic Vulnerability

Increased borrowing by consumers and more liberal lending practices by financial institutions lead to higher leverage across the economy. High leverage magnifies gains during favorable times, but it also exacerbates losses during downturns. This interconnectedness can transform localized financial issues into broader systemic crises, as seen in the severe recession of 2007-2009.

Risk Perception and Mispricing

When economic conditions are stable, economic agents tend to underestimate risk. Consumers and lenders may misprice the risk inherent in long-term financial commitments because past stability makes shocks seem unlikely. This miscalculation can lead to an accumulation of unsustainable levels of debt, setting the stage for severe economic downturns when an unexpected shock occurs.

Moral Hazard and Regulatory Environment

A prolonged period of stability can foster an environment where both lenders and borrowers take on riskier behaviors, assuming that adverse outcomes are unlikely. This moral hazard can be compounded by regulatory frameworks that fail to adequately account for such risks, thereby creating conditions in which short-term profits are prioritized over long-term stability, ultimately increasing the likelihood of a severe recession.

Macroeconomic Stability

During periods of sustained low volatility and predictable growth, such as the Great Moderation, both consumers and lenders experienced relatively stable economic conditions. This led to a collective sense of confidence, where the past performance of the economy was mistakenly taken as indicative of future performance. Consequently, this stability reduced the perceived risks associated with taking on debt or issuing loans, encouraging more aggressive financial behavior.

Credit Expansion

In an environment characterized by stable growth and low inflation, lenders often feel more secure in extending credit, while consumers are more inclined to borrow. This mutual trust in the economy’s continuous upward trajectory can lead to an overextension of credit, where borrowing and lending occur more liberally, potentially obscuring underlying vulnerabilities in the financial system.

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