Rogoff on the demise of the Great Moderation

A question from last years exam that will have to be rethought:

"Globalisation and innovation are essential elements in understanding the worldwide
decline both in inflation and in the volatility of output since the early 1990s."
Discuss.

Nor do I think I'll be teaching the Great Moderation as a topic any more, or at least not in the form that I taught it in the past few years. As Ken Rogoff puts it in this recent interview (hat tip Arnold Kling):

 'there is a whole industry about the Great Moderation and what caused it, and it is going to suffer as much as the financial industry!, and it is going to suffer as much as the financial industry!'

There were two sides to this debate: financial innovation and the dampening of volatility and superior monetary policy.

Obviously the reduction in volatility in financial markets that was associated with the Great Moderation was a mirage.  Not only were we lucky in repeatedly drawing 'nice' realizations from the distribution but since financial institutions convinced themselves that the distribution itself had changed, they ended up correlating risks making a crash of this magnitude almost inevitable. 

What Rogoff has to say about monetary policy is also very interesting. For instance:

'Consider the fact that a lot of the inflation targeting literature employs models with perfect financial markets. So it's not exactly amazing that scholars wedded to this approach find that there is never a good case for looking at housing prices, above and beyond their effects on output and inflation. Yet empirical researchers have long argued that there is considerable danger whenever asset price inflations are accompanied by sharp rises in indebtedness. The doctrinaire inflation targeters dismissed this perspective, but hopefully they are rethinking things now. This is another reason why optimal inflation targeting models are simply too fragile'

Update: I've just noted that a while back Brad Setser also had some interesting thoughts on the role that the idea of the Great Moderation had on the possibly contributing to the scale of the current financial crisis.  He observed that widespread belief in the Great Moderation was what allowed firms to justify their high levels of leverage to themselves. It meant they could operate with less capital than they otherwise would have been able to.

'Big bets on the “great moderation” throughout the economy helped to create the financial basis for a potentially big slump.'