On Great Moderation through Great Contraction, it is useful to propose a chronological reconstruction of the sequence of events. The revolution in the new information and communication technologies halted the progressive decline of productivity growth in the United States, which returned to markedly high rates of expansion in the second half of the 1990s. During the same period, following the financial crises that hit the countries of South-East Asia and Russia (1997-98) , the Federal Reserve’s policy remained essentially accommodating, with a strong expansion of liquidity also to counter the so-called millennium bug. The “new economy” euphoria, beyond being compatible with objective interpretations of the increases in productivity linked to the introduction and spread of the new technologies, was reflected in US household consumption, with a rapid rise in debt and a sustained decline in savings, but with financial positions basically in balance thanks to the increase in net wealth due to capital gains, in part the result of soaring share prices during the dot-com bubble.
The powerful expansion in US final demand and imports was gradually accompanied by growth in the exports and output of the major emerging economies such as China and India, which had previously lagged behind, and an upwards trend in US inflation, dealt with by a tightening of monetary policy at the beginning of 2000. Monetary tightening ended by bursting, the dot-com bubble in 2000-01. The recessionary effects of this were compounded by those of the severe shock of the September 2001 terrorist attacks. Amid fears of recession and deflationary conditions of the kind that had prevailed in the previous decade in Japan, the Federal Reserve’s response was again very accommodating. A drastic reduction in interest rates was accompanied by a strongly expansionary budgetary policy, which remained in place also in relation to the war operations in Iraq and Afghanistan. Monetary policy also remained expansionary for a long time, facilitating a return to sustained growth in household consumption, not countering the trend towards a zero saving rate, and giving free rein to financial innovation, in conditions of abundant liquidity, especially with the repackaging in 2004-06 of mortgages − in a context of constantly rising house prices − into structured products that opened up new investment possibilities to banks.
The growing US current account deficit was accompanied by ever-larger surpluses in emerging countries and Japan, with a significant build-up of official reserves, in a context of a relatively sluggish rise in domestic consumption demand and saving rates even higher than the nonetheless elevated rates of investment. The oil-producing countries also recorded sharply higher trade surpluses, reflecting the rise in oil prices due to the expansion of global demand. The increase in international liquidity connected with the growing payments imbalances and the Fed’s accommodating monetary policy − which contributed, given the limited flexibility of emerging countries’ currencies and the Chinese renminbi in particular, to the global economic expansion − led to a prolonged period, from 2004 to 2007, of low price volatility in financial markets and low nominal yields. This was also due to the large volume of investment in fixed income securities by international investors and countries that had accumulated high levels of reserves by running large and rising current account surpluses. The result was the search by investors for investments with higher risk-return profiles and the attendant supply of structured financial instruments backed mainly by home mortgages granted with loan-to-value ratios exceeding even 100 per cent on the false premise that house prices could only increase.
The strong expansion of global demand engendered inflationary pressures, to which the monetary policy authorities responded, in part with a view to countering the possible impact on domestic prices of the expansion-driven increases in oil and raw material prices. The rise in interest rates was followed by the progressive deflation of the realestate bubble, which had a domino effect, particularly on the structured products created using subprime mortgages, with their higher default risk. In the summer of 2007 this triggered the financial crisis, which, despite central banks’ prompt and massive response, has gradually turned into a global crisis affecting whole industries and economies. In this context, a crucial role was played by financial regulation that was behind the curve, indeed entirely absent from some market segments. Speculative behaviour in the markets, the growth in leverage and the various kinds of pro-cyclicality operating at institutional level as well as in the decisions of market participants amplified the centrifugal tendencies. At the root, however, there remain the large trade and current account imbalances that the countries participating in the global economy built up unchecked .
