Did leaving the gold standard tame the business cycle? Evidence from NBER reference dates and real GNP.

• Author: Young, Andrew T.

1. Introduction

   "Our empirical results are striking [...] a clear rejection of the null hypothesis of no postwar duration stabilization." This is how Diebold and Rudebusch (1999, p. 7) summarize the six papers that constitute the second part of Business Cycles: Durations, Dynamics and Forecasting. The view that the U.S. economy has been more stable since World War II is widely held and dates back at least to Arthur Burns' (1960) presidential address to the American Economic Association. Furthermore, Baily (1978) can be credited with singling out 1946 as a date of demarcation. He notes that, from 1900-1945, the U.S. gross national product (GNP) gap was 381% more volatile than it was from 1946-1976. Baily chooses this break point to coincide with the U.S. Employment Act of 1946, and it is the basis of the Diebold and Rudebusch (1992; 1999) empirical analyses. (1)

   However, there are other plausible dates to consider and an important paper by Cover and Pecorino (2005) addresses this issue. They follow Diebold and Rudebusch (1992) in using a rank-sum test to evaluate potential break points in the length of business cycles. Expansion and recession lengths are defined primarily in terms of National Bureau of Economic Research (NBER) reference dates. Unlike Diebold and Rudebusch, however, Cover and Pecorino (henceforth "CP") evaluate all potential dates in terms of the associated probability of a structural break. CP find that March 1933 is the most probable break point when considering either NBER dates or the Romer (1994) alternative reference dates. This finding holds whether considering the length of expansions or the ratio of expansion length to the following recession length. CP (2005, p. 467) identify March 1933 with the U.S. departure from the gold standard.

   Is the CP claim of a March 1933 break point convincing? Of note, it is based on a particular and narrow definition of macroeconomic stability. Specifically, the claim is based on an examination of business cycles and the durations of their stages. However, a large part of macroeconomic analysis instead focuses on (i) growth cycles and/or (ii) the volatility of aggregate time series. The contribution of this article is to evaluate whether or not 1933 remains the most probable break point when macroeconomic stability is assessed from a perspective of (i) and/or (ii).

   The issues explored in this article are not only important from the perspective of economic history. CP's identification of March 1933 with departure from the gold standard leads them to claim (2005, p. 467) that their findings represent a challenge to real business cycle (RBC) theory, given that stabilization is then viewed as the product of discretionary monetary policy. (2) Furthermore, 1933 can be generally associated with the increased government activism of the Roosevelt administration. So, did discretionary policy of one type or another stabilize the U.S. economy? Or, alternatively, what if the break is actually later--say, 1946, as conventionally assumed? This would correspond to the Full Employment Act. However, it would also correspond to the end of World War II and the start of the diffusion of wartime technologies. Also, returning soldiers and laborers associated with the domestic war mobilization reentered peacetime production with new human capital. These changes in real factors could have resulted in a structural break.

   The article is organized as follows. Section 2 elaborates on the difference between business and growth cycles both in principle and in practice. Section 3 outlines methodology applied by CP to NBER reference dates. Section 4 reports the results of applying that methodology to both NBER reference dates (business cycles) and reference dates defined using HP-filtered real gross national product (GNP) (growth cycles). Section 5 then contrasts the existing literature on post-World War II stabilization (focusing on cycle durations) with the literature on the "great moderation" of the 1980s (focusing on aggregate time series volatility). Section 6 outlines two empirical methodologies related to the later literature, and section 7 reports the results of applying them to the question of post World War II stabilization. Section 8 summarizes our conclusions, including (i) the claim of a break point around 1933 is robust to the consideration of growth rather than business cycles but (ii) examining the volatility of real GNP suggests a considerably later break point perhaps as late as the 1950s.

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2. Business Cycles versus Growth Cycles

   The difference between the two cycle concepts is semantically obscured because the term "business cycle" is often used interchangeably for both types. However, the "growth cycles" concept arose subsequently to the business cycle concept. Growth cycles were defined by the NBER in the 1960s as periods of increases and decreases in economic activity around some defined trend (Mintz 1969, 1974; Moore and Zarnowitz 1986). This can be contrasted to the NBER concept of business cycles as absolute increases and decreases in economic activity. (See Figure 1 for a graphical compare and contrast of the two cycle concepts.) Lucas (1983, 1987) popularized the growth cycle concept as a focus of macroeconomics and co-opted the "business cycle" terminology for that purpose. (3) Real business cycle theorists, such as Kydland and Prescott (1991, 1996), further entrenched the growth cycle concept as part of accepted macroeconomic methodology.

   Thus far, the literature on post World War II stabilization summarized by Diebold and Rudebusch (1999) is based on the business cycle concept as stated by the NBER (e.g., "a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real gross domestic product (GDP), real income, employment, industrial production, and wholesale-retail sales.") (4) NBER reference dates are primarily monthly and represent months where recessions turn expansionary or expansions turn recessionary ("troughs" and "peaks," respectively).

   Growth cycles, on the other hand, are consistent with a macroeconomics based on some variant of the neoclassical growth model (Solow 1956, Cass 1965, and Koopmans 1965) where some (constant or smoothly evolving) growth rate in labor-augmenting technical change defines a balanced growth path (or trend) for the economy. Shocks can cause the output of the economy to be temporarily above or below this trend. One interpretation of such deviations from trend is as periods when the economy is operating above or below its potential level of output. Of note, the economy can be above trend during a time when economic activity is falling (a business cycle recession); likewise, the economy can be below trend when economic activity is rising (a business cycle expansion).

   The terms expansions and recessions are straightforwardly descriptive of business cycle stages but they can be awkward in application to growth cycles. (Better analogous terms might be periods of general prosperity or depression.) However, expansions and recessions during growth cycles ostensibly consist of periods' of economic activity above and below the trend, respectively, and reference dates would correspond to the turning points. (5)

   Also of note, business cycle stages can be analyzed purely in terms of their durations. However, when applying a growth cycle concept to actual data, it is almost impossible to abstract entirely from the magnitude of fluctuations. This is because a trend must be defined and the definition of the trend is invariably influenced by the volatility of the relevant data. For example, the popular Hodrick and Prescott (HP) (1997) filter is a decomposition of a time series into a trend (or growth) component and a residual (or cyclical) component. This decomposition arises from the minimization of a function that penalizes according to the level of the cyclical component and the change in the trend growth rate. With quadratic penalties for both, all else equal, a large fluctuation in economic activity will result in a decomposition assigning a larger change in trend at that point in time. (6)

   The differences between a business cycle and growth cycle view of the macroeconomy can be significant in practice. For example, according to the NBER reference dates from 1875-1983, the longest recession was the Great Depression beginning in 1929 (III) and lasting 14 quarters. However, examining HP-filtered real GNP data covering the same time period, the U.S. economy was below trend for 19 quarters on two occasions, the first beginning in 1937 (IV) and the second beginning in 1945 (IV). These long periods below trend are the result of the relatively high GNP growth periods following the trough of the Great Depression and during World War II and their (positive) effect on the HP-filter defined trend.

   In other cases the choice of a business cycle or growth cycle perspective can simply affect how we perceive the timing of events. For the 1875-1983 time period the NBER reference dates mark 1961 (I) as the beginning of the longest expansion (35 quarters). Detrended GNP data suggests the same basic time period as the longest expansion, but it begins later (1965 [III]) and the duration is shorter (17 quarters). This discrepancy is due to the time needed for the economy, following the decrease in economic activity beginning in 1960 (I), to not only grow but to achieve a level of GNP above trend. (7)

   For our purposes, we do not wish to argue for or against either cycle concept. We note only that the growth cycle concept is at least as prevalent as the business cycle concept in macroeconomic analyses. Therefore, if CP's claim of a most probable break point around 1933 is robust to considering growth cycle as well as business cycle reference dates, this would strengthen that claim considerably.

3. The Diebold and Rudebuseh/Cover and Pecorino Empirical...