I'm fixing to start a section on stabilization policy in intermediate macroeconomics. As part of the discussion, I wanted to include a statistic I heard from a buddy of mine recently: the Sharpe ratio for the US economy was higher before the Fed was created than afterward. One could look only at GDP growth, but the Sharpe ratio (the ratio of the average rate of return and the standard deviation of the return) gives a measure of the return per unit of volatility. Since people like more stuff (higher GDP) and also like to consumption smooth, this is metric provides a good measure of how well economic policy is doing.
He pointed me to some historical data and where I could verify his claim. Sure enough, one finds a pre-1913 Sharpe of 1.13 (growth of 4.2% per year, with a standard deviation of 3.7%) and a post-1913 Sharpe of 0.67 (growth of 3.4% and a standard deviation of 5.1%). Plotted below is a 20-year moving average of the Sharpe Ratio:
He pointed me to some historical data and where I could verify his claim. Sure enough, one finds a pre-1913 Sharpe of 1.13 (growth of 4.2% per year, with a standard deviation of 3.7%) and a post-1913 Sharpe of 0.67 (growth of 3.4% and a standard deviation of 5.1%). Plotted below is a 20-year moving average of the Sharpe Ratio:
To me, this is pretty good evidence for passive economic policy. That GDP growth has been lower, and volatility higher, after the creation of the Fed than when the US had "wildcat banking" and a civil war does not speak highly for the aptitude of our central bankers.
A counter argument, might be that it has just taken a while to figure out how to conduct stabilization policy, but now we finally have got the hang of it. Why, just look at the "Great Moderation"- and really the whole period following WWII. The Sharpe from 1990-2008 is 2.11 and the Sharpe from 1949-2008 is 1.48- both higher than pre-Fed (granted, growth during the "Great Moderation" was indeed moderate- about 2% per year).
Maybe so. The data we have isn't really going to tell us one way or the other. The last 18 years could have been luck, or they could have been an example masterful manipulation of the economy. The stability since WWII could be due an increasing openness to trade, geo-political stability, developments in financial markets, changes in demographics (such as women entering the workforce in much larger numbers), or other causes not related the work of monetary or fiscal policy. There is no way to know what was most responsible for the rise in the US's Sharpe ratio.
A real test might be the current crisis. Although we'll never see a counter factual, a major economic shock should do more to reveal the workings of economic policy than times with smaller shocks. It is a consensus opinion that the Fed was a major reason that the Great Depression was great (see Bernanke's opinion here). So, in major crises, the Fed is 0 for 1. The policy makers weren't able to avoid the present contraction, but let's hope they can get us out of it and start batting .500.
A counter argument, might be that it has just taken a while to figure out how to conduct stabilization policy, but now we finally have got the hang of it. Why, just look at the "Great Moderation"- and really the whole period following WWII. The Sharpe from 1990-2008 is 2.11 and the Sharpe from 1949-2008 is 1.48- both higher than pre-Fed (granted, growth during the "Great Moderation" was indeed moderate- about 2% per year).
Maybe so. The data we have isn't really going to tell us one way or the other. The last 18 years could have been luck, or they could have been an example masterful manipulation of the economy. The stability since WWII could be due an increasing openness to trade, geo-political stability, developments in financial markets, changes in demographics (such as women entering the workforce in much larger numbers), or other causes not related the work of monetary or fiscal policy. There is no way to know what was most responsible for the rise in the US's Sharpe ratio.
A real test might be the current crisis. Although we'll never see a counter factual, a major economic shock should do more to reveal the workings of economic policy than times with smaller shocks. It is a consensus opinion that the Fed was a major reason that the Great Depression was great (see Bernanke's opinion here). So, in major crises, the Fed is 0 for 1. The policy makers weren't able to avoid the present contraction, but let's hope they can get us out of it and start batting .500.
I think the Sharpe ratio is probably a pretty rough proxy for stabilization policy performance. But even if it where a precise metric, it is higher right now than it has ever been before.
I'm sure its a pretty rough proxy. But I also think its a much better proxy than just looking at the volatility of GDP and inflation, as Mankiw does, for example.
It is higher now, but I hope you are not implying that is good evidence in favor of active policy. It's not much higher than it was for the first 60 years on this country- when we had essentially no stabilization policy. And recently we've experienced much lower growth and expended a lot of resources implementing such policies...
Where was the peak of the data series? Eyeballing suggests that it was prior to December 2007. Is this so?
The peak was in 2004. I could only find GDP numbers at the annual frequency if I wanted to go back to 1790. It'd be nice to have higher frequency data for this, but if it exists, I haven't seen it.