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For release on delivery
1:15 p.m. EDT
June 16, 2009

Defining Deviancy
Remarks by
Kevin Warsh
Board of Governors of the Federal Reserve System
to the
Institute of International Bankers
New York, New York

June 16, 2009

In a seminal essay delivered about 16 years ago, Senator Daniel Patrick Moynihan
offered a striking view of the degradation of standards in society.1 He observed that deviancy-measured as increases in crime, broken homes, and mental illness--reached levels unimagined by
earlier generations. As a means of coping with the onslaught, society often sought to define the
problem away. The definition of customary behavior was expanded. Actions once considered
deviant from acceptable standards became, almost immaculately, within bounds.2
Society moves on, as it were. Well-meaning efforts are periodically made to treat its
failings. But if these efforts prove less than successful, citizens and policymakers alike tend to
grow increasingly accustomed to the unfortunate statistics. Every bit the reformer throughout his
decades of public service, Moynihan seemed reluctantly resigned to society’s construct: “In this
sense, the agencies of control often seem to define their job as that of keeping deviance within
bounds rather than that of obliterating it altogether.”3
Given the financial crisis, deep contraction in the real economy, and extraordinary fiscal
and monetary responses, I cannot help but wonder what constitutes deviance in economic terms
in 2009 and beyond. What level of real economic output and unemployment is expected and,
more important, accepted? And what level of volatility constitutes the “new normal”?4 As I will
discuss, we must be wary of macroeconomic policies that--in the name of stability-- may have
the effect of lowering trend growth and employment rates.
In Moynihan’s framework, will we in the official sector be accepting of periods of
significant financial and economic distress, however infrequent? That is, will deviancy be

Daniel Patrick Moynihan (1993), “Defining Deviancy Down: How We've Become Accustomed to Alarming
Levels of Crime and Destructive Behavior,” American Scholar, Winter.
The views expressed herein are my own and do not necessarily reflect the views of other members of the Board of
Governors or of the Federal Open Market Committee. I am grateful for the valuable assistance of Karen Dynan and
Nellie Liang of the Board staff who contributed to these remarks.
See Moynihan, “Defining Deviancy Down,” note 1.
See Mohamed El-Erian (2009), “A New Normal,” Pimco Secular Outlook, May,

-2defined down with the understanding that a rare crisis is the price for dynamic, robust economic
growth? Or will the official sector say, “Never again--not on our watch,” and become less
tolerant of deviations in economic and financial conditions? Under the mantle of reforming
capitalism, will policymakers instead define deviancy up, and seek to guarantee stability in our
economic affairs?
I suspect that, for a time, policymakers will be more attracted to this latter path. Stability
is a fine goal, but it is not a final one. Long after panic conditions have ended, stability threatens
to displace economic growth as the primary macroeconomic policy objective. But we must
recognize that the singular pursuit of stability, however well intentioned, may end up making our
economy less productive, less adaptive, and less self-correcting--and in so doing, less able to
deliver on its alluring promise. This fate, however, does not have to be ours. The U.S. economy
is capable, in my judgment, of delivering more.
The Growth Experiment5
This most recent boom and bust is not, as they say, our country’s first rodeo, but it may
turn out to be the most consequential since World War II. And, here, I am not just talking about
the near-term peak-to-trough changes in growth and employment levels, which are likely to
prove significant.
Policymakers are revealing new policy preferences and prescriptions--fiscal policy, trade
policy, regulatory policy, and monetary policy, chiefly among them. Long after the official
recession ends, the choices being made may significantly alter the contour of the U.S. economy.
The harder question that remains is whether these changes will prove beneficial.


The term “Growth Experiment” was coined two decades ago to describe certain pro-growth tax policies. See, for
example, Lawrence B. Lindsey (1990), The Growth Experiment: How the New Tax Policy Is Transforming the U.S.
Economy (New York: Basic Books). I, however, am referencing a broader range a macroeconomic policies.

-3From the mid-1980s through 2007, U.S. real gross domestic product (GDP) growth
averaged more than 3 percent per year, and was less volatile than in previous decades. The
average unemployment rate was less than 5-3/4 percent, a full percentage point less than in the
previous 15 years. Most notable was the realized acceleration in labor productivity in the mid1990s.
The bipartisan, pro-growth policies that predominated during this period contributed
meaningfully to these gains. Tax and spending decisions generally sought to expand the
economic pie. Trade policies were aimed at opening new markets to U.S. products and services,
and removing barriers domestically. Regulatory policies permitted failure, and relied in equal
parts on capital requirements, regulatory standards, and, no less important, market discipline. As
a result, businesses were well positioned to adopt new efficiency-enhancing technologies and
processes to excel in the pro-growth environment. These policies helped drive significant
productivity gains, and remarkable U.S. and global prosperity.6
I do not mean to suggest that the period that preceded the crisis was a golden age. It
wasn’t. Even during this seemingly enviable, secular period of prosperity, the U.S. recessions of
1990-91 and 2001 remind us that periodic, cyclical weakness occurs. The labor markets
deteriorated during these downturns, and at great costs to many families and communities. But
these periodic deviations were accepted, in some sense, by the body politic. There were lessons
to be learned, reforms to be implemented, and public and private practices to be improved upon.


Since 1980, the performance of the world economy has proved strong. Real world GDP grew by approximately
145 percent from 1980 to 2007, a compound average of about 3.4 percent per year (Becker and Murphy (2009)).
They also contend that even if the current recession were to be deeper and more prolonged than contemplated by the
most pessimistic forecasters, global annual growth rates would still average better than 2.7 percent from 1980 to
2010, with per capital incomes rising a total of about 40 percent over the period. See Gary Becker and Kevin
Murphy (2009), “Do Not Let the ‘Cure’ Destroy Capitalism,” Financial Times Magazine, March 19,

-4But the broad outlines of the growth experiment forged on, and were judged by most to be
largely a success.
Hence, the relative stability that earned the Great Moderation its enduring moniker is not,
in my view, the greatest economic accomplishment of the past few decades. The acclaim should
be assigned to the resulting economic boom that massively increased economic output and living
standards. Maximum sustainable growth, not stability per se, was the predominant policy goal.
Strong growth, of course, was made possible, in part, by the low volatility that marked the
period.7 Firms choose to invest more, for example, in less volatile economic conditions. But,
pro-growth policies were the coin of the realm.
But, as I remarked to another group of international financiers more than two years ago:
“The Great Moderation…is neither a law of physics nor a guarantee of future outcomes. It is
only a description--an ex post explanation of relative prosperity. If policymakers and market
participants presume it to be an entitlement, it will almost surely lose favor.”8 Well, warnings
notwithstanding, it was treated like an entitlement by far too many in the private and public
sector, and as a result, lost considerable favor.
The Panic of 2008
Has the experience of the last 20 months caused the findings of the vaunted growth
experiment to be fundamentally revised? During this recent period of turmoil, the imponderable,
or what was previously thought to be virtually impossible, happened with great speed and force


Whether by good fortune or good policy, between the start of the Great Moderation in the mid-1980s and the end
of 2007, the standard deviation of annualized quarterly real U.S. GDP growth was 2.1 percent, less than half as large
as its value over the two previous decades.
Kevin Warsh (2007), “Market Liquidity: Definitions and Implications,” speech delivered at the Institute of
International Bankers Annual Washington Conference, Washington, March 5,

-5and frequency.9 Asset prices plummeted, and market volatility reached its highest level in
decades. Financial market functioning was deeply impaired across most asset classes and
geographies. As a result, the U.S. economy endured a sudden stop. In the final quarter of last
year and the first quarter of this year, private employment registered the largest two-quarter
percent decline since the mid-1970s, and real GDP saw the most dramatic decline in a halfcentury.
These data are clearly indicative of significant deviance, and justifiably raise questions
about the success of the growth experiment. Policymakers are rightly disposed to react, respond,
and revisit the presumed record of accomplishment. In revising the historical record, however,
we should not too hastily discount the preceding period of prosperity. We must avoid a classic
case of what behavioral economists term “availability bias,” when decisions made are influenced
disproportionately by more recent events.
Ultimately, I will leave it to economic historians to assess whether the Panic of 2008 was
more anomalous than the period of prosperity that preceded it. I believe that the categorization
of recent events as deviant, ultimately, will depend on what happens next. That is, if policy
changes cause future economic performance to suffer, then the boom of the last generation may,
regrettably, turn out to be more exceptional than the bust.
The Stability Experiment
That new policies are being implemented during a period of economic turmoil is no
coincidence. These new preferences reveal much about the type of economy to which
policymakers aspire. And to be clear, the stability experiment appears well intended. It aspires
to manage the economy with greater care and more expansive and effective regulation, as well as


Kevin Warsh (2009), “The Panic of 2008,” speech delivered at the Council of Institutional Investors 2009 Spring
Meeting, Washington, April 6,

-6a larger and more persistent role for government action, and an increase in home bias in global
Advocates of the stability experiment--each guided by their own compass--seem all too
inclined to announce that the growth experiment has ended, and to conclude that the results are
deeply disappointing. They seem to prefer to define deviancy up, wishing to assure an uncertain
citizenry. If government policies are corrected, and private practices are made more prescriptive,
they argue, the ship of state can ensure that the real economy avoids rough seas altogether. The
political economy confirms the policy response: Policymakers may pay greater attention to
insuring against rare bad events--to which they could be held to account--than to allowing scores
of great things to flourish.
As I mentioned at the outset, stability, in the sense of lower macroeconomic volatility, is
a fine objective, but it is not a final one. The conduct of monetary policy, for example, aims to
achieve price stability throughout the economic cycle. But central bankers do so because we
believe it is the precursor to strong and sustainable growth. If other policies--notably, those for
fiscal, regulatory, and trade--treat stability as the ultimate objective, then we might find ourselves
with lower growth and diminished economic potential.
Reform efforts are sorely needed, and practices demand marked improvement. But
policymakers are wise to resist the hubris that most recently afflicted actors in the financial
I describe this mix of new pro-stability policies as an experiment for good reason. It
might deliver on its promise of lower volatility, lower unemployment, and higher growth over
the course of a generation. But, it might not. The costs of the stability experiment might turn out
to be large. Necessarily and hastily crafted when the financial crisis began, the stability

-7experiment is likely to survive far longer than the panic that preceded it. It is surging in
popularity and is likely to grow in application, particularly if, as I suspect, the economic picture
Incipient Recovery
Since mid-March of this year, financial conditions have continued to improve. Panic
conditions are showing signs of retreat. Asset prices are rebounding, searching for a new
equilibrium from their panic-induced depths--both in the United States and across the vast
majority of our trading partners. And this improvement in markets coincided with the arrival of
the proverbial green shoots of spring. This gloss of recovery is appealing, of course, and not
only to central bankers.
I, like you, am rooting for the positive trend to continue. But, in my estimation, the rather
indiscriminate bounce off the bottom--across virtually all assets and geographies--may be more
indicative of a one-time reset, which may or may not be complete. I would be more comfortable
going forward if we observe more dispersion in the valuations of particular assets and greater
differentiation across asset classes and geographies.
The panic’s hasty retreat should not be confused with robust recovery. For economic
performance will turn ultimately on the force of private final demand; and for now, it remains
weak. Real consumer spending rose only modestly in the first quarter of this year, after dropping
sharply in the second half of last year. Businesses reduced real spending at an annual rate of
more than 35 percent and continued to cut their workforces. Real exports fell at an annual rate of
close to 30 percent.
The trauma experienced by businesses and consumers coming out of the panic should not
be underestimated. Notwithstanding recent encouraging signs that the contraction is abating, I

-8would expect business capital expenditures and consumer spending to continue to disappoint for
the next several quarters. Even if, as I expect, the United States emerges from this recession
sooner than our advanced foreign trading partners, I am still very cautious about predicting a
sustained run-up in net exports so soon after the virtual collapse of global trade.
Exceptional fiscal expenditures, by their own terms, are intended to replace shortfalls in
aggregate demand. And recent extraordinary monetary policy actions are intended to lower riskfree rates and grow balance sheet capacity to help offset the pullback by private financial
intermediaries. But financial markets may extract penalty pricing if fiscal authorities are unable
to demonstrate a credible return to sustainable budgets. And they are unlikely to look kindly on
monetary authorities unless they decidedly and unambiguously chart their own independent
paths. The Federal Reserve should not--and will not--compromise another kind of stability-price stability--to help achieve other government policy objectives.
On balance, I would not be surprised if these countervailing forces--unprecedented public
support and underwhelming private demand--fight to a draw by the fourth quarter. But the scale
of stimulus and the recent blow to the real economy are both lacking precedent, so predicting the
victor is tough business. Of course, the extraordinary monetary and fiscal support may prove
more efficacious in the near term than I expect, leading to a continued easing in credit
conditions, a slowdown in the rate of deleveraging, improved inventory levels, and better
quarterly economic statistics. Even so, the benefits of stimulus are likely to wane. More
important, unemployment rates, in my judgment, are likely to remain higher and linger longer
than in recent recessions. The “jobless recovery” may prove to be a familiar and vexing refrain.

-9As a wise Stanford mentor of mine coined many years ago, “The economist’s lag is a politician’s
Medium-Term Prospects
The rebalancing of U.S. GDP and global demand is likely to require some patience.
During the transition, there may well be political impetus for still more-aggressive
macroeconomic policies. In evaluating new measures, however, policymakers’ predominant
interest should be ensuring the credibility of their fiscal and monetary frameworks. For, if
macroeconomic policies were to become unanchored, or misunderstood by markets, continued
government aggressiveness could prove counterproductive.
The global economy runs the risk of being mired in a period of slower growth for several
years to come. Some portion of the subpar economic performance may be owed to the normal
capital and labor reallocations that take place during recoveries. And given the serious
misallocations that marked the onset of this recession, there is good reason to believe that the
period of reallocation will be deeper and last longer. A reduction in the size of the finance and
housing industries, for example, is well under way. Efforts to forestall those changes, in my
judgment, are unlikely to succeed as promisingly as advertised. But perhaps a larger risk is that
changes in public policies may, in the pursuit of stability, hold down the growth of the U.S.
economy over this period.
Simple textbook models tell us that a nation’s output is the product of the number of
hours worked and the output produced per hour. In thinking about the medium-term prospects
for the economy, I find it useful to consider these two factors separately.


See George Shultz (1993), Turmoil and Triumph: My Years as Secretary of State (New York: Charles Scribner’s

- 10 Output per hour, or productivity, is the secret sauce to U.S. economic growth and to
rising living standards, but I fear that the recipe may have lost some key ingredients. Growth in
labor productivity arises when a firm’s workers use more and better physical capital, or when
firms become more efficient at converting inputs into output. Innovation plays a key role, both
because it directly boosts efficiency and because firms’ decisions to invest in physical capital
tend to depend on the underlying pace of innovation. In addition, in today’s economy, the
productivity of many firms relies heavily on intangible, or intellectual, capital; although hard to
measure, intangible capital appears to also be tied to innovation.
To be concrete, from 1995 through 2007, U.S. labor productivity growth in the nonfarm
business sector averaged about 2-1/2 percent per year, a marked improvement from the 1-3/4
percent pace that marked the prior quarter century. This period of rapid growth in labor
productivity was driven by large capital investments, significant improvements in management
processes, and remarkable advances in technology. Looking ahead, if policy is less encouraging
of capital accumulation, or returns to innovations are constrained by policy, we may find a
material reduction in the growth rate of productivity and living standards.
The level of support that the financial system is capable of providing also remains highly
uncertain. Private financial institutions are now understandably slow to create new products that
connect savers and investors. Although it is undesirable to revert to the excessive risk-taking
that preceded the crisis, current financial practices seem suboptimal in promoting economic
growth. Furthermore, repeated interventions by the public sector run the risk of causing
systemically significant institutions to operate more like public utilities than efficient allocators
of capital and proper arbiters of liquidity.

- 11 Productivity may also suffer at the hand of policies that discourage trade. Trade
enhances productivity by promoting efficient specialization, permitting economies of scale, and
increasing the potential returns to innovation.11 However, the bipartisan consensus favoring free
trade appears broken, with each political party internally divided on the question. Given the
contention, however imprecise, that Anglo-American-style capitalism caused the turmoil, there
may be a shortage of credible and persuasive voices to fight the growing global tide of economic
As for hours worked, the other key determinant of output, the risks seem unmistakable.
We have grown accustomed to falling natural rates of unemployment during the last two
decades. Even when unemployment spiked during recent recessions, the prevailing rate found its
way to still lower levels. According to most economists, the non-accelerating inflation rate of
unemployment (NAIRU) was in the neighborhood of 5 percent prior to the financial crisis.
Looking ahead, I could well imagine that the natural rate of unemployment trends higher.
Historically, small businesses have tended to be the largest drivers of new job creation. But how
they will respond if macroeconomic policies favor stability over growth is difficult to predict.
The answer may ultimately depend on their access to growth capital and liquidity given the
changing mix of public policies and private practices.
More generally, I believe that the dynamism of the U.S. economy contributed critically to
pre-crisis levels of employment. The remarkably low level of the NAIRU was made possible in
part by the extraordinary churn in jobs seen in the U.S. economy. For example, over the 12
months preceding the start of the recession in December 2007, although 62 million people lost
their jobs, 63 million jobs were created. Policies aimed at limiting the range of economic

For a discussion of the benefits of trade in the modern global economy, see W. Michael Cox and Richard Alm
(2007), “The Best of All Worlds: Globalizing the Knowledge Economy,” in Federal Reserve Bank of Dallas: 2006
Annual Report (Dallas: FRB Dallas).

- 12 outcomes do not, in my view, keep unemployment rates low. These policies make it more costly
for firms to adjust the size of their workforces, thereby making employers more reluctant to hire.
Gauging trend growth in output and employment is essential to the proper conduct of
monetary policy. Broad changes in macroeconomic policies may make it more difficult for
central bankers to make such calculations. To the extent changed policies reduce potential
growth, or raise the natural rate of unemployment beyond recent estimates, it is more difficult to
make good and timely policy. We must keep a keen eye on these risks as conditions evolve.
Ironically, the longer that output and employment disappoint, the more attractive the
gloss of stability may become. As a result, we should evaluate the benefits and costs of the
stability experiment with a keen eye to guard against downside risks for the real economy.
Longer-Term Prospects
I have not lost confidence in the inherent innovation, creativity, and dynamism in the
U.S. economy. Nor have I lost confidence in the inherent good sense of our citizens. If the
stability experiment fails to deliver on its promise of higher employment and better economic
performance, then policymakers ultimately will change their prescriptions yet again. And so, in
the long term, after the final results of the U.S. experiments with growth and stability are finally
tabulated, the broader U.S. experiment in democratic capitalism will endure--and our economy
will emerge stronger than ever.