Believe it or not, one of the most striking facts about the U.S. economy over the past 25 years has been the relative stability it has enjoyed—until all hell broke loose the last few months.

That may be difficult to believe today, given the severity of the strains on the financial system and the reigning panic in Washington and Wall Street. But until recently economists stood in wonder at the relative stability and prosperity of the American economy over the past couple of decades.

Ever since Fed Chairman Paul Volker wrung inflation out of the economy in the late 70’s and early 80’s, the United States and much of the Western world has enjoyed what most economists consider a golden age. Fed Chairman Ben Bernanke and other economists dubbed this age “The Great Moderation.”

What made this period unique was the combination of robust economic growth, tame inflation, short and mild recessions, and low unemployment. Periods of economic growth and decline during these 25 years were smoother and less disruptive than at any time in history, and the crises the economy faced were easier to contain and did less serious damage than in the past.

During this time crisis after crisis hit the economy: the Savings and Loan Crisis, the “Asian Flu,” the Russian default on their debt, the bursting of the dot com bubble and even the September 11th attacks. Each of these was damaging, but none of them tipped our economy into a 1982 or 1973 style recession, and certainly no threat of a crisis as severe as the Great Depression. In fact, the US economy pretty much hummed along despite these crises. At no period in history had an economy been able to sustain such serial shocks without serious consequences such as soaring unemployment and declines in GDP.

It was this stability in the economy that earned former Federal Reserve Chairman Alan Greenspan the title “Maestro”—reflecting the common belief that after nearly a century the Federal Reserve had finally mastered the art of managing the economy’s ups and downs.

These days there is little talk of the great moderation, except perhaps to wonder what happened to it. A sense of crisis, perhaps panic, rules the day. The stock market has recently experienced declines comparable to the recession of 1937, and each government attempt to stem the bleeding seems to inspire more panic. Economists seem to agree that a painful recession will hit America’s economy, and are arguing more about how long and severe it will be rather than whether it will come.

What can explain such a sudden reversal of both our fortunes and of economic opinion?

Perhaps one answer is the “great moderation” itself. Continued...