Recession Should Be Over Soon
Kurt Brouwer January 14th, 2009
This chart and the other chart below are from a report on the Vox blog. It was done by Nicholas Bloom, a Stanford economics professor, and Max Floetotto, a Stanford Ph.D candidate in economics.
This chart from the report shows the extreme volatility experienced in the U.S. stock market during October and November. It also shows that volatility — while still quite high — has fallen significantly.
Source: Voxeu.org and Bloom/Floetotto
Bloom and Floetotto had done an earlier report in which they forecast a deeper and longer recession. Now, they are a bit more optimistic, but they warn that any stimulus spending needs to be done quickly for it to have a positive effect.
The Recession Will Be Over Sooner Than You Think (Vox, January 12, 2009, Nicholas Bloom & Max Floetotto)
…Many pundits (e.g. Krugman) are warning that a dire recession is in the offing. We would have agreed with them three months ago; indeed, we wrote a VoxEU column predicting a severe recession in 2009; based on the analysis of 16 previous economic shocks, we forecasted a 3% drop in GDP and a 3 million increase in unemployment in each of Europe and the US with these predictions…
We also worried about a far worse outcome – Europe and the US slipping into another Great Depression due to damaging policy responses. Luckily, using the latest data on uncertainty measures, our model predicts that the worst has been avoided.
Good news: Great Depression II avoided and growth resumes mid-2009
Much like today, the Great Depression began with a stock-market crash and a melt-down of the financial system. Banks withdrew credit lines and the inter bank lending market froze-up. What turned this from a financial crisis into an economic disaster, however, was the compounding effect of terrible policy. The infamous Smoot-Hawley Tariff Act of 1930 was introduced by desperate US policymakers as a way of blocking imports to protect domestic jobs. Instead of helping workers, this worsened the situation by freezing world trade. At the same time policymakers were encouraging firms to collude to keep prices up and encouraging workers to unionize to protect wages, exacerbating the situation by strangling free markets.
In fact economic uncertainty is now dropping so rapidly that we believe growth will resume by mid-2009.
I’m impressed by this section because the authors acknowledge that they had previously been much more pessimistic and now, due to events, they have changed their minds.
This view that the economy will begin growing this summer makes sense in historical terms. The two previous recessions lasted only eight months and this one is already in its 13th month. Assuming growth resumes in July, the recession would have lasted 18 months or so, which is a little longer than the post-World War II average duration of a recession. The report continues:
Uncertainty is now falling
It now appears that the global policy response to the credit crunch has avoided repeating those mistakes. Instead, it has focused on delivering a massive dose of tax and interest rate cuts, and spending increases. Policies restricting free-markets have largely been avoided. This has calmed stock markets as the fears of an economic Armageddon have subsided. At the same time political uncertainty has dropped as world leaders have clarified their stimulus plans.
Figure 1 [see above] shows one measure of uncertainty – the implied volatility on the S&P 100 – commonly known as the financial “fear factor”. This jumped over three fold after the dramatic collapse of Lehman’s in September 2008. But it has fallen back by 50% over the last three weeks as both economic and political uncertainty has receded…
Source: Voxeu.org and Bloom/Floetotto
This second chart illustrates a range of potential effects from the stock market crash on overall GDP growth. The black line shows the likely outcome, with the dotted lines showing a broader range of possible outcomes, both better and worse than that shown by the black line. The report continues:
As uncertainty falls the economy will rebound
The heightened uncertainty after the credit crunch led firms to postpone investment and hiring decisions. Mistakes can be costly, so if conditions are unpredictable the best course of action is often to wait. Of course, if every firm in the economy waits, economic activity slows down.
But now that uncertainty is falling back growth should start to rebound. Firms will start to invest and hire again to make up for lost time. Figure 2 shows our predicted impact of the spike in uncertainty following the credit crunch. This is based on our detailed analysis of 16 previous financial, economic and politically driven uncertainty shocks. After falling by 3% between October 2008 and June 2009, we forecast GDP will rapidly rebound from July 2009 onwards…
To me, this report echoes the words President Franklin Delano Roosevelt uttered during the Great Depression, “We have nothing to fear, but fear itself.”
Bloom and Floetotto’s message is a little less stirring — we have nothing to fear, but uncertainty — yet, I think they are correct. Any human activity is diminished when those in it are beset by uncertainty. Businesses, families and other economic actors tend to cut back on planned activities, purchases and spending when they are uncertain about the future.
Here is just one example that illustrates how uncertainty is causing even government institutions to stop working on projects. The Orange County Register reports:
For the first time in campus history, UC Irvine is being forced to suspend construction on two major buildings due to a state financial crisis that’s also affecting other schools.
The university stopped building the 64,000 square foot Arts Building on Monday night. The $42 million building is 36 percent completed. And the campus only has enough money to keep constructing the new Telemedicine/Medical Education Building through the end of January. The$40.5 million, 67,000 square foot building is 40 percent complete.
The state budget crisis isn’t expected to be resolved by late January, meaning that work on the Telemed building will come to a temporary halt.
“I can’t ever remember having to stop construction on a building, but we’ve never faced a financial crisis like this,” said Ray Dormaier, UCI’s vice chancellor of planning and budget…
Uncertainty is a self-fulfilling process. That is, some uncertainty tends to beget even more uncertainty. It causes companies and institutions to postpone or even cancel necessary projects and it causes families and individuals to put off purchases of all types of goods.
The idea that uncertainty begets more uncertainty is similar to the philosophy of hedge fund manager, George Soros, who wrote in his book, The Alchemy of Finance (Wiley), that markets are inherently reflexive. That is, buying begets more buying until a peak is reached and then selling begets more selling until a bottom is reached.
We have been in a strong selling cycle and, as Soros correctly pointed out, selling leads to more selling. This selling cycle has been driven in part by uncertainty and fear.
With the uncertainty curve seemingly headed down, it follows that market volatility will also diminish a bit. Assuming uncertainty and volatility are diminishing, at some point the stock market selling will end and a buying cycle will begin.
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That excerpt on UC Irvine reminds of my freshman orientation, the Chancellor joked that UCI stood for Under Construction Indefinitely. I guess I need to make an Alumni contribution.
All this financial stimulus yet our all cash/no debt/low overhead business is having a difficult time obtaining a loan to purchase an additional unit. We have a million in cash saved for this expansion yet all the partners are having to submit their own personal financial statements. Out of the nine banks called only two banks (both small state banks) have responded. In the end we’ll probably get a fair interest rate for the loan and move forward, however the fact remains, the banks are not lending even to those who have exceptional financial standing.
I don’t known how we will move out of anything if so much of everything in the economy (except government spending) is still frozen.
In any case, forget Wall Street, NYC is now ‘zombie land’.
Chris, thanks for the chuckle. I never knew that was the inside joke at Irvine.
Kurt quotes George Soros:
“…markets are inherently reflexive. That is, buying begets more buying until a peak is reached and then selling begets more selling until a bottom is reached.”
I have a simile for this: the lag time between putting on the brakes and when the vehicle comes to a stop.
The larger and faster the vehicle, the greater the distance it must travel before coming to a stop, even when brakes are applied. Factor in oil slicked or muddy roads, and the braking distance will be even more prolonged.
(And in the real world of flesh, metal and asphalt, the brakes must be applied slowly and carefully, especially if one is on a motorcycle or bicycle, otherwise the ride risks going over the handlebars.
Likewise, the captain and crew of a boat under full sail in gale force winds probably have to take a much longer time slowing her down, before their boat can be safetly and gently brought to port and then returned to her berth.)
The greater the momentum, the longer the distance before the vessal or vehicle slows down, no matter how powerfully the brakes are applied.
The markets have been analogous to a Formula One race car going at top speed on an oil slicked road.
Once the brakes are applied, our hypothetical Formula One would have to make a good number of turns around the track just to slow down before the driver can bring it to a full and complete stop.
By contrast, someone gently coasting down the road in a Toyota, engines off, could bring that vehicle to a stop fairly quickly.
Bloom and Floetotto’s model is intriguing. The problem with most other macroeconomic models is they fail to take into account uncertainty.
Nevertheless, I don’t think we should get too optimistic just yet. First of all according to the model, the economy always bounces back quickly after an uncertainty shock. That clearly was not the case in 2001-2003 when unemployment continued to rise for 7 quarters after the trough in GDP. Secondly, their recent conclusions are based on the assumption that uncertainty, at least as modeled by their stock market proxy, is coming down permanently. I’m not so confident that that is the case. Third, although they have applied their model to the case of the Great Depression, most of their modeling relies on relatively minor economic uncertainty events such as the Cuban Missle Crisis or 9/11. The level of uncertainty that resulted from the financial crisis really has only one other precedent in modern American history, as shown by their own data, and that is the Great Depression. Of course that level of uncertainty was maintained for over four years. But it had many ups and downs and as I stated earlier this may just be a temporary lull in the uncertainty. Also, the international empirical evidence on major financial crises is not very encouraging. Rogoff released a paper recently on financial crises that showed that in such events GDP reaches trough on average 1.9 years after the beginning of the recession/crisis and unemployment reaches trough 4.8 years after the beginning of such an event:
http://www.economics.harvard.edu/faculty/rogoff/files/Aftermath.pdf
As it is, what their model shows is pretty horrific. A 3% decline in GDP from October 2008 through June 2009 would be consistent with what many people are now forecasting: a 6% decline in GDP in 2008Q4, a 4% decline in 2009Q1 and a 2% decline in 2009Q2 (all at an annual rate). Without a stimulus, based on the empirical evidence on major financial crises, and the experience of the previous recession, I suspect that the economy will not bounce back as quickly in the second half of the year as this model suggests. We probably will have two more quarters of negative growth and several quarters of rising unemployment after that. With a stimulus on the other hand, and based on Romer’s calculations, I would say the turnaround may start a quarter earlier and unemployment might not rise for as long afterwards. Either way I don’t think things will bounce back as quickly as the authors of this model think.
This article and the commentary does not look at the entire picture. The driving force behind low volatility and growth was easy access to credit. All bubbles are credit led and busts are lack of credit driven. The VIX is hardly an appropriate measure of credit availability or economic output. Furthermore it is total debt in the system that matters and the Fed stimulus packages is but a drop in the bucket against the >$50T debt outstanding. Deflation is happening. This recession will not end in 09 or even 2010. See Japan. Learn.
Mark — Thanks for your thoughtful comment.
I have read Rogoff’s paper and I think the timeline Bloom/Floetotto give is consistent with Rogoff’s findings, at least in terms of GDP trough. 1.9 years from the beginning of the recession (Dec 2007) would be July -August 2009.
In terms of the authors’ market volatility chart, there is corroboration for that to an extent in the CBOE Volatility Index (VIX), which is at 50 now, but hit a high of 80 in the Fall.
You say, ‘…without a stimulus… I think you must mean without additional stimulus because we have already had fiscal and monetary programs designed to improve economic output. No doubt there will be more, but quite a bit has already been attempted.
DB — Nice analogy. The faster you are going, the harder it is to stop. And, if you do crash, the more intense the impact.
Jim — I think you misunderstood the post. Looking at the VIX or another measure of stock market volatility was done to estimate uncertainty, not credit availability or economic output.
I do agree that the economic malaise in Japan is worth studying and we did just that some time ago. Here is the post Bubbles, Bailouts and Bankruptcies. In that post, I suggest that our current attempt to boost long-term economic output with infrastructure spending is unlikely to succeed.
Kurt,
I don’t want to nitpick (actually I do, it’s my favorite hobby), but by my calculations 1.9 years from the beginning of December 2007 would take you to late October 2009, which implies a trough in the fourth quarter (assuming this crisis is exactly like the international average).
I hope you’re right about the decline in uncertainty. One thing I’ve noticed is that stock market volatility seems to correlate with measures of credit market tightness such as the TED spread. The TED spread has shown considerable improvement in the last few months but it is still higher than it was prior to June 2007, and is higher than it should be, theoretically, if the credit markets were working smoothly.
And although Bernanke is pulling his levers as furiously as the Wizard of Oz did behind the curtain, he still is not having much real effect on the economy. The transmission of monetary policy, the financial markets, are badly damaged, and they need an overhaul (more automotive metaphors). That is why even many monetarists are now calling for a fiscal stimulus. Unfortunately although fiscal deficits we’re running already are huge, I think that they’re going to have to get even bigger, at least until monetary policy regains its effectiveness.
One more thought while I’m here. I forgot to mention this the first time. The recovery from the 1990-1991 recession was also painfully slow. It took 5 quarters from the trough in GDP before there was a peak in unemployment. For whatever reason, this seems to be a characteristic of recent recessions. Yet another reason why I think this recovery is going to take a long time.
Mark — I’m glad you’re nitpicking. It’s always helpful and it means you’re paying attention. I think the report from Bloom/Floetotto is good news, but certainly it’s not definitive that they are correct. However, whether we are talking July or September or October of this year, that constitutes pretty soon in my book.
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