How Bad Will the Downturn Be? Stylized Facts

The IMF released several chapters of the World Economic Outlook; one chapter entitled Financial Stress and Economic Downturns provides some insights into the ramifications of the current financial turmoil.


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Figure 4.7 from WEO (Oct. 2008). Notes: Sources: Haver Analytics; OECD, Analytic Database; OECD, Economic Outlook (2008); and IMF staff calculations. The difference between banking-related and non-banking-related episodes is significant at a minimum of 10 percent for quarters 0, 1, 2, 3, and 4. The sample is constant for all quarters. The difference between slowdowns preceded by banking-related financial stress and slowdowns not preceded by financial stress is significant at a minimum of 10 percent for t – 6 to t + 6. The sample is constant for all quarters.

So financial stress before a recession presages a statistically significantly more severe recession; the fact that it’s a banking type of financial stress (as opposed to say exchange rates or interest rates) suggests that it will be even worse than otherwise. Finally, the prevalence of arm’s-length finance (as compared to the bank-centric systems dominant in Europe) means that the impact will likely be even more negative in the US case.

From the chapter written by Subir Lall, Roberto Cardarelli, and Selim Elekdag:

Implications for the Current Crisis in the United States and Euro Area

Figure 4.15 compares data for the current crisis in the United States and euro area against the medians of selected macroeconomic variables around the beginning of the six major financial stress episodes examined above and against the averages for these variables across all financial stress episodes that were followed by recessions. The current imbalances and adjustments appear generally much smaller than those for the six episodes examined here, except for U.S. residential real estate investment and the U.S. current account.23 The patterns of credit and asset prices in the United States prior to the current crisis are very similar to those for the typical financial-stress-driven recession. The deleveraging process by households in the United States is proceeding faster than in the typical recession, although deleveraging by firms seems to be proceeding somewhat more slowly and from a stronger initial position. Finally, although bank assets remained robust during the second half of 2007, partly reflecting the reintermediation of off-balance-sheet commitments, the ratio of credit to GDP declined significantly in the first quarter of 2008, suggesting that the pace of deleveraging may have picked up (see also Chapter 1).

The current crisis is different for the United States in important ways from previous episodes. Corporate balance sheets and firms’ reliance on external financing were on a more solid footing entering the current crisis, which should provide some resilience. However, the sheer size of the U.S. mortgage market, which is at the heart of the crisis, and the role of residential investment suggest that household saving and consumption behavior may play a much larger role in the current downturn than in the past. On a positive note, the policy stance in the United States has been proactive, as exemplified by the aggressive cuts in policy rates and the measures taken to shore up liquidity in both commercial banks and investment banks. Moreover, banks have raised substantial amounts of capital, although continuing declines in the mark-to-market value of assets suggest that substantially more capital will be needed before the financial system can resume significant discretionary lending.

Overall, these results suggest that the economic impact of financial stress may be greater in the United States than in the euro area. The U.S. economic downturn may well become more severe and could evolve into a recession. The evidence for the euro area is more consistent with the pattern for a slowdown than a recession, and the dynamics also appear to be evolving with some lag.

While this last paragraph might seem obvious given recent events, it’s important to recall that this chapter would have been written at least several weeks ago (before being approved by the Executive Board), if not longer. Had this report come out before the collapse of Lehman Brothers, I would have bet a lot of criticism would have been leveled at the authors, arguing that the conclusions were alarmist. Indeed, a lot has changed in three weeks.

Some related findings were reported in a paper I discussed a couple months ago, here.

Financial picture of the day:


Figure from S. Sadeesh, Fixed Income Special Report: Money Market Monitor Deutsche Bank (October 6, 2008).

Originally published at Econbrowser on Oct, 6, 2008 and reproduced here with the author’s permission.

One Response to "How Bad Will the Downturn Be? Stylized Facts"

  1. Guest   October 10, 2008 at 10:14 am

    I’m so sick of idiot commentators saying ‘it could evolve into a recession.’ Pull your head out your butt. It’s been a recession, hidden by gov’t statistical massaging. The question is how severe the depression will be and if the dollar will survive once the gov’t is forced to either default or monetize its overwhelming debt.The free ride is over, now we have to pay for it.