The Credit Crunch May Cause Another Great Depression

Back in June 2008 I wrote a piece for VOXEU predicting a mild recession in 2009. Over the last few weeks the situation has become far worse, and I believe even these pessimistic predictions were too optimistic. I now believe Europe and the US will sink into a severe recession next year, with GDP contracting by 3% in 2009 and unemployment rising by  about 3 million in both Europe and the US. This would be the worst recession since 1974/75. In fact the current situations has so many parallels with the Great Depression of 1929-1932, when GDP fell by about 50% in the US and by about 25% in Europe, that even my updated predictions could again be over optimistic.

Uncertainty is higher then it’s been in 20 years

One of the most striking effects of the recent credit crunch is the huge surge in stock market volatility this has generated. The uncertainty over the extent of financial damage, the identities of the next banking casualty and the unpredictability of the policy response have all led to tremendous instability. As a result the implied volatility of the S&P100 – commonly known as the index of “financial fear” – has more increased almost six-fold since August 2007. In fact since the outbreak of the Credit Crunch it has jumped to levels even greater than those witnesses after the events of the 9/11 Terrorist attacks, the Gulf Wars, the Asian Crisis of 1997 and the Russian default of 1998 (see Figure 1).

But after these earlier shocks volatility spiked and then quickly fell back. For example, after 9/11 implied volatility dropped back to baseline levels within 2 months. In comparison the current levels of implied volatility have been building since August 2007 and are likely to remain stubbornly high.

But even these more moderate surges in uncertainty after these earlier shocks had very destructive effects. The average impact of the sixteen shocks I examined in prior research[1] was to cut GDP by up to 2% in the following six-months. The current shock is both larger than these on average and also appears to be more persistent. If these earlier temporary spikes in uncertainty led to a 2% drop in GDP the impact of the current persistent spike in uncertainty is likely to be far worse.

The rise in uncertainty and banking collapse look like the Great Depression

For a broader historical comparison to the credit crunch we can also go back 70 years to the Great Depression. This was the last time that volatility was persistently high (Figure 2). 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. The Federal reserve board desperately scrambled to restore calm but without success. What followed was massive levels of stock-market volatility and a recession of unprecedented proportions. From 1929 to 1933 GDP fell by 50% in the US and about 25% in Europe, a bigger drop then in every recession since World War II combined. On these numbers a recession not only looks almost inevitable, but its longer run effects start to become alarming.

So why is this banking collapse and rise in uncertainty likely to be so damaging for the economy? First, the lack of credit is strangling firm’s abilities to make investments, hire workers and start R&D projects. Since these typically take several months to initiate the full force of this will only be fully felt by the beginning of 2009. Second, for the lucky few firms with access to credit the heightened uncertainty will lead them to postpone making investment and hiring decisions. It is expensive to make a hiring or investment mistake, so if conditions are unpredictable the best course of action is often to wait. Of course if every firm in the economy waits then economic activity slows down. This directly cuts back on investment and employment, two of the main drivers of economic growth. But this also has knock-on effects in depressing productivity growth. Most productivity growth comes from creative destruction – productive firms expanding and unproductive firms shrinking. Of course if every firm in the economy pauses this creative destruction temporarily freezes – productive firms do not grow and unproductive firms do not contract. This leads to a stalling productivity growth.

And much like the Great Depression politicians may make this worse

Finally, on top of the survey in uncertainty and collapse in credit we also have the specter of a damaging political response. One of the major factors compounding the Great Depression was that politicians moved to hinder free trade and encourage anti-competitive practices. The infamous Smoot-Hawley Tariff Act of 1930 was introduced by desperate US policymakers as a way of blocking imports to protect domestic jobs, but helped worsen the recession 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. The current backlash against capitalism could lead to a repeat, with politicians swinging towards the left away from free-markets. This happened after the Great Depression, it happened after the major recession of 1974/75 and I think it will happen again now. This will lock in the short-run economic damage from the current credit crunch into longer run systematic damage from anti-growth policies.

So the current situation is a perfect storm – a huge surge in uncertainty that is generating a rapid slow-down in activity, a collapse of banking preventing many of the few remaining firms and consumers that want to invest from doing so, and a shift in the political landscape locking in the damage through protectionism and anti-competitive policies.

An inconvenient recession

In fact the only upside of all this is the massive slow-down in economic growth will rapidly cut the growth rates of CO2 emissions.  Pollution is tightly linked to the level of economic activity, so that a few years of negative growth would lead to reductions in pollution levels not seen since the 1970s. It seems ironic that the greed of Wall Street may have inadvertently achieved what millions of well intentioned scientists, activists and politicians have failed to achieve – a slow down Global warming.



[1] “The impact of uncertainty shocks”, National Bureau of Economic Research, working paper W13385.

10 Responses to "The Credit Crunch May Cause Another Great Depression"

  1. Guest   October 8, 2008 at 11:45 am

    Nothing like smiling while talking about a great depression. ABOLISH THE FRB

  2. Anonymous   October 8, 2008 at 1:57 pm

    I see that the stock market volitilty from the 1970’s and 1980’s is conveniently missing.Gee, I wonder why?

  3. Guest   October 8, 2008 at 3:57 pm

    what about the new economies and their role? They were not there in 1920-30ies?

  4. Mike   October 8, 2008 at 6:38 pm

    The current backlash against capitalism could lead to a repeat, with politicians swinging towards the left away from free-markets. This happened after the Great Depression, it happened after the major recession of 1974/75Certainly the Democratic party did not swing to the left after the 74-75 recession. They turned away from workings people and embraced the “new democrats” lead by Bob Strauss, who are pro-business. Current democrats are the party of Robert Rubin, and receive massive campaign donations from financial interest.It is time to give up “the free market” line. The market is many things, oligopoly, prone to inflate bubbles, but hardly free.

  5. Guest   October 8, 2008 at 7:19 pm

    Let’s hope CO2 production does declines rapidly! Unfortunately, the use of dirty energy may not taper dramatically. Investment in clean energy will waver and have less political sway. It’s time for economists to give up their anthropocentric, growth oriented, neoliberal economic mantra and act like they’re an integral part of the planet, rather than unconscienable apologists for ripping it off. All power to the microbes! Perhaps they will finally get in your ear? Please bone up on ecological economics and the work of Herman Daly, or we all may become fossils one day.

  6. JEFF   October 8, 2008 at 8:41 pm

    Forget about being ecocentric! We need to be energy independant. We should have been drilling for oil and exploiting the natural resources of this great country instead of having to keep the Middle East “Free” so to have their oil sold to us! Look how much money (that We Don’t have) has been spent protect that free flow of oil – How shameful – We should be building nuclear reactors for power, converting shale to oil and working on alternatatives as well. Plus – How about put in prison all of those Wall Street Execs who “stole” billions from the US taxpayers!

  7. Guest   October 9, 2008 at 6:32 am

    Can anyone tell how the banks will give credit to unemployed and tapped out consumers?

  8. Guest   October 9, 2008 at 6:04 pm

    I don’t understand. What does a great depression mean today? I own property – with a mortgage. I have a couple hundred grand in the bank. What does it mean to me?I am so confused.

    • Guest   October 10, 2008 at 8:29 am

      To “confused:” Better in the bank than in the stock market. I expect the gov to insure all bank deposits soon, but please be sure not to exceed the deposit insurance levels. Also expect some programs to help individuals with falling home values in addition to the gov’s already eliminating the tax on loan forgiveness on foreclosure.Two phrases keep running through my mind: “You can’t get a loan unless you don’t need one.” and “You find out who’s swimming naked when the tide goes out.” latter by Warren Buffet. Looks like we’re moving away from a time when businesses and individuals were able to finance themselves on credit to one in which they have to maintain a cash reserve in house. This is a change in culture that takes a while to achieve. It also will make the economy less efficient, as sitting on cash is less productive than investing it. The second phase will be a gradual rebuilding of trust between institutions. Only then will the credit culture be rehabilitated. I do remember that some people who lived through the Depression said it wasn’t all bad in that there was less focus on money and more on helping others. Good luck!

  9. Guest   October 10, 2008 at 8:55 am

    I am “confused.” Thank you for your response!