The recession will be over sooner than you think

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 made from VAR forecasts (see Bloom 2008 for details).

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.

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 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. Other measures of uncertainty have also fallen; this is even true for the frequency of the word “uncertain” in the press!

bloom%20fig%201%281%29.jpgAs 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.1

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. bloom%20fig%202%281%29.jpgSo it’s now or never for expansionary policy Many economists make the case for a stronger policy response. That might be right, but policy makers need to act fast. Any additional economic stimulus – be it a spending package, quantitative easing or a couple of rounds of liquidity injections – has to be enacted quickly. Dithering over different courses of policy will actually make things worse by adding uncertainty (see Caballero 2008). This is exactly what happened after 9/11 when the Federal Reserve Board criticized Congress for creating unnecessary uncertainty with its lengthy debates on investment tax credits.

Delaying the stimulus package until the summer may mean that it is too late. The economic medicine will be administered just as the patient is trying to leave the hospital!

References Caballero, Ricardo (2008). “Normalcy is Just a Few Bold Policy Steps Away,” December 17, 2008.

Bloom, Nick, Max Floetotto and Nir Jaimovich (2008). “Really Uncertain Business Cycles.”

Bloom, Nick (2008). “The Impact of Uncertainty Shocks,” Stanford mimeo, forthcoming Econometrica.

Krugman, Paul (2009). “Ideas for Obama,” New York Times column, 11 January 2009.

Footnotes 1 See “Really Uncertain Business Cycles” by Bloom, Floetotto and Jaimovich for a more detailed discussion ; here is the abstract from that paper: “This paper proposes uncertainty shocks as a new impulse driving business cycles. We first demonstrate that uncertainty, measured by a number of proxies, appears to be strongly countercyclical. When uncertainty is included in a standard vector-auto-regression, uncertainty shocks lead to a large drop and rebound in economic activity. Guided by this we build a stochastic dynamic general equilibrium model that extends the benchmark neoclassical growth model along two dimensions. It allows for heterogeneous firms with non-convex adjustment costs for both capital and labor, and time varying uncertainty defined as fluctuations in the variance of technology shocks. Increases in uncertainty lead to large drops in employment and investment. This occurs because uncertainty makes firms cautious, leading them to pausing hiring and investment. This freeze in activity also reduces the reallocation of capital and labor across firms, leading to a large fall in productivity growth. Taken together, the freeze in the hiring and investment, and the drop in relocation, lead to a business cycle sized drop and rebound in output, investment and productivity growth after a rise in uncertainty.”

Originally published at Vox and reproduced here with the author’s permission.

17 Responses to "The recession will be over sooner than you think"

  1. Guest   January 14, 2009 at 9:18 am


  2. Darla   January 14, 2009 at 10:56 am

    Oh my poor dears! Did you fall and hit your heads?

  3. Glenn   January 14, 2009 at 11:43 am

    ABSOLUTELY incredible that your turnaround revised expectations appear to be driven by one positive yet minor variable of measured volatility. You must be drinking Jones kool-aid?

  4. ex VRWC   January 14, 2009 at 11:46 am

    HAW HAW, this is such great timing! An article whose premise is entirely about the VIX drop posted on a day when it rises 20%!This deserves a round of ‘Send in the clowns!’Send in the ass clownsSend in the ass clownsDon’t bother, they’re here

  5. Anonymous   January 14, 2009 at 11:51 am

    Uncertainty is beginning to increase again, now that it is clear that the same old bubble politics are the prescription. More disaster. Who are these idiots?John Ryskamp

  6. Guest   January 14, 2009 at 11:53 am

    Check out their backgrounds: two corrupt, unmoored academics. Shouldn’t they be executed?

  7. Anonymous   January 14, 2009 at 12:23 pm

    This doesn’t look like it will hold!What about the 6,000,000 predicted to lose their jobs this year?

  8. Amar Harolikar   January 14, 2009 at 1:44 pm

    Relationship between implied volatility and business cycles is very interesting. I agree that we’ll have an inflexion point around middle of 2009, however I really doubt a positive GDP happenning in H2 2009. H2 2009 is likely to range between plus and minus 1%. 2010 will probably have consistent positive GDP growth but again most likely around 1% range.Amar Harolikar

  9. Guest   January 14, 2009 at 3:32 pm

    The momentum factor is going to make even 2010 seem like a recession for a lot of people even if the GDP figure recovers…It will be interesting to see when the stock market recovers -usually what 6 months before a real recovery- so when does that put it??

  10. aciduzzu   January 14, 2009 at 6:57 pm

    this type of thinking leads to great depressions. and intelligent readers own mini depressions.

  11. iconoclast   January 15, 2009 at 2:11 am

    Dream on.Skate to where the puck is going, not to where it is!

  12. Guest   January 15, 2009 at 6:26 am

    If only the cure for a debt crisis was more record government and consumer spending. The authors haven’t lived long enough but will now have the opportunity to round out their PHD’s with some sobering real world experience in the coming years.

  13. Guess   January 16, 2009 at 2:28 am

    That’s a troll!See them laughing at you on the page

  14. ph. klein   January 16, 2009 at 6:12 am

    Sentiment analysis is clearly underrepresented in economics. And this is true while “psychological factors” determine the economic developments on the way up as well as down far more than ever before, especially due to the “Information Age” in which we all live and act. Yes, I can see a chance that the necessary evolution of this crisis can be sped up immensely by a much faster digestion of information, leading to much faster corrections of imbalances, which is what this crisis is about.The relationship of certainty and uncertainty is particularly interesting. In the stock market positive certainty unfolds amidst low volatility and appears to last longer. Uncertainty leads to higher volatility and is relatively short-lived. Negative certainty peaks again with low volatility and marks nicely the end of a bear market.Not every bear market was followed by a recession, but I believe every market bottom preceded the end of a recession.

  15. Guest   January 16, 2009 at 7:19 am

    These weathermen have some very sophisticated tools to help them forecast the weather. They are missing one tool, a window.

  16. Anonymous   January 16, 2009 at 9:40 am

    If VIX stays low, maybe. But how do we know that VIX will not rise again? On the graph, Gulf War I has two peaks, not just one.Also, there is a difference between a systemic and non-systemic crisis. With the systemic crisis like the one we are in, there are reams of difficult to anticipate unpleasant domino effects.Has anyone tried to construct a synthetic VIX back to the Great Depression?

  17. The End of the Tether   January 17, 2009 at 5:27 am

    I’ll have a nice Sunday reading again Joseph Conrad’s “Typhoon”; from what I remember of it, I’m sure I’ll be laughing reading it in the prospects of certainty and uncertainty.I nice sunday to you all anyway.