Half-way to recovery

Last year I wrote a piece[1] predicting a severe recession in 2009. Based on my analysis of 16 previous economic shocks I forecast a 3% drop in GDP and a 3 million increase in unemployment in Europe and the US.[2] Unfortunately this looks to be reasonably accurate. But I also worried about a far worse outcome – the World slipping into another Great Depression due to a damaging policy response to the crisis. Fortunately this looks to be inaccurate.

I now think that the broadly pro-market consensus of the G20 governments means this worst case scenario has been avoided. Tariffs are not going to be dramatically raised in global trade wars. Governments are not regulating away free markets, and wholesale nationalizations of banks seem to have been avoided as well.

This has averted fears of an economic Armageddon by avoiding the major policy mistakes of the 1930s that led to the Great Depression. As a result uncertainty measured by implied volatility on the S&P 100 – commonly known at the financial “fear-factor” – has fallen back by more than 50% since its peak, and the stock market has begun to rise. I believe growth will resume by late 2009, and the half-way point of the credit-crunch may have passed.

Another Great Depression has been avoided

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.

As a result uncertainty is now falling

Figure 1 shows the implied volatility on the S&P 100 as a measure of uncertainty.


This jumped over three fold after the dramatic collapse of Lehman’s in September 2008. But it has fallen back by half as political uncertainty has receded. Events like the G20 meetings showed how international leaders have agreed to maintain free markets, albeit with sensible increases in financial regulation. But this agreement on a common global policy response is radical stuff. Having the Americans and the British agree with the French on anything is an achievement, and an agreement on a global plan for economic growth is more or less unprecedented.

But we are only half-way there as the extent of the damage to the economy is still very much uncertain. There is a sea of toxic assets whose value is unknown, and whose eventual victims remain unclear. As a result uncertainty has fallen, but to a level that before the Credit Crunch occurred only after extreme events like the 9/11 terrorist attacks.

The fall in uncertainty will help spur the recovery

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.[3] This big spike in uncertainty in the fall of 2008 was a major factor behind the recent rapid slowdown. 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.

So the good news is that no government is advocating to abandon capitalism altogether. Instead, they are applying the short-run therapy of massive tax and interest rate cuts, and the long-run therapy of stricter financial regulation. The patient sitting in the recovery ward now just has to pray that this treatment has no nasty side-effects.

 Nicholas Bloom

The Department of Economics, Stanford University, and The Centre for Economic Performance, London School of Economics

[2] The predictions are made from VAR forecasts. This VAR methodology is described in “The impact of uncertainty shocks”, forthcoming Econometrica, http://www.stanford.edu/~nbloom/uncertaintyshocks.pdf Our predictions use this methodology with a 3x uncertainty shock and a 30% stock-market fall.
[3] See “Really Uncertain Business Cycles” by Bloom, Floetotto and Jaimovich for a more detailed discussion http://www.stanford.edu/~nbloom/RUBC_DRAFT.pdf

57 Responses to "Half-way to recovery"

  1. NFrazier   April 18, 2009 at 2:41 pm

    “The patient sitting in the recovery ward now just has to pray that this treatment has no nasty side-effects.”Germany is spending on cars, the UK is supporting housing, Japan is buying back corporate bonds, and the US is propping up construction, housing, and “the banks.” The debt and excess supply imbalances that led to this crisis appear to be getting even worse (possibly just to win the next round of elections?).If fiscal tightening occurs, these policies create the risk of an even deeper recession. If fiscal tightening does not occur, then there is a risk of protracted stagnation at best – with sovereign default or devaluation increasingly becoming a possibility. It would appear that an even more ominous crisis may be necessary to develop the political will to do the heavy lifting.That heavy lifting will consist of allowing the sectors in excess supply to shed capacity (e.g. temporary nationalization & downsizing of several major US banks) and allowing sectors not in excess supply such as US exports, Chinese consumer demand, and education to add capacity.For example, if the US and China were to jointly agree to allow Chinese rural migrant workers (who are used to working around 100 hours per week for $100) to immigrate to the US to work in US factories at $20/hour and if these governments were to instead channel fiscal spending into funding this transition (e.g. provision for relocating expenses, funding for language classes & healthcare, etc), this crisis would be half over in the long term as well. Specifically, those workers would end up boosting demand for US housing again – the original fissure in the crumbling global economy. The sudden shortage of cheap labor in China would increase wages over there as well which would further increase demand for US exports and enable some of the existing factory workers in the US to keep their jobs. US factory workers that did get displaced could go into education and healthcare to meet the increasing demand for those services with the expanded US population. That’s the kind of heavy lifting that is needed.If this prototypical example seems like mere “musical labor-market chairs,” note that it acts like a tax on the Chinese exporters that were paying $1/hour wages. And as economists know, such an effective compression of tax brackets would boost aggregate demand (to meet excess supply) without adding to government debt indefinitely.

  2. NFrazier   April 18, 2009 at 3:29 pm

    Incidentally, I realize that the above illustrative fix to the current global imbalances would be outlandish to implement from a practical perspective. But that also gives an indication of how intractably the global political-economy is stuck in this mess.Ideally, the international community would put more pressure on foreign countries to raise the wages of their “cheap export labor” and break apart monopolistic business practices. It would also help if all countries not only adopted a free floating exchange rate, but if the US government would tax the froth off of gains in the US markets that foreign exporters like to park their dollars in. This would force the US dollar down and increase the real buying power of foreign labor’s wages even further. (Assuming that the dollar isn’t hoarded in reserves instead… but perhaps the WTO could do something in that case).

  3. NFrazier   April 18, 2009 at 3:45 pm

    While some of the above might appear to be pro-protectionist at first glance, it is actually promoting precisely the opposite policy: free trade between nations not only with respect to goods and consumers – but with respect to employees and employers as well.

  4. NFrazier   April 18, 2009 at 4:15 pm

    Furthermore, many still feel that the lessons of the Great Depression revolve around monetary policy mistakes made in the 1930’s.The above suggests that it was in fact the real imbalances in the 1920’s that ultimately needed to be corrected. In other words, if Germany had been fiscally tighter and the US dollar had been allowed to appreciate faster in the 1920’s, then Germany would not have suddenly found itself in the position of no longer being able to afford US imports and the US manufacturers would not have found themselves suddenly penniless and without work. Sustainable demand requires real compensation to those supplying the output that feeds that demand. When this condition is met, the real economy restructures around a balance of trade and debt-deflation is averted – as the remarkably solid external sector performance of Germany since WWII attests.So again, the choices of fiscal expenditure currently being pursued by old economies are not going to fix the underlying problems driving the crisis – it is going to make them even worse.

  5. NFrazier   April 18, 2009 at 4:36 pm

    Using the US-China imbalance as the prototypical model again, this suggests a variation on the solution to the current malaise. If China were to fund its current stimulus with gradual redemptions of its US bonds (instead of instructing its domestic banks to now begin working on indebting its domestic consumer – groan…), its domestic demand would rise, the dollar would fall, US demand would fall, its exports would rise, US employment would rise, and Chinese manufacturing labor would have the funds to – e.g. pay for training in the domestic services sector.Again, it would be the Chinese exporters who would be transferring wealth back to those who generated it.