VoxEU Column Global economy

The credit crunch may cause another great depression

The crisis is shaping up to be 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.

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).

Figure 1. Daily US implied stock market volatility

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 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 were massive levels of stock-market volatility and a recession of unprecedented proportions.

Figure 2. Stock market volatility since the Great Depression

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 spectre 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 policy-makers as a way of blocking imports to protect domestic jobs, but helped worsen the recession by freezing world trade. At the same time policy-makers 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 that 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 slowdown in global warming.

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

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