VoxEU Column Financial Markets

The uncertainty shock from the debt disaster will cause a double-dip recession

UPDATED: The potentially explosive combination of Eurozone debt contagion, vulnerable banking systems, and European and American political paralysis has pushed stock-market volatility to levels nearly as bad as the days following the 11 September 2001 terrorist attacks. Nobody knows what happens next. This column reviews research on 16 previous shocks and concludes that today’s uncertainty shock will create a short, sharp contraction in late 2011 of about 1% with a rebound coming in spring 2012.

Editor's Note: This is an UPDATE of the column first posted on 9 August 2011

In the ten days that have passed since posting my original warning, stock markets have swung wildly. Market makers are incredibly uncertain about the future.

  • Will Democrats and Republicans in the US manage to agree on how to deal with US debts?
  • Will Germany bail out the failing southern European governments?
  • Are there banks in the US and Europe that are going bust?

When there is this much uncertainty even the smallest rumour generates wild market swings. Mundane news can generate hundred-point swings. Good news sends the markets soaring. Bad news sends the markets crashing.

Six more weeks of panic according to historical patterns

So how long will this stock-market panic last? On average the previous 16 uncertainty shocks have had a 1.9 month half-life – this means it takes almost two months for the peak level of uncertainty to fall back by 50%. Hence, within about six weeks the current panic should have subsided (since it is already about two weeks old).

As I discuss below, this panic is likely to cause a double-dip recession in late 2011. The uncertainty will lead firms to pause hiring and investing until probably early 2012.

But despite my short-run pessimism, I’m very positive on long-run US and European growth. Why?

  • First, this disaster will help to push both continents to undertake long-needed reforms of retirement systems (particularly in Europe) and healthcare systems (particularly in the US).

Already countries like Greece are torching swathes of regulations, cutting back the public sector, and delaying retirement. In the US this disaster might be enough to initiate serious reforms to limit healthcare spending, to avoid this breaching 20% of GDP.

  • Second, the growth of China and India will continue to drive global growth.

These countries have decades more of high growth, and as they grow they will represent a larger share of the world economy, accelerating global growth.

In fact I am sufficiently optimistic in the long-run that today I even invested my tax rebate in the S&P index. So I certainly hope for a rapid recovery!


The US and European debt crisis of the last week have generated massive economic uncertainty. One measure of the economic uncertainty – the VIX index of stock-market volatility – has jumped to levels not seen since the crash of 2008.

Stock market volatility is now so high that it’s reached the level that occurred right after the 9/11 terrorist attack (see Figure 1) – a period of incredible political and economy uncertainty. Other measures of uncertainty are also spiking, like news headlines, and the frequency of the word “uncertain” in press reports (Alexopoulos, and Cohen 2008).

Right now nobody knows what is going to happen next.

UPDATED Figure 1 (see old version below). 

The research says: Uncertainly leads to recessions

I have studied 16 previous uncertainty shocks – events like 9/11, the Cuban Missile Crisis, the assassination of JFK – and the only certain thing about these is they lead to large short-run recessions (Bloom 2009).

When people are uncertain about the future, they wait and do nothing.

  • Firms do not to hire new employees, or invest in new equipment if they are uncertain about future demand.
  • Consumers do not buy a new car, a new TV, or refurnish their house if they are uncertain about their next paycheck.

The economy grinds to a halt while everyone waits.

Durables are the hardest-hit sectors

These uncertainty shocks hit hardest the sectors that make durables products – those like cars, TVs, and furniture. These are goods that we can wait to replace. These industries typically see massive falls in demand, often of well over 50% as people put off purchasing expensive new goods for another six months.

Based on my research, I predict another short, sharp contraction in late 2011 of about 1%, with a rebound in spring 2012. This research looks at the average impact of the previous 16 uncertainty shocks to predict the impact of future shocks. Typically these leads to reductions of growth of about 2% immediately after the shock, with a recovery about six months later once uncertainty subsides.

Using the same line of reasoning, I correctly predicted a similar recession before the Credit Crunch and conditions look depressingly similar this time around.

And I should point out this research is not all my own work. It builds on the research of a previous Stanford economics professor – Ben Bernanke. This professor published his work in a now forgotten paper called “Irreversibility, Uncertainty and Cyclical Investment” (Quarterly Journal of Economics, 1983). While that paper might be forgotten by most, we can be sure that the Chairman of the Federal Reserve Board is not among the forgetful.


Alexopoulos, Michelle and Jon Cohen (2008). “Uncertainty and the credit crisis”, VoxEU.org, 23 December.

Bernanke, Ben (1983), “Irreversibility, Uncertainty and Cyclical Investment”, Quarterly Journal of Economics 98(1): 85-106.

Bloom, Nicholas (2008). “Will the credit crunch lead to recession?” VoxEU.org, 4 June.

Bloom, Nick (2009), “The Impact of Uncertainty Shocks”, Econometrica, May 623-685. 


Figure 1 (version posted on 9 August 2011). Daily US implied stock market volatility (VIX index, commonly known as the "financial fear factor")

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