Every horror movie fan knows the scene before the attack. Creepy electronic music plays. The victim is shown from behind. The camera scans around the bushes, in the dark, to the sound of heavy breathing. You know something evil is going to happen, but not when, where or how.
Right now the world economy feels a lot like that. Every economist is predicting a macabre 2009 (Philadelphia Federal Reserve 2008). But nobody quite knows where the blows will fall, how bad things will get or who will survive.
In this piece I want to provide one way of predicting the impact of the credit crunch on US and UK growth. This is the methodology behind my claim that output will contract by up to 3% in 2009 which I made in a VoxEU piece on October 8th.
Bad omens for growth
In my academic research I have been looking at the impact of large uncertainty shocks on the US economy over the last 40 years.1 These events – like the Cuban Missile Crisis, the Assassination of JFK, the Gulf War and 9/11 – typically double stock-market volatility and reduce stock-market levels by 10%. Their average impact is to reduce GDP growth by 1.5% in the following 6 months, with a recovery within 12 months.
In comparison, the credit crunch is a monster of a shock. It has generated an incredible six-fold increase in stock-market volatility and a 30% fall in the stock market level – three times the average impact of the previous uncertainty shocks. Based on these numbers my central prediction is that GDP growth will be reduced by 4.5% in 2009 because of the credit crunch. Since the consensus forecast2 before the credit crunch for US and UK growth was +1.5%, this reduction in growth leads me to predict a -3% contraction in 2009. Forecasting 2010 is even less accurate, but my central prediction is a return to about +1.5% growth.
The S&P volatility massacre
Figure 1 plots the predicted impact of the 30% fall in stock-market levels as a deviation against the prior forecast. The central prediction - denoted by the solid black line - is that this 30% fall in stock-market levels will reduce growth against prior forecasts by almost 4% by late 2009. But growth will recover to trend by mid 2010. The dashed red lines on either side of this prediction are the one standard-deviation confidence bands indicating the degree of forecast reliability.
Figure 2 plots the predicted impact of the six-fold increase in stock-market volatility since September 2008. The central prediction - denoted by the solid black line - shows a fall of almost 3% against trend by mid-2009, with a rebound by 2010. The reason for this rapid rebound is that uncertainty leads firms to pause investment and hiring. But once uncertainty falls back to normal levels – which I forecast will happen by the mid 2009 (based on the average duration of all previous large uncertainty shocks) – firms will start to invest and hire again to make up for lost time. Hence, the uncertainty impact of the credit crunch will cause a rapid slow-down in the first-half of 2009 and a recovery by late 2009.
Finally, Figure 3 shows the combined effect of the drop in stock-market levels and the rise in uncertainty. As can be seen the combined impact of this is to reduce output by 4.5% in mid 2009, which given the prior estimate of +1.5% growth in mid-2009, leads to my new forecast of -3% growth for 2009. By late 2009 this contraction will have eased off, with normal rates of growth returning by 2010.
Hence, I predict growth in 2009 will contract rapidly, falling by an annualised rate of up to 3%. But uncertainty should fall by mid-2009, releasing a backlog of investment and employment that should propel a rapid recovery in 2010, with growth returning to 1% or 2%.
The final lunge
But as every horror fan knows the monster never dies. Despite being skewered with every sharp object in sight it always manages one final lunge. In the case of the credit-crunch the risk of a final lunge comes from a damaging political response. Politicians around the world are pushing to roll-back free markets, impose greater regulation, restrict trade and provide multi-sector bail-outs. This move away from free-markets towards regulation, protectionism and subsidies risks turning a temporary downturn into protracted recession.
The major lesson from the Great Depression of the 1930s was that terrible policies managed to turn a financial crisis into a disaster. The infamous Smoot-Hawley Tariff Act of 1930 was introduced by US policymakers to block imports in a desperate attempt to protect domestic jobs. But it helped worsen the recession by freezing world trade. At the same time policymakers were encouraging firms to collude and workers to unionise to raise prices and wages.
The current backlash against capitalism risks leading to this repeat. This happened after the Great Depression and it happened after the major recession of 1974/75. Although 2009 will be a year of shrinking rapidly, if politicians protect free markets 2010 should see a return to growth.
1 “The impact of uncertainty shocks”, The predictions are made from VAR forecasts, which are often used by economists to forecast macroeconomic data. Details of the VAR forecasts is contained in the paper, with the underlying data in http://www.stanford.edu/~nbloom/VAR.zip
2 For the US see the Philadelphia Federal Reserve Board Survey of Professional Forecasters consensus prediction of 1.5% in August 2008. For the UK see CBI’s 1.6% forecast in 2 June 2008.