The Uncertainty Shock from the Debt Disaster Will Cause a Double-Dip Recession

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.

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.

Figure 1. Daily US implied stock market volatility (VIX index, commonly known as the “financial fear factor”)

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.

References

•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.

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