Wednesday, 19 November 2008

Nightmare on Main Street

Nicholas Bloom, assistant professor of economics at Stanford University, has an article on on 2009 will be the nightmare on Main Street. He says
Every economist is predicting a macabre 2009, but no one knows for sure how bad things will get or who will survive. This column, by comparing the current crisis to uncertainty shocks of the last 40 years, predicts GDP growth could be reduced by as much as 4.5%. But, if politicians protect free markets, growth should be back in 2010.
Bloom starts by noting that his academic research has been looking at the impact of large uncertainty shocks on the US economy over the last 40 years. He argues there are bad omens for growth coming from the credit crunch.
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 forecast 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.
He then looks at "the S&P volatility massacre". This guy has seen way too many b-grade horror movies! Bloom looks at the predicted impact of the 30% fall in stock-market levels as a deviation against the prior forecast. The central prediction 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.

Then he looks at the predicted impact of the six-fold increase in stock-market volatility since September 2008. The central prediction shows a fall in growth 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 he forecast will happen by the mid 2009 – 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.

Next he considers the combined effect of the drop in stock-market levels and the rise in uncertainty. 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.

The important upshot of this is Bloom's conclusion,
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.

No comments: