Wednesday, March 4, 2009

What does all this tell us?

From Free Exchange:

"Barro of bad news
Posted by: | WASHINGTON
Business cycles

MACROECONOMIC historians to your data sets, the global downturn has seemed to call. Carmen Reinhart and Kenneth Rogoff have given us a detailed survey of the economic consequences of financial crises—work which revealed that crisis-driven recessions tend to be longer and deeper than other species. Today, in the Wall Street Journal, Robert Barro explains the findings of his examination of stock market behaviour and economic downturns. He also sounds a rather ominous warning:

In applying our results to the current environment, we should consider that the U.S. and most other countries are not involved in a major war (the Iraq and Afghanistan conflicts are not comparable to World War I or World War II). Thus, we get better information about today's prospects by consulting the history of nonwar events -- for which our sample contains 209 stock-market crashes and 59 depressions, with 41 matched by timing. In this context, the probability of a minor depression, contingent on seeing a stock-market crash, is 20%, and the corresponding chance of a major depression is only 2%. However, it is still the case that depressions are very likely to feature stock-market crashes -- 69% for minor depressions and 83% for major ones.

Emphasis mine. Mr Barro defines a minor depression as a fall in real GDP per capita of 10% or more, and a major depression as a fall in real GDP of 25% or more. His study seems to differ from that of Ms Reinhart and Mr Rogoff in that they examine financial crises as precipitators of recession, while Mr Barro examines stock market crashes as barometers of recession. That is, a recession brought on by a collapse in stock prices might or might not be severe, but a recession coincident with a broad and deep market crash suggests dangerous conditions indeed. Markets recovered much of their value following the crash of 1929, for example, but began a sustained decline in 1930 as the extent of the financial damage became clear.

What does all this tell us? Well, that there is a real risk of an economic calamity of historic proportions, such that policymakers must work diligently to avoid disastrous errors—sharply contractionary policy, for instance, or a modern day Smoot-Hawley. Or war. But also that things aren't yet that bad. As Mr Barro notes, a 20% chance of a minor depression implies an 80% chance of avoiding a 10% decline in real GDP per head. Given the situation—massive losses of housing and equity wealth, financial collapse, implosion of global demand, and so on—that's a pretty impressive statisic."


Don the libertarian Democrat wrote:

March 4, 2009 16:42

There's a huge upside to be seen as calling a market top or bottom, but is there any real downside? It seems that if you correctly call the top or bottom, you are seen as knowing what you're talking about. If you incorrectly call the top or bottom, you're seen as simply missing a few salient points, not that you're clueless. If this is correct, then you will always have people calling tops and bottoms, sometimes in the same paragraph.

Is there any way to weed out buffoons in economics or investment? We already know that it's impossible in banking and the overseeing of it. Here's my prediction:

There will be a bestseller entitled "How To Run A Ponzi Scheme And NOT Get Caught". The fact that it will work and go undetected for a long time will be assumed by the author.

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