CentrePiece Spring Recent research by Nick Bloom as well as research of an earlier - PDF document

Recent research by Nick Bloomresearch of an earlier vintage by Fedwill lead to an economic slowdown muchworse than we currently anticipate. Will the effects of the recentcredit crunch is a hugevolatility. The uncertaintythe unpredictability of the policy responseof central banks and governments haveall led to tremendous instability.A standard measure of uncertainty Ðthe Ôimplied volatilityÕ of the S&P100 ofmore than doubled since the subprimemagnitude to those that followed thePresident Kennedy, the Gulf War and theterrorist attacks of 9/11 (see Figure 1).But after these earlier ÔshocksÕ,back. For example, after 9/11, impliedvolatility dropped back to baseline levelscurrent levels of implied volatility haveremained stubbornly high for the lastseven months, rising rather than abatingMy research shows that even thefollowed previous shocks had verydestructive effects. The average Figure 1 (before the credit crunch) wasto cut US GDP by 2% over the next sixthe current credit crunch are worrying. If these earlier temporary spikes inuncertainty had such a significant effecton economic activity, the impact of thecurrent persistent spike in uncertainty islikely to be far worse. On these numbers,a recession is almost inevitable.For a broader historical comparisonto the credit crunch, we can also goback 70 years to the Great Depression. Figure 1:Monthly US stock market volatility 1962-2008The vertical axis shows a percentage measure of volatility known as Ôannualised standarddeviationÕ.Prior to 1986,this is calculated as the percentage actual volatility of monthly returnson the S&P500 index of the US stock market.After 1986,it is calculated using the percentageÔimplied volatilityÕ from an option on the S&P100 index. 0%10%20%30%50% Gulf War 2Russia & LTGulf War 1 Yearsince last Augustvery damaging unpredictable, the best course of action isThis directly cuts back on investment of economic growth. But it also hasknock-on effects in depressingproductivity growth.Most productivity growth comes from Ôcreative destructionÕ Ð productivefirms expanding and unproductive in the economy pauses, then creativedestruction temporarily freezes Ðproductive firms do not grow andunproductive firms do not contract. Thisleads to a stalling of productivity growth.Similarly damaging effects alsoTVs. The housing market is also hit hard:One reassuring fact is that globalThis was the last time that volatility waspersistently high (see Figure 2).Much like the credit crunch today, theGreat Depression began with a stockfinancial system. Banks withdrew creditfroze up. The US central bank Ð theto restore calm but without success.What followed were massive levels ofstock market volatility and a recession ofunprecedented proportions. From 1929 to1933, US GDP fell by 50%, a bigger dropthan in every recession since World War IIcombined. On these numbers, a recessionlonger-run effects start to becomereason is that firms typically postponewhen business conditions are uncertain. Itinvestment mistake Ð so if conditions are Figure 2:The Great Depression was notable for very high volatilityThe vertical axis shows a measure of volatility derived from Schwert (1990),which contains daily stock returns to the Dow Jonescomposite portfolio from 1885 to 1927,and to the Standard and PoorÕs composite portfolio from 1928 to 1962.The figure plots thevolatility of monthly returns following exactly the same procedure as for the actual volatility data from 1962 to 1985 in Figur 1960195519501945194019351930192519201915191019051900198518801875g panicThe Great DepressionRecession of 1937Oil and coal strike 30%60%90% Yeartoday,the Great damaging effect of uncertainty shocks isBernanke. His doctoral thesis of morethan 25 years ago explored the negativeeffects of uncertainty shocks.The main paper from that thesis wasnegative effects of uncertainty in causingrecessions, noting that: Ôevents whoselong-run implications are uncertain cancreate an investment cycle by temporarilyincreasing the returns to waiting forinformationÕ (Bernanke, 1983).So what is stopping Bernanke actingforestall the recession? Well, as Bernankealso knows, the same forces ofuncertainty that lead to a recession alsorender policy-makers relatively powerlessto prevent it.become cautious, so they react much lessreadily to monetary and fiscal policyshocks. According to research on UKreduce the responsiveness of firms bymore than half, leaving monetary andfiscal policy-makers relatively powerlessSo the current situation is a perfecteffectiveness of standard monetary andfiscal policy to prevent this.Policy-makers are doing the best theycan Ð making huge cuts in interest rates,dishing out tax rebates and aggressivelysuggests not. A recession looks likely.Ben Bernanke (1983),ÔIrreversibility,Uncertainty and Cyclical InvestmentÕ,Quarterly Journal of EconomicsNick Bloom (2007),ÔThe Impact ofUncertainty ShocksÕ,National Bureau ofEconomic Research Working Paper No.W13385,also available as CEP DiscussionPaper No.718 (http://cep.lse.ac.uk/pubs/download/dp0718.pdf).Nick Bloom,Stephen Bond and John VanReenen (2007),ÔUncertainty and InvestmentReview of Economic StudiesWilliam Schwert (1990),ÔIndexes of U.S.StockJournal of Business63(3):399-426. prevent it Nick Bloomeconomics at Stanford University and aresearch associate in CEPÕs productivity andinnovation programme.