The price of market uncertainty is a double-dip recession

Nicholas Bloom interviewed by Viv Davies, 26 Aug 2011

Nicholas Bloom of Stanford University talks to Viv Davies about the evidence for a double-dip recession as a result of market uncertainties. They discuss market signals and the Eurozone crisis, and how the US and Europe could resolve its debt problems. Bloom maintains that healthcare reform in the US and the retirement age in Europe are key. The interview was recorded on 23 August 2011. [Also read the transcript]

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Viv Davies interviews Nick Bloom for Vox

August 2011

Transcription of a VoxEU audio interview [http://www.voxeu.org/index.php?q=node/6906]

Viv Davies:  Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from CEPR. It's the 23rd of August 2011, and I'm talking to Nicholas Bloom, Assistant Professor of Economics at Stanford University. We discuss his recent article on Vox in which he suggested that the uncertainty shock from the current debt crisis in Europe and the US will cause a double‑dip recession. Bloom explains how he arrived at that conclusion. We discuss stock market volatility, market signals in the Eurozone crisis, and how the US and Europe could resolve its debt problems.

I began the interview by asking Nick to explain the research basis upon which he determined that a double‑dip recession was imminent.

Nicholas Bloom:  Well, this is based on looking at measures of uncertainty and, in particular, looking at stock market volatility. There's a line of research I've been involved in that builds very heavily, in fact, on Ben Bernanke's old work, himself, when he was an academic, an Assistant Professor at Stanford, back in the early 80s. Ben Bernanke wrote this paper called "Irreversibility: Uncertainty in Business Cycles," and the idea is that when uncertainty goes up, firms and consumers want to wait because it's expensive to make a mistake.

You can imagine if you were a firm in Swindon outside London and you're thinking of opening, let's say, a restaurant chain. You're thinking of opening up another restaurant. You're going to go out, hire some employees, buy a piece of land, buy equipment, et cetera. If you're uncertain about what's going to happen next, you probably want to wait, because you don't want to spend all the money refitting a restaurant and hiring people and discover you've made a bad decision.

Of course, if every firm and every consumer decides to wait‑‑for consumers it's a similar logic; consumers like us, it might be we put off buying a new car or a new TV‑‑then the economy enters a recession.

I've actually been studying the kind of shocks, the stock market volatility we've seen over the last few weeks, going back over 40 years, so, looking at these things I call ‘uncertainty shocks.’ Things like the assassination of JFK, the Cuban Missile Crisis, the Gulf Wars, 9/11, so events that generate huge spikes in stock market volatility. These appear to be followed by short, sharp recessions.

Typically, stock market volatility goes up, and it’s a great indicator of uncertainty. When uncertainty goes up, everyone pauses and delays and you get a short, sharp recession.

Given what's happened just now over the last few weeks with all the uncertainty around US and European debt, whether the governments will manage to agree to actually sort out their debt problems, I forecast there will be a recession in the second half of 2011 as businesses and consumers put off spending and investment, but by 2012 things will return to normal.

Viv:  But there seems to be an emerging consensus amongst European and UK market analysts that, whilst we're looking ahead to a period of sluggish growth and rising unemployment, a recession isn't likely. Do you think they're wrong?

Nicholas:  Oh yes, absolutely. They're definitely wrong. I don't know, there's always that joke about economists have three hands. They can say, on one hand, on the other hand and keep going. The first thing to say is my forecasts are based, they're more US‑focused. I've looked at US data. Although, some guys at the Bundesbank, I know, looked at German data and found a similar affect of measures of uncertainty generating a recession.

Here are the rough numbers. Every time you have one of these uncertainty shocks, a big spike in stock market volatility—and to be clear, I've measured this using something called the VIX, the V‑I‑X, Index, which is backed out from options prices on the S&P 500, it's a measure of forward‑looking volatility—every time the VIX Index spikes, which is measured as going above 40, we see in the next six months output growth in the US falls by about 2% and then recovers to normal by about nine months out.

Now in the US, output growth or GDP per capita growth per year is about 2%, so that's about 1% every six months. Just on the numbers, I'm forecasting we'll go from plus 1%, which would be baseline in the second half of 2011, to minus 1% in the US.

Now, European growth levels are pretty similar, and the effects, I think, are likely to be pretty similar in Europe. The only difference is maybe, and in fact until recently, Germany appeared to be growing slightly faster. But no, my prediction still is that I think Europe will enter a recession in the second half of 2011, at least defined as the large countries.

Many of them I think, by the way, certainly in southern Europe, probably already are in recession. Greece definitely is, and I haven't looked at the data recently, but I would be almost certain that Portugal, Ireland, and some of the other credit‑crunch countries are also already in a recession.

But in terms of others that are currently doing slightly better, like Germany in particular, UK, France, I think, are likely to dip into recession in the second half of '011.

Viv:  Briefly, how would you describe recession?

Nicholas:  Well, it's a good question. Recession, like many things ,I know—for example happiness—appears to have no clear definition. Robert Hall, who is actually the head of the NBER Business Cycle Dating Committee‑‑he's actually a colleague here at Stanford, so I've discussed with him this a few times—says there's really no formal definition of a recession. The closest you can get is two consecutive quarters of contraction.

If the economy contracts, or shrinks, two quarters in a row, usually they define that as a recession, but not always. But if I take that as my definition, I think the economy is likely to contract for quarters three and four in 2011, so that will be a recession. It's about the smallest possible thing that will count as a recession.

I don't think it would be contracting in the beginning of 2012, so you could say it was a small recession. But basically, I'm looking at negative growth in the second half of 2011.

Viv:  You've mentioned European growth just now, and you state in your article that, "Whilst good news tends to send the market soaring, bad news sends the markets crashing." If this is the case, do you think that European leaders, for example, could be doing more to create confidence in the markets? If so, what do you think they should be saying and doing to prevent further contagion and uncertainty in this Eurozone?

Nicholas:  What I think is going on now, people in the market are very uncertain about what's going to happen going forwards. What that means is they tend to respond very strongly to any new news, even if that's wild rumours or speculations, it seems to be sending the markets soaring up or down. In economics terms the concept is they have diffuse Bayesian priors, which means they don't know that much right now. Market makers are very unsure about what's going to happen in future. So a piece of news that normally wouldn't have much of an impact right now has a huge impact.

I don't know. The analogy is kind of like you're at a party and someone turns the lights off. If they stay off for a while, you can imagine rumours spread around like wildfire of what's going on. The markets feel a bit like that right now. They're very uncertain because basically they're unsure about what's going to happen to the fiscal position in the US and Europe. The problems in the fiscal position are pretty deep down.

In America, the big problem really is healthcare expenditure. You can hear I'm British, and I've been living in the US now for five years. Over here healthcare is tremendously expensive. If you get sick, it just costs a fortune. I personally don't pay for it. I have healthcare insurance, but it costs a lot in insurance.

That reflects the fact that Americans just spend amazing amounts on health. They're now approaching spending 20% of GDP on healthcare, so $1 in every $5. They basically can't afford that, so the intermediate solution has been borrowing money from abroad indirectly via the government. If they're ever going to balance the government books, they need to fix healthcare.

In Europe their problem is less healthcare but more, basically, in retirement. In places like Greece people are living for a very long time. They live to 75, but they retire at 50. They only start working at 20. There just isn't enough working life to pay for retirement, so they've been borrowing.

In both cases, in the US because of healthcare, in Europe because of retirement, there are serious problems with the government budget deficit, and markets don't know whether politicians have political will in them to fight it. Voters hate increasing taxes or reductions in spending, and politicians basically are loathe to do that.

What do they do? They procrastinate and put it off. If I was a politician, frankly, I may do the same. If you're the politician that really fixes the long‑run problems of the economy, you probably face being voted out of office at the next election.

This uncertainty about what politicians are going to do makes markets very nervous, and so they bounce up and down to the smallest piece of news. That's why, if you wanted to reduce stock market volatility, the best way to do it would be creating more confidence, and that would be really for governments to put their fiscal position in order.

For example, in Europe for them to increase their retirement age. Say, in Greece push it from 50 to probably mid-60s where it needs to be. In the US, do something to control healthcare expenditure. Once that happened it would be clear that the budgets are going to be more balanced going forwards, and I think stability would return.

Viv:  What about more short‑term signals to the markets? Do you think that the leaders of France and Germany, for example, were wrong to have dismissed the idea of Eurobonds?

Nicholas:  Well, the problem with Eurobonds and any real short‑term solution is, the underlying issue is southern Europe is borrowing more than it spends. Obviously, Greece, Portugal, I guess Ireland we can include in this group, the PIGS group, so Spain, Italy. Germany and northern Europe, Germany in particular, just can't bail these guys out forever. It's kind of the dad and the kids with the credit card. If you have one kid that's spending that wad on your credit card, then maybe mom or dad can cover it. But if you have five of them spending like crazy, at some point they just have to cut off all the credit cards.

It's really very much like that with southern Europe. When it was a small country like Greece, you could fix the issue by just, Germany pours money into the ECB, and the ECB buys back Greek bonds. But when there's a large number of countries, it's harder.

The Eurobond is kind of a backdoor solution to it, because they're only going to be attractive if someone like Germany's backing them up. That means Germany has to guarantee the loans of Eurobonds in countries like Greece. Implicitly, Germany is guaranteeing Greece much like the parents guarantee the kid's credit card. It's only valuable because some risk will actually be used. I don't think Germany, realistically, wants to or has the ability to subsidise all of southern Europe.

I don't know. I'm skeptical. I think the fundamental problem is that southern Europe overspends because they retire too early. The economies aren't growing fast enough.

They also have very low labour force participation for women. In a Greek household, you maybe have the woman doesn't work, the man only works between ages of 20 and 50. There just isn't enough working years in that household to cover everything they want to buy.

More basic issues around getting more women to work, having longer working lives for men, are going to be needed to be done to solve the problem. I think short‑run solutions around just channeling money, directly or indirectly, from Germany isn't going to fix it.

Viv:  Nick, based on your research, whilst you would maintain that another recession is imminent, you don't foresee it as being on a scale of another Lehman Brothers fallout?

Nicholas:  No, not at all. Lehman's was the economic equivalent of an asteroid hitting New York. I guess, as an economist, it's my equivalent of most people's JFK moment or the 9/11 moment. I remember exactly where I was sitting, and it was unbelievable. It was a huge, venerable organization. I had friends working in Lehman's. It's part of the financial system, and it went under. You certainly realized anything was possible, really. If Lehman's can go down, anything is possible. What's happening now is a much more vanilla‑flavored type of event. If there's some increase in uncertainty, we may get a double dip, but it's going to look nothing like what we saw in '08 to '10.

Viv:  Nick Bloom, thanks very much for taking the time to talk to us today.

Nicholas:  Hey, you're welcome, Viv. Great to catch up. 

Topics: EU policies, Financial markets, Global crisis
Tags: double-dip recession, Eurozone crisis

Assistant Professor of Economics at Stanford University