The most serious concern is that the downturn will become something worse than the largest recession of the post-World War II period -- 1982, when real per capita GDP fell by 3% and the unemployment rate peaked at nearly 11%. Could we even experience a depression (defined as a decline in per-person GDP or consumption by 10% or more)?
The U.S. macroeconomy has been so tame for so long that it's impossible to get an accurate reading about depression odds just from the U.S. data. My approach uses long-term data for many countries and takes into account the historical linkages between depressions and stock-market crashes. (The research is described in "Stock-Market Crashes and Depressions," a working paper Jose Ursua and I wrote for the National Bureau of Economic Research last month.)
The bottom line is that there is ample reason to worry about slipping into a depression. There is a roughly one-in-five chance that U.S. GDP and consumption will fall by 10% or more, something not seen since the early 1930s.
Our research classifies just two such U.S. events since 1870: the Great Depression from 1929 to 1933, with a macroeconomic decline by 25%, and the post-World War I years from 1917 to 1921, with a fall by 16%. We also assembled long-term data on GDP, consumption and stock-market returns for 33 other countries, sometimes going back as far as 1870. Our conjecture was that depressions would be closely connected to stock-market crashes (at least in the sense that a crash would signal a substantially increased chance of a depression).
Our data reveal 251 stock-market crashes (defined as cumulative real returns of -25% or less) and 97 depressions. In 71 cases, the timing of a market crash matched up to a depression. For example, the U.S. had a stock-market crash of 55% between 1929-31 and a macroeconomic decline of 25% for 1929-33. Likewise, Finland had a stock-market crash of 47% for 1989-91 and a macroeconomic fall of 13% for 1989-93. We found that 30 cases where there were both crashes and depressions were also associated with wars. In fact, World War II is the worst macroeconomic event of the period, with strong U.S. wartime economic growth as an outlier.
In the post-World War II period, the Organization for Economic Co-operation and Development (OECD) countries were strikingly tranquil up to 2008. The worst macroeconomic event in that period came in Finland in the early 1990s. Sweden also faced a financial crisis in the early 1990s, though it reacted quickly and is now being touted as a possible guide for leading the U.S. out of its current economic crisis.
Outside of the OECD, there have been many linked stock-market crashes and depressions since World War II -- including the Latin American debt crisis of the 1980s, Mexico's financial crisis in the mid-1990s, the Asian financial crisis of the late 1990s, and Argentina's financial turbulence that lasted until 2002.
What this says to me is that the crashes are a triggering event, which if the underlying weaknesses are present and totally exposed LEAD TO DEPRESSION
Today we have had a world where instead of margin buying (1929), we had real estate values as the wealth of nations, backed by mortgages to unworthy clients, whose immensity had grown larger than the aggregate wealth of those nations to such an extent that only printing more money WORLDWIDE can close the gap between reality and the speculative bubble.
If this is not done there will be a chain of collapses. If it is done stupidly there will be a chain of collapses, AND a complete loss of prior value in things like social security and retirement in comes as devalued dollars/rials/rubles/yen/marks are created to pay off the bad loans and the insurances over them (the AIG's), AND civil and social 'unrest'.
Real wealth cannot be built on values of things we cannot create. Fortunes might be made or lost, but that is not wealth. That's the lottery once removed, when opportunity to strike for cash met the knowledge and preparedness of some to raid the make believe value increase in land.
The odds are roughly one-in-five that the current recession will snowball into the macroeconomic decline of 10% or more that is the hallmark of a depression.
The bright side of a 20% depression probability is the 80% chance of avoiding a depression. The U.S. had stock-market crashes in 2000-02 (by 42%) and 1973-74 (49%) and, in each case, experienced only mild recessions. Hence, if we are lucky, the current downturn will also be moderate, though likely worse than the other U.S. post-World War II recessions, including 1982.
In this relatively favorable scenario, we may follow the path recently sketched by Federal Reserve Chairman Ben Bernanke, with the economy recovering by 2010. On the other hand, the 59 nonwar depressions in our sample have an average duration of nearly four years, which, if we have one here, means that it is likely recovery would not be substantial until 2012.
Given our situation, it is right that radical government policies should be considered if they promise to lower the probability and likely size of a depression. However, many governmental actions -- including several pursued by Franklin Roosevelt during the Great Depression -- can make things worse.
I wish I could be confident that the array of U.S. policies already in place and those likely forthcoming will be helpful. But I think it more likely that the economy will eventually recover despite these policies, rather than because of them.