Harvard Econ Prof: 20% chance of a depression

Harvard economics professor Robert J. Barro published an opinion piece in today’s Wall Street Journal, “What Are the Odds of a Depression?,” citing research by himself and Jose Ursua (also of Harvard) for the National Bureau of Economic Research. (See an abstract of Barro and Ursua’s paper for NBER, “Stock-Market Crashes and Depressions,” here.)

Barro and Ursua studied the correlation between stock-market crashes and depressions and determined 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.”

Barro writes:

Looking at all of the events from our 34-country history, we find that there is a 28% probability that a “minor depression” (macroeconomic decline of 10% or more) will occur when there is a stock-market crash. There is a 9% chance that a “major depression” (a fall of 25% or more) will occur when there is a stock-market crash. In reverse, the chance that a minor depression will also feature a stock-market crash is 73%. And major depressions are almost sure to have stock-market crashes (our data show the probability is 92%).

AB — 4 March 2009

Disaster myopia in the economy

In an article yesterday in the Financial Times“Error-laden machine,” John Plender in part blames a phenomenon called “disaster myopia.”

Plender defines disaster myopia as “the tendency to underestimate the probability of disastrous outcomes, especially for low frequency events last experienced in the distant past.”

This sounds like a good term to describe the reason people live next to volcanos or in Los Angeles, as well as the thinking of many 23-year-olds who brag, “Don’t preach to me. I’ve been driving this way all my life, and I haven’t had an accident yet!”

But according to Plender, it also explains investor behavior over the past several years:

The risk of falling victim to this syndrome was particularly acute in the recent period of unusual economic stability known as the “great moderation”. Investors were confronted by falling yields against a background of declining volatility in markets. Many concluded that a new era of low risk and high returns had dawned. Their response was to search for yield in riskier areas of the market and then try to enhance returns through leverage, or borrowings.

Equally popular were trading strategies such as carry trades, which involved borrowing at low interest rates and investing at higher rates, especially via the currency markets. Favourite trades included borrowing in Japanese yen to invest in Australia or New Zealand, and borrowing in Swiss francs to invest in Icelandic assets.

This was dangerous because the interest rate spread could be wiped out in short order by volatile currency movements. Yet because volatility remained low for so long, disaster myopia prevailed. Carry traders were lulled into a false sense of security, while more sceptical competitors joined in for fear of underperforming.

Plender says disaster myopia is a term used by academics, which got me curious. Along with other references, I found that disaster myopia is covered in Asset Price Bubbles, edited by William C. Hunter, George G. Kaufman, and Michael Pomerleano.

AB — 4 March 2009

Questions for research on Bubbleconomics

To understand what Bubbleconomics means (or whether it even really exists), I think a list of questions such as the following is valuable:

  • What is the definition of Bubbleconomics?
  • What is an economic bubble?
  • What are the characteristics of an economic bubble?
  • What are the causes of an economic bubble?
  • What are the results of an economic bubble?
  • Is an economic bubble good, bad, or neutral, and from whose point of view?
  • Is the world economy as a whole an economic bubble of some kind?
  • How do individuals and organizations behave during an economic bubble?
  • Can bubbles be controlled or prevented?
  • What are some case studies of economic bubbles and what are the lessons to be drawn?
  • What should organizations do during bubbles?
  • What should individuals do during bubbles?
  • If the overall economy is a bubble, what are the risks?
  • If the overall economy is a bubble, should anything be done about it? What if anything can be done about it?
  • What are some metrics that can be use to measure and describe an economic bubble?
  • If Bubbleconomics is an accurate model of the current economy, what are the alternatives and how could they be implemented?

AB — 4 March 2009