Following1 the recent turmoil in financial markets associated with the sharp decline in house prices, a fierce debate has been raging on whether the United States might experience a recession in the coming months. Moreover, economic activity in a number of other major industrialized countries has also started to slow down, raising the possibility of wider spread recessions. These developments have highlighted a number of questions about the linkages between the real economy and the financial sector during recessions. Two specific questions often raised are: How do macroeconomic and financial variables behave around recessions, credit crunches and asset (house and equity) price busts? And are recessions associated with credit crunches and asset price busts different than other recessions? Insights gained from analysis of these questions can shed light on the possible future path of the U.S. and other economies.
To shed light on these questions, in a recent paper (What Happens During Recessions, Crunches and Busts? by Stijn Claessens, M. Ayhan Kose and Marco E. Terrones), we examined the main characteristics of the linkages between key macroeconomic and financial variables around business and financial cycles for 21 OECD countries over the 1960-2007 period. In particular, we analyze the implications of 122 recessions, 112 (28) credit contraction (crunch) episodes, 114 (28) episodes of house price declines (busts), and 234 (58) episodes of equity price declines (busts) for economic activity in these countries over the sample period2. Among these events, there is a considerable overlap, since there are 18, 34 and 45 recession episodes associated with credit crunches, house price busts and equity price busts, respectively (see Figure 1).
With respect to the first question, our analysis suggests that the typical recession lasts almost 4 quarters and is associated with an output drop of roughly 2 percent. While recessions have been becoming shorter and milder over time, they remain highly synchronized across countries. Most macroeconomic and financial variables exhibit procyclical behavior during recessions. For example, output recessions are characterized by sharp declines in (residential) investment, industrial production, imports and asset prices (equity and housing), modest declines in consumption and exports, and some decrease in employment rates. Two key “policy” related variables—short-term interest rates and fiscal expenditures—tend to behave countercyclical during recessions. Moreover, recessions tend to coincide with the episodes of contractions in domestic credit and declines and asset prices. In particular, credit contractions are closely associated with recessions. House price declines are also highly synchronized across countries, despite the fact that housing is the quintessential nontradable asset, and the degree of synchronization rises especially during recession episodes. Equity prices exhibit the highest degree of synchronization reflecting the extensive integration of financial markets. However, the popular saying that “Wall Street has predicted seven of the past five recessions” resonates here as the fraction of countries experiencing bear equity markets frequently exceeds the fraction of countries in a recession.
In about one out of six recessions, there is also a credit crunch underway and, in about one out of four recessions, also a house price bust. Recessions associated with housing busts and credit crunches are both deeper and longer-lasting than other recessions are. In contrast, recessions with equity price busts do not seem more costly than other recessions.
In terms of the question whether the current U.S. Slowdown has any similarities with previous recessions and recessions with crunches and busts, we can shed some light by comparing patterns in macroeconomic and financial variables (see Figure 4). The considerable slowdown in U.S. output over the last few quarters is not atypical of the onset of previous recession episodes in the United States and other OECD countries. However, recent declines in residential investment, house prices and credit are clearly sharper than those observed prior to most of earlier recessions. Moreover, rising inflationary pressures, in part due to the oil and other commodity price shocks, can further weaken economic activity. This suggests that, if a recession were to occur in the United States, its amplitude might be deeper and its duration longer than that of a typical recession.
The hefty combination of expansionary fiscal and monetary policies already employed, and the relatively healthy balance sheets of non-financial corporations going into this slowdown, however, could mitigate the risk of an adverse outcome. As such, the current slowdown in the United States is an evolving case affected by multiple factors, and it is not clear whether it will eventually be a mid-cycle slowdown, or if a recession, how severe it will be.
(1) Financial Studies Division, Research Department, IMF. [email protected] The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management. This note describes research in progress by the author and is issued to elicit comments and to further debate.
(2) The cyclical turning points in the log-level of any series are determined using the BBQ algorithm (Harding and Pagan, 2002, “Dissecting the Cycle: A Methodological Investigation,” Journal of Monetary Economics, Vol. 49, pp. 365-381). A cycle has two phases—a contraction phase (from peak to trough) and an expansion phase (from trough to peak). A recession refers to the contraction phase of output. We call a recession mild or severe if the peak-to-trough output drop falls into the bottom or top quartile of all output drops, respectively. Similarly, we define an equity (house) price bust as a peak-to-trough price decline which falls into the top quartile of all equity (or house) price contractions. Lastly, we define a credit crunch as a peak-to-trough-contraction in credit which falls in the top quartile of all credit contractions.