Creditcrunch

The Credit Crunch May Cause Another Great Depression

October 2008

Back in June 2008 I wrote a piece for VOXEU predicting a mild recession in 2009. Over the last few weeks the situation has become far worse, and I believe even these pessimistic predictions were too optimistic. I now believe Europe and the US will sink into a severe recession next year, with GDP contracting by 3% in 2009 and unemployment rising by about 3 million in both Europe and the US. This would be the worst recession since 1974/75. In fact the current situations has so many parallels with the Great Depression of 1929-1932, when GDP fell by about 50% in the US and by about 25% in Europe, that even my updated predictions could again be over optimistic.

Uncertainty is higher then it’s been in 20 years

One of the most striking effects of the recent credit crunch is the huge surge in stock market volatility this has generated. The uncertainty over the extent of financial damage, the identities of the next banking casualty and the unpredictability of the policy response have all led to tremendous instability. As a result the implied volatility of the S&P100 – commonly known as the index of “financial fear” - has more increased almost six-fold since August 2007. In fact since the outbreak of the Credit Crunch it has jumped to levels even greater than those witnesses after the events of the 9/11 Terrorist attacks, the Gulf Wars, the Asian Crisis of 1997 and the Russian default of 1998 (see Figure 1).

But after these earlier shocks volatility spiked and then quickly fell back. For example, after 9/11 implied volatility dropped back to baseline levels within 2 months. In comparison the current levels of implied volatility have been building since August 2007 and are likely to remain stubbornly high.

But even these more moderate surges in uncertainty after these earlier shocks had very destructive effects. The average impact of the sixteen shocks I examined in prior research[1] was to cut...