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Understanding Recessions

Understanding Recessions

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Published by Abhijeet Singhal

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Published by: Abhijeet Singhal on Mar 14, 2009
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05/08/2013

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Understanding RecessionsBackground
After 5 years of synchronized high economic growth since 2004, the global economy isnow grappling with synchronized recessionary conditions. The financial turmoil thatstarted in the United States, initially led by sharp declines in house prices, hastransformed into a severe credit crunch with substantial losses in equity markets.Moreover, it has now spread to a number of advanced and emerging countries, andbecome the most severe global financial crisis since the Great Depression. This has led toan intensive debate about how much the crisis will impact the real economy.In India too, the slowdown has become evident initially in the tradeable segments, suchas industry and exports. The linkage effects would then lead to a slowdown even in thenon-tradeable segments of the economy. Industrial output which had been growing indouble digits (since Jul 07), led by a strong upsurge in capital goods, has been slowingdown and declined by 0.4% in Oct 08. Similarly exports which grew by 27% in FY08started slowing down since August 2008, declining by 12 % in October 2008.
Hypothesis
In this note we attempt to explore the following questions;What could be the severity and probable duration of this recession in the developedcountries and whether India is likely to get into a recession? For the purpose we haveused the recent research findings of the IMF Working Paper “What happens duringRecessions, Crunches and Busts”.
The IMF Report
Recessions, or a decline in GDP over 2 quarters can result from a number of causes.When recessions are caused due to a crisis in financial markets, the impact on theeconomy is different from recessions emanating from other causes such as the oil pricehike. The current spell of recession has begun with a crisis in the housing and creditmarkets. In view of this a recent IMF research report becomes relevant in making someassessment of the current recession. The report covers 21 OECD countries over the
 
 2period 1960-2007. There is analysis of the implications of 122 recessions, 112 (28) creditcontraction (crunch) episodes, 114 (28) episodes of house price declines (busts), 234 (58)episodes of equity price declines (busts) and their various overlaps in these countries.Through empirical research, the study has explored the linkages between the financialand key macro economic variables, with a view to determining the severity and durationof recessions.
Highlights of the IMF Study
 
The study indicates that interactions between macroeconomic and financial variables canplay major roles in determining the severity and duration of a recession.
 
In particular, recessions associated with credit crunches and house price busts are deeperand last longer than other recessions. They typically result in output losses two to threetimes greater than recessions without such financial stresses.
o
 
The more adverse effects of a recession with a (severe) house price bustarise in part due to compressed credit markets, in turn leading to aconsiderable reduction in consumption and (residential) investment.
o
 
A regression analysis shows that the changes in house prices tend to be thefinancial variable most robustly associated with the depth of recessions.
 
The typical recession lasts almost 4 quarters and is associated with an output drop of roughly 2 %. Most macroeconomic and financial variables exhibit pro-cyclical behaviorduring recessions.
 
There is also a pattern of recessions becoming shorter and milder over time, especiallyafter the mid-1980s. In particular, the amplitude of a typical recession fell from 2.6% in1973-1985 to 1.4% in 1986-2007. (Amplitude is the percent change in output from a peak to the next trough of a recession).
 
Recessions remain highly synchronized across countries. Moreover, recessions oftencoincide with the episodes of contractions in domestic credit and declines in asset prices.
 
Episodes of credit crunches, house price and equity price busts last much longer thanrecessions do.
 
A credit crunch episode typically lasts two-and-a-half years and is associated with nearlya 20% decline in credit.
 
 3
 
A housing bust tends to persist even longer—four-and-a-half years with a 30% fall in realhouse prices.
 
And an equity price bust lasts some 10 quarters and when it is over, the real value of equities drops by half.
 
There can be considerable lags between financial market disturbances and real activity.
 
The lessons from the earlier episodes of recessions, crunches and busts examined by IMFare sobering, suggesting that recessions following the current crisis will likely be morecostly than other recessions, because they take place alongside simultaneous creditcrunches and asset price busts.
 
Furthermore, although the effects of the current crisis have already been felt graduallyaround the world, the past evidence suggests that its global dimensions are likely tointensify in the coming months.
View on US Recession
In the light of the summary findings stated above, some assessment of the US recessioncan be conjectured. Since the crisis emanated in the credit and housing markets, theduration of the recession can be expected to range between 8 – 18 quarters depending onthe severity of the problem.In Q3, 08, US GDP shrank 0.3% (QoQ), its sharpest contraction in 7 years withconsumption expenditure declining 3.1% and residential investment declining 19.1%.(Consumption expenditure forms 72% of GDP).While the current economic environment in the US may share some features with theonsets of typical U.S. and OECD recession (IMF Report), it is worse in some dimensions.The difference can be seen particularly in terms of speed of credit contraction, drop inresidential investment and decline in house prices. The IMF study has shown that suchcredit contraction (crunch) and house price decline (bust) episodes on average lasted 6(10) and 8 (18) quarters, respectively. If these statistics, based on a large number of episodes, provide any guidance, they suggest that the adjustments of credit and housingmarkets in the United States are only in the early stages relative to historical norms and

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