Barro And The Probability Of A Depression

"What Are the Odds of a Depression?," an article written by Robert Barro, and published in today's Wall Street Journal is making the blog rounds today (HT Greg Mankiw, and RealClearMarkets). I like the article for many reasons, two of which I will name.

He gathers data to answer a question or hypothesis, and I like his data.

We also {in addition to U.S. data] 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).

Barro provides statistically generated information about a current problem of great interest, the probability of the U.S. falling into a depression, defined as a fall of at least 10% of GDP.

In the end, we learned two things. Periods without stock-market crashes are very safe, in the sense that depressions are extremely unlikely. However, periods experiencing stock-market crashes, such as 2008-09 in the U.S., represent a serious threat. 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.