Young Economics.

Comments on the Bernanke Interview

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Last night, Ben Bernanke appeared on 60 minutes and expressed belief that the recession could come to an end by the end of this year.  Here’s a quick article on the topic in case you missed it (link).

This statement is in no way an indication that our troubles are soon to be over, but it does imply we are on the road towards recapturing economic normalcy.  A recession is commonly defined as a period of negative economic growth; specifically, GDP measures must contract for at least 2 quarters.  An end to our recession will thus be seen when the data we collect on output measures stop falling.

So problems solved, right?  Not really.  Economists like to benchmark how any given economy is performing by comparing it to some “potential” level of output.  They drum up this potential figure by looking at a number of predictors, such as the level of technology currently available or the size and skill-set of the labour force.  Once this potential is understood, they can start to make inferences about what an average unemployment rate would look like, or what asset prices (homes, stocks, etc.) should approximately be.  But more importantly, they can use this potential figure to look at how our performance today compares with how we could be going.  This measure in known as the output gap.

During the extent of the recession we have been moving further away from our potential output, and will continue to do so as long as growth continues to be negative.  As a rule of thumb, a negative output gap is associated with high levels of unemployment and constrained aggregate demand.  Thus as we continue to recess, unemployment continues to rise and the problems continue to worsen.

So in light of this, what does the end of the recession imply?  It means output will stop falling, our output gap will stabilize, and unemployment rates should stick at whatever high levels they’ve reached by the time we turn the corner.  However, it will still be hard to find jobs, company earnings will still be hampered by low demand, and housing and equity markets will still be held back until recovery closes the gap.

For the empirical argument behind this, here is a paper by Rogoff and Reinhart detailing the effects of financial crises (link).  They find that across 20+ banking crises, GDP contracts for an average period of 2 years while unemployment rates stay relatively high for 5 years.  Also, equity markets generally stay in contraction for 3.5 years, while housing prices stay low for 6 years.

So we’ve got a long way to go.  At least when stabilization occurs we won’t have to keep reading about how the world is going to explode.

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Written by jk

March 16, 2009 at 1:16 pm

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