Wednesday, January 14, 2009

More Good News

These guys from Stanford are predicting that the economy will begin growing again in mid-2009.  The novelty of their analysis comes from examining the uncertainty that influences recessions. The idea is that the real problem in a recession is not some drop in aggregate demand or some failure in the financial sector, but the fact that firms become uncertain about the future.  With uncertainty, firms abandon plans to hire and delay their investments to the future. 

One way to measure the uncertainty in the market is to look at implied volatility in the stock market. Without going into technical details, you can back this number out by looking at how wildly the stock market swings on a day to day basis.  Their graph shows that while volatility spiked incredibly in late 2008, it has started to fall recently.

If it stays at this lower (but still relatively high) level, then their model predicts a recovery as firms (with more certainty) become willing to undertake new investments again.  If volatility were to fall even further, the recovery would take place even faster. 

This speaks to one issue with the stimulus bill. In some ways it is less important how big it is or exactly what it proposes to spend money on. What is important is that we enact it soon so that firms can observe with certainty what the government is going to do. The dithering is what hurts the economy, not the actual type or amount of spending.

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