A perfect storm is brewing

One of the most outstanding effects of the recent credit crunch is the huge surge in stock market volatility. The uncertainty over the extent of financial damage, the identities of the next banking casualty and the unpredictability of the response of Bernanke and company have all led to tremendous instability.

As a result the implied volatility of the S&P100 index of the US stock-market, commonly known as the index of 'financial fear', has more than doubled since August 2007. In fact since the outbreak of the credit crunch it has jumped by similar levels as after shocks like the Cuban Missile Crisis, the Assassination of President Kennedy, the Gulf War and the 9/11 terrorist attacks.

After these earlier shocks volatility spiked and then quickly fell back. For example, after 9/11 implied volatility dropped back to baseline levels within two months. In comparison, the current levels of implied volatility have remained stubbornly high for the last seven months, rising rather than abating as the crises continues.

These temporary surges in uncertainty, after these earlier shocks, had very destructive effects. The average impact of the 16 pre-credit crunch shocks was to cut GDP and employment by 2 per cent over the following six months. So the omens for the impact of the current credit-crunch are worrying.

If these earlier temporary spikes in uncertainty led to a 2 per cent drop in GDP over six-months the impact of the current persistent spike is likely to be far worse. Thus, the combination of a reduction in banking credit alongside a huge survey in uncertainty suggests a recession in the US is almost inevitable.

For a longer-run historical comparison to the credit crunch we can go back 70 years to the Great Depression. This was the last time that volatility was persistently high. Much like today, the Great Depression began with a stock-market crash and a meltdown of the financial system. Banks withdrew credit lines and the inter bank lending market froze-up. The US central bank, the Federal Reserve Board, desperately scrambled to restore calm but without success.

What followed was massive levels of stock market volatility and a recession of unprecedented proportions. From 1929 to 1933 GDP fell by 50 per cent, a bigger drop than in every recession since World War II combined. The economy did not fully recover until more than a decade later, after the end of World War II. On this comparison a recession not only looks almost inevitable, but its longer run effects start to become alarming.

So why is this rise in uncertainty likely to be so damaging for the economy? The reason is that firms typically postpone making investment and hiring decisions when business conditions are uncertain. It is expensive to hire a worker and then have to fire them again, or buy new capital equipment and then sell it again. So if conditions are unpredictable the best course of action for firms is often to wait. Of course if every firm in the economy waits then economic activity slows down. This directly cuts back on investment and employment, two of the main drivers of economic growth.