Disentangling the channels of the 2007-2009 recession

Harvard Professor James Stock and Princeton Professor Mark Watson presented a very interesting paper last week at the Spring 2012 Conference for the Brookings Papers on Economic Activity. Their paper studied similarities and differences between the 2007-2009 recession and other U.S. business cycles.

Stock and Watson characterized the comovements over 1959:Q1-2007:Q3 of 198 different U.S. macroeconomic variables in terms of 6 primary factors. These factors could be calculated from the first 6 principal components of a non-redundant subset of their observed variables. This method amounts to finding 6 different summary indexes (or 6 different sets of weights to associate with each of 132 of these series) that could collectively account for as much of the variation as possible of all the data.

Their first question was whether the observed U.S. macroeconomic data continued to track those factors in the same way during the most recent recession and recovery as they had historically. Stock and Watson’s answer was, for the most part, yes. For example, the solid line in the graph below plots year-over-year real GDP growth rates (relative to trend), while the dashed line gives the values you would have expected if you’d known only what the 6 historical factors were doing and if you assumed that the relation of GDP to those factors was the same since 2007 as it had been before. GDP seems to have a similar relation to other macro variables during the most recent recession and recovery as it had historically. Statistical tests fail to reject the hypothesis of a stable relation for most of the 198 series they studied. Some of the series that did seem to exhibit some new dynamics include commodity prices, unemployment durations, and some monetary indicators.

Deviation of 4-quarter percent change in real GDP from trend. Solid line: actual. Dashed line: predicted on the basis of
1959:Q1-2007:Q3 correlations. Source: Stock and Watson (2012).

From these tests the authors conclude:

We believe that the most natural interpretation of these three findings is that the 2007Q4
recession was the result of one or more large shocks, that these shocks were simply larger
versions of ones that had been seen before, and that the response of macro variables to these
shocks was almost entirely in line with historical experience. The few series for which behavior
departed from historical patterns have natural explanations, in particular the DFM [dynamic factor model] predicts
negative interest rates because it does not impose a zero lower bound and the DFM does not
predict the Fed’s quantitative easing.

Stock and Watson then went on to try to understand the nature of the recent large shocks. The individual factors as calculated by traditional principal component analysis do not have any economic meaning or interpretation, in part because if the model were rewritten in terms of any linear rearrangement of the original six factors, it would have identical implications for the correlations and forecasts of any observed variables. Stock and Watson therefore proposed to consider six observable shocks that economists believe may be responsible for economic fluctuations, these being oil prices, monetary policy, productivity, credit spreads, uncertainty, and fiscal policy. They looked at the relation between measures that other authors had proposed for each of these structural shocks and their own estimated 6 factors, to find linear combinations of their factors most consistent with how other researchers had been summarizing the data. For example, for the oil shock, they considered using the measure proposed in my 1996 paper in the Journal of Monetary Economics, a separate measure favored by Kilian (2008) or the change in oil price itself. They construed the “oil shock factor” to be the linear combination of their six factors that has the highest correlation with one or all of these three separate measures and smallest correlation with other observed structural shocks.

The authors concluded:

the structural analysis is consistent with the recession being caused by initial large oil
price shocks followed by multiple financial and uncertainty shocks….

The picture of the recession that
emerges… is one of increases in oil prices through the first part of the recession,
followed in the fall of 2008 by financial sector volatility, a construction crash, heightened
uncertainty, and a sharp unexpected drop in wealth. Notably, there no large surprise movements
of the real variables given the factors through the previous quarter.

But if the Great Recession can be interpreted as normal responses to abnormally large shocks, what about the anemic recovery? Stock and Watson attribute this to a slowdown in trend growth rates, which they infer statistically from a procedure similar to taking a 12-year average of the growth rate. Again quoting from Stock and Watson’s paper:

The explanation for this declining trend growth rate which we find the most compelling rests on
changes in underlying demographic factors, primarily the plateau over the past decade in the
female labor force participation rate (after rising sharply during the 1970s through 1990s) and the
aging of the U.S. workforce. Because the net change in mean productivity growth over this
period is small, this slower trend growth in employment corresponds directly to slowdown in
trend GDP growth. These demographic changes imply continued low or even declining trend
growth rates in employment, which in turn imply that future recessions will be deeper, and will
have slower recoveries, than historically has been the case. In other words, jobless recoveries
will be the norm.


17 thoughts on “Disentangling the channels of the 2007-2009 recession

  1. Anonymous

    “The explanation for this declining trend growth rate…rests on… primarily the plateau over the past decade in the female labor force participation rate….and the aging of the U.S. workforce.”
    Stock & Watson obviously have not been paying any attention to the western credit markets over the last 15 years. Nor have they bothered to comprehend the writing and research by Reinhart and Rogoff. “Trend” growth since the late 1970′s has been achieved by increasing credit indebtedness of future generations. Our dilemma is that there are no longer enough profits to service existing debt, much less any room to expand private debt. Instead, America is retrenching into a Statist political economy where public debt is used as a substitute for organic growth and commercial discipline.
    I do agree to a certain extent that the aging of the baby boomers will moderate economic activity. It is however true, that the economy is so crippled by debt and high commodity prices, that employment growth can barely accommodate the young entering the economy… it can not absorb the 20 million people currently lost to the workforce… and it can only achieve this anemic performance with a federal budget deficit at 10% of GDP!!!

  2. ppcm

    The paper of Professors Waston and Stock deserve all the respect that a benchmark 6-factor,198-variable DFM may raise.Drawing on the data as provided by the NBER US business cycles,where both Professors are referenced as experts,the contemporary business cycles have made wonders in lengh.When the average lengh of recoveries had been of 3.8 years from 1904 till now,from july 1982 till 19 december 2007 the USA have enjoyed an unprecedented period of expansion of 23 years.
    In economics, data are continuously feeding new theories and making others obsolete literature. It may be worth to review very few of the casualties of these modern times:
    The predictive value of the long term yield curve no longer predictive,but at best coincident.
    Treasury Spread: 10 yr bond rate-3 month bill rate (http://www.newyorkfed.org/research/capital_markets/Prob_Rec.pdf),Please note that the mutation of the long term yield curve predictivity, is in compliance with the extended lengh of recoveries.
    The relationship between the corporations profits and the gross fixed private capital formation or Tobin q,is no longer valid (financial profits were, are much larger than production profits)
    Okun law is broken,an interesting paper from Zero Hedge is exposing the versatility of the theory “Guest Post: It’s Far Deeper Than Broken Okun”
    Those economies are carrying much more TARPitudes than declared.
    An IMF report ( The State of Public Finances:Outlook and Medium-Term Policies After the 2008 Crisis) is expanding at length on the state of public debts.The Fed St Louis may assist in furthering examination of the debts evolution and distribution, public,private.The broken structure of the economies, more financial papers than commercial papers.Not reassuring is the homogeneity in the debt load and distribution in Europe and the USA.
    As for some of the turpitudes the OCC report may outline the means and the ends,
    OCC’s Quarterly Report on Bank Trading and Derivatives Activities
    Second Quarter 2011
    Furthering the comparison with the modern time,reading A. Bliss may reveal the hardship of the output gap.
    Production in Depression and Recovery
    Copyright 1935. National Bureau of Economic Research, Inc. A. BLISS

  3. Steven Kopits

    Oil shocks, indeed.
    Here are some oil stats for you:
    Compared to trend from say, 2007, we are missing 1 in every 7 vehicles on the road.
    Compared to trend for commercial airline departures, we are missing 1 in 3.
    That’s an extraordinary loss of mobility. In fact, it is the real mobility crisis.

  4. AWH

    lead and coincident indicators are not the same as drivers

    being from harvard only accentuates that the academic wing is mostly without knowlege of the finnancial flaws that mostly drove this one, which in many respects was unlike anyting since the 30s

  5. Ricardo

    I am always bothered when any economist uses terms like “one or more large shocks.” Essentially this simply says, “we really do not know what it is that caused the problem but we think it is some really big event, maybe _____(fill in the blank). But that really big event is really outside the real economy, even though we know that no economic event is really outside the real economy. We are simply going to assume that it is outside the real economy and it has no interrelationship with the real economy such as cause and effect.”
    Then “demographic factors” has become the buzz phrase de jour. We are also going to assume that markets do not take certain factors into account such as “demographic factors” and so this can also be considered a “large shock” or something.

  6. dwb

    the common shock is monetary policy (the Fed triggered or allowed recessions to disinflate since 1980s). The Fed WANTED the housing “bubble” to pop, lets not forget.
    As for the anemic recovery, we keep getting jostled by the hawks and the doves as they fight over the gas pedal or the brake.
    well, duh. you cannot go very far when you keep braking.
    Why are we getting 2% inflation in the face of an output gap so large?
    Well, when corporate HR doles out meager cost of living adjustments they make it 1.7-2% on average because its ingrained into out psyche that 2% is the inflation target.
    So, the power of a credible central bank setting an inflation target is that they get it even in the face of high unemployment.
    Imagine, if all that power to set expectations were channeled into a conditional statement like, i dunno, “we are going to close the output gap and stabilize nominal income”.

  7. Stephen McCourt

    It is human nature to find “unique” explanations for events that are larger than our imaginations (the GFC). In my industry (pension plan management), this has led to untold hours spent describing how the “deleveraging” associated with the 2007-09 is quite different in nature than normal “recessions.” I find it somehow refreshing to hear a perspective that the recession was “normal,” just deeper.
    Incidentally, I listened to Alan Greenspan last week discuss his thoughts on the U.S. recovery at a conference last week, and it sounds like he would likely put himself in this camp – the shock being housing, of course.

  8. Brian

    So Stock and Watson develop 6 factors that the authors specifically cannot relate to anything in the real world. They present two graphs showing their factors can fit to a curve. They then propose, without any actual rationale relating to their graph, what they think happened.
    This isn’t an “interesting paper” to me. Dear god. That appears to be an utter silliness paper, devoid of real meaning, of a kind all too common in economics. This emperor has no clothes at all. Not even a fig-leaf.
    It is appalling, but not surprising, that they could ignore the debt bubble. The collusion, explicit and implicit, between those responsible for the creation of the bubble and professors at the “best universities” is hardly secret.
    This as an atrocious paper, suitable for enriching lawns.

  9. Mike Laird

    Why do economists refuse to even consider that mortgage fraud occurred on a grand scale? Bail outs to banks and homeowners have been the center piece of major recovery actions, but mortgage fraud doesn’t make the list of 6? Why?

  10. 2slugbaits

    It would be interesting to see if Stock and Watson’s findings are robust to other OECD economies.

  11. Simon van Norden

    I’m puzzled by someone like Stock or Watson doing this kind of analysis using deviations from trend and then looking at those deviations right up the present time. Our estimates of recent trends are subject to substantial revision; so how can we tell whether recent deviations from trends (which we measure very imprecisely) are similar to those of old?

  12. JDH

    Simon van Norden: To clarify, the principal components method is typically applied to stationary series with zero mean and unit variance. Stock and Watson accomplish this by generally using growth rates. The “trend” is essentially a very slowly moving average of growth rates. When I looked at their plots of trend for selected series, they did not look that controversial to me.

  13. tj

    Steven’s comment got me thinking about labor mobility. I am not the first to say this, but part of the slow recovery in employment is related to job seekers who have a home that is underwater and they can’t afford to sell it at a loss. Thus, their job search is somewhat constrained geographically. It would be intersting to see how ‘average days a home is on the market’ during this recession compares to other recessions. Maybe their model captures that, I didn’t look.

  14. Paul Hodges

    This is the first time I have seen a US paper which references the aging Western babyboomers as a factor in slower growth rates.
    It supports the evidence we have collated in our new book Boom, Gloom and the New Normal (www.new-normal.com). This argues that the Boomers have been surprised by their increased life expectancy, and are very worried by their consequent need to make their savings/pensions stretch for an extra decade.
    The only way they can achieve this is by spending less and saving more. Hence growth rates are lower, whilst demand for ‘safe’ savings assets such as T-bonds continues to rise.
    Thanks for posting

  15. Jeff Ryan

    Unfortunately, the link to your 1996 paper doesn’t seem to work when you click on the “View full text” button. Hope someone can get that fixed – you’ve been named by a number of folks as the “go-to” person regarding oil prices.

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