The economic cycle of fear: How panic fuelled a global recession

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As President Franklin D Roosevelt famously once observed: “The only thing we have to fear is fear itself”. It is an aphorism that policymakers should take note of, given the findings of research by Philippe Bacchetta and Eric van Wincoop into the causes of the Great Recession.

5 min read

As the two academics reveal, negative sentiment can fuel a self-fulfilling chain of events that quickly evolves into a panic driven, full-blown global economic crisis.

BacchettaPhilippe Bacchetta is a professor of Macroeconomics. His research interests include international finance, financial crises, exchange rates and monetary economics.

The Great Recession that began in the US in 2008 was exceptional in a number of ways. It was not only longer and more damaging than many previous crises, but it was also unusually widespread. This was truly a global crisis. The steep decline in output, consumption, investment and corporate profits experienced in the US was mirrored across the world.

Many commentators have ascribed the global nature of the crisis to high levels of trade and financial integration. However, research by academics Philippe Bacchetta and Eric van Wincoop suggests other mechanisms played a major role; important findings if we are to learn the lessons of the past and try to avoid a similar recession in the future.

Historically, major recessions have had a profound effect on economic output in the countries where they initially occurred, but their impact elsewhere has often been limited. That is true for the Great Depression, for example, where the decline in output was much greater in the United States than in the rest of the world.

The anatomy of a crisis

With the Great Recession of 2008 -2009, however, poor performance in the US across numerous economic and business metrics during late 2008 and early 2009 was also experienced in many other parts of the world. As was the negative outlook and increased uncertainty about future growth prospects.

Contagion in the financial system, and restricted credit availability in particular, was not primarily responsible for the global nature of the 2008-2009 crisis.

To the casual observer such contagion might not seem surprising in a 21st century globalized economy. Why wouldn’t the ripples from game changing disruptive technologies, or a significant market crash, reach across oceans to countries and continents far from the original source? As the authors note, however, contagion in the financial system, and restricted credit availability in particular, was not primarily responsible for the global nature of the crisis. Credit did not decline noticeably in non-US countries. And previous research suggests that the transmission of a financial shock between countries requires closer integration of goods and financial markets than that demonstrated by the countries affected. Instead, some other mechanism was at work.

But why was the Great Recession so widespread, and why was this recession different from previous recessions? These were the two questions the authors set out to answer.

Their fears became self-fulfilling, demand dried up, and the predicted slump became a reality

The solution, suggest the authors, lies in the economic related fear that gripped the world’s corporations and consumers. As the various members of the global economic ecosystem revised their expectations of future income and economic activity downwards, their fears became self-fulfilling, demand dried up, and the predicted slump became a reality. Survey results show that the average GDP growth expectations of a set of 17 non US countries broadly tracked US sentiment, as did the perceived variance from growth forecasts.

The authors constructed a two country model to investigate the mechanisms for contagion and the factors that play a role in the spread of negative sentiment. They discovered a devastating chain of events.

Where firms have set prices, but then encounter funding constraints on operations and experience low profits and tight credit, those firms may not be able to invest enough to maintain productivity levels. The confidence of workers – who are also consumers – is dented as they anticipate reduced income, and budget accordingly decreasing consumption. Lower demand feeds through to lower profits and, if credit remains tight, leads to lower investment, productivity and income. Firms go bust. Panic sets in. Recession ensues.

Thus lower economic expectations may become economic reality, in turn increasing uncertainty about future output. But what about the contagion? The authors show that limited integration at least is required for economic panic to spread between two countries.

Where one country is seized by a self-fulfilling economic malaise the other country will necessarily panic as well.

Sufficiently integrated countries are unable to form different perspectives on the future. Beyond a certain threshold of integration between two countries, conditions will be such that where one country is seized by a self-fulfilling economic malaise the other country will necessarily panic as well. Or, the economic situation will be benign enough that investment is possible and calm prevails. Below that integration threshold, however, it is possible for one country to remain unaffected by the panic of another country.

Economic panic

The authors show how, in 2008 and 2009, conditions were highly conducive to creating a self-fulfilling cycle of panic that was likely to lead to falling economic output and performance. In particular, losses from financial firms led to deleveraging and a credit crunch made it difficult for firms to borrow. Low interest rates in many countries limited scope for central banks to use interest rate cutting as a monetary tool to promote growth. Also, high levels of government indebtedness restricted the ability of countries to stimulate growth through government spending.

Add a trigger event, such as the turmoil in US markets following its real estate crash and collapse of collateralized debt obligation markets, plus sufficient integration between countries, and a contagious panic and ensuing recession is difficult to avoid.

In their research the authors identify a self-fulfilling mechanism that has the potential to cause a global economic panic, and the conditions that make such a panic more likely. In doing so, they provide policymakers with an opportunity to devise policies focused on preventing conditions coalescing in a way that leads to similar recessions. Business practitioners can benefit too by taking the findings into account when they develop their risk and forecasting strategies, for example.

But while policymakers and practitioners may try to stave off future recessions, with global integration increasing the phenomenon of economic mass panic is probably here to stay.

Read the original research paper: Bacchetta P. & van Wincoop E. (in press). The Great Recession: A Self-Fulfilling Global Panic. American Economic Journal: Macroeconomics.

Featured image by peshkov / istockphoto

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