What odds a depression in the US?

Economist Robert Barro looked at international data on stock market crashes of greater than 25% to see whether they were associated with depressions. He defined a depression as a fall in real GDP of greater than 10%. These depressions lasted on average 4 years. He came up with a 20% probability of a depression based on this data. For more detail see
http://online.wsj.com/article/SB123612575524423967.html

I thought it was an interesting but fairly simplistic approach. Let's do some quick guesstimates based on a wider and more relevant range of data.

1. He just looked at stock prices data and looked at declines of over 25%. Would have been more interested if he looked at declines over say 40% or 50% as we know the current decline is at least that large adn possibly much larger . Presumably you'd get much higher odds of a depression in situations with larger stock price declines. I'd guess he'd get maybe 30-40% odds of depression based on a stock market crash of over 50% - which is where we are now.

2. Also would have been convincing if he'd looked at real estate prices as well. My understanding is that real estate price declines of current levels haven't occured since the great depression in the US so on that basis you'd probably have to give the odds a lot higher than 20%. Given that you're batting 1 for 1 on the impact of large real estate creashes you'd have to say 50%-100% chance of depression but obviously a sample of 1 isn't much of sample.

3. A few months ago I looked at sharp (>30% in real terms) declines in real estate prices over the past 25 years in many countries. What I found was interesting (I haven't got the figures here but from what I remember):

- Finland - depression
- Sweden - avoided depression with prompt action and also no other countries around in trouble
- Asian crisis - data for 6 countries - 5 out of 6 countries depression
- Japan 1990's - 10 years of extremely low growth so don't know if it qualifies as a technical depression but it counts for me
- 6-8 countries just had severe recessions associated with their house price slumps.

On that basis you'd have to say 8/16 equals 50% chance of depression.

It would also seem sensible to add in what we already know about the current situation, as summarised in points 4-6 below.

4. The world wide nature of the current situation means the usual method of exporting your way out of a credit related problem does not exist. If you restricted your data to the periods of worldwide contraction for your large stock market and real estate market situations you're almost certainly going to get much higher odds but it's obviously going to make your data set smaller. On this basis maybe 60-80% chance of depression.

5. We have a simultaneous large fall in the stock market and the resident ail real estate market - having both together rather than just one is going to increase the chance of depression. On this basis maybe 60-80% chance of depression.

6. What do we know currently about this recession:

- it's already had the longest postwar recession
- the banks are still in trouble
- rapid economic contraction at this point in the US and worldwide
- no sign of any turnaround in any major industry
- massive oversupply in residential and commercial property
- the first negative quarter of earnings since 1936
None of this suggests GDP is going to do anything apart from decline fairly rapidly in the next 6 months and that is then getting us pretty close to but probably not quite in depression territory. On that basis say 50-60% chance of depression on the basis of the current situation as we could still turn around before we reach that point.

So, to summarise the above 6 points, my guesses for the chance of a depression (defined by 10% minimum drop in real GDP over an average 4 year period) are:

1. Large stock market crashes - suggests 30-40% chance of depression

2. US large real estate market crashes - suggests 50-100% chance of depression

3. World wide data on large real estate market crashes - suggests 50% chance of depression

4. Worldwide data on large stock market and real estate market crashes that are synchronized with each other around the world - suggests 60-80% chance of depression.

5. Simultaneous large drops in real estate and stock market - suggests 60-80% chance of depression.

6. Looking at the current length, depth and trajectory of the recession so far - suggests 50-60% chance of depression.

Based on all that I'd guess a 50-80% chance of depression. Let's say a 2 out of 3 chance. Certainly even being optimistic I'd find it hard to argue for a less than 50% chance. That's a scenario worth taking seriously.

What are the implications of this.

1. Save money by finding things you enjoy that don't cost money rather than things that cost a significant amount of money.

2. Give some thought to what you would do if things go wrong for you or your family. e.g. you loose your job and can't find another one, can't get credit, house prices stay down or go lower, stocks stay down or go lower etc.

3. Give some thought to how you might help others if things turn out badly for them. It feels good to help others - here's our chance.

4. Don't go rushing out to buy houses, stocks etc unless you can afford to risk loosing a fair bit of that money in the next few years. Of course even in a depression they may go higher than current prices within 5 years, but who knows, things will be clearer later.

5. Reduce debt.

6. If you're a trader like me be prepared to continue to short the market unless there are some clear early signs of recovery. Given the size and nature of current government interventions be prepared for signs that a recovery stalls and we have a double dip recession like in 1981 then 1982/3 and 1929-33 then 1937/8.

If there's no depression what have you lost by taking these actions - very little. Maybe you are a little less wealthy then you would have been but presumably the economy will be OK so you'll be OK as far as making a wage etc.

However, if you choose to assume the best and fail to plan for trouble, you could find yourself in a difficult situation in an economy in which there are few opportunities for improving your financial, job and debt situations.