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Sizing Up The Odds Of A Depression

Harvard economist Robert Barro has a Wall Street Journal op-ed today writing up his recent attempt to quantify the chances of a depression. His short answer: 20 percent.  

I don't have time to read Barro's full paper now. (You can read the abstract here--the details look slightly different than the details in the piece.) But there is one methodological issue I'd raise based on his short description. It has to do with the difference between the post-war experience of developed countries and, well, everyone else.

In the op-ed, Barro pools together all the examples of stock market crashes since the late 19th century in the 34 countries he studied. Of the 209 crashes unrelated to major wars, he says, 41 appear to be suspiciously connected to the ensuing depression. (There were 18 other depressions, but the connection is less obvious.) But, as he concedes, pretty much none of these depressions hit a developed country after World War II.

I don't think that's an accident. In fact, there's a pretty extensive economics literature explaining why financial crises haven't tended to trigger depressions in these cases. (It has to do with the governments stepping in to prevent financial institutions from failing en masse and demand from collapsing, which is a rough approximation of what we're doing now.)

Having said that, Barro's certainly right to think the recent crash could trigger a depression. My point is just that his 20 percent figure is probably a little off if he's basing it on the experience of countries that don't resemble us in important ways.

On the other hand, even Barro says the news isn't all bad: "The bright side of a 20% depression probability is the 80% chance of avoiding a depression." True, true.  

P.S. The final paragraph of Barro's op-ed seems like it merits elaboration, no?

I wish I could be confident that the array of U.S. policies already in place and those likely forthcoming will be helpful. But I think it more likely that the economy will eventually recover despite these policies, rather than because of them.

Not exactly the kind of claim you make casually in passing...

(Via Greg Mankiw.)

--Noam Scheiber