Odds of Depression Are 20% According to Harvard Economist Robert Barro

Robert Barro, a Professor of Economics at Harvard University a fellow at Stanford University's Hoover Institution looked at economic data from the past 130 years to determine the probabilities of a small and large depression occurring. In particular, what he found was that stock market crashes make the onset of a depression much more probable.

Depression as a word is often thrown around cavaliarly but it has a precise definition - a decline in per-person GDP or consumption of 10% or more. The Great Depression saw a decline of 25%. Recent GDP reports from last quarter showed annualized GDP shrinkage of 6.2%. It's not inconceivable the way the economy has been decelerating that this quarter's numbers won't be worse.

Writing in the Wall Street Journal, Barro says:

"In fact, knowing that a stock-market crash has occurred sharply raises the odds of depression. And, in reverse, knowing that there is no stock-market crash makes a depression less likely."

Nothing extraordinary here. It all makes intuitive sense. He continues:

"In applying our results to the current environment, we should consider that the U.S. and most other countries are not involved in a major war (the Iraq and Afghanistan conflicts are not comparable to World War I or World War II). Thus, we get better information about today's prospects by consulting the history of nonwar events -- for which our sample contains 209 stock-market crashes and 59 depressions, with 41 matched by timing. In this context, the probability of a minor depression, contingent on seeing a stock-market crash, is 20%, and the corresponding chance of a major depression is only 2%. However, it is still the case that depressions are very likely to feature stock-market crashes -- 69% for minor depressions and 83% for major ones."

Looking on the bright side, if there is a 20% chance of a minor depression, then there is an 80% chance that there won't be one. The US avoided depressions with the stock market crashes of 2000-02 (by 42%) and 1973-74 (49%). These events produced mild recessions. Of course, they also didn't produce a total collapse of the US banking system and the near-bankruptcy of a major part of the US industrial heartland - GM, Ford, Chrysler.

He ends by saying that the average duration of the 59 non-war, non-depressions covered in his analysis were four years. That means recovery wouldn't happen until 2012. When you consider that this is not an average recession (and may even flitter with depression), then it's easy to see the downturn lasting at least that long.

As I have shown in my comparison of the Dow today to the Great Depression and the same comparison done between the Dow and the Nikkei crash in 1989, a prolonged and severe recession/depression have historically beaten up markets even more than what we've seen so far.