Cochrane Spin Control

http://johnhcochrane.blogspot.com/2012/05/slow-recoveries-after-financial-crises.html

John Cochrane writes "On my reading list: In the meantime, Jim Stock and Mark Watson do very careful econometric analysis and conclude that this recession really didn't have much to do with the financial crisis: "no new “financial crisis” factor is needed.   They continue, More ominously,  we estimate that slightly less than half of the slow recovery in employment growth since 2009Q2, compared to pre-1984 recoveries, is attributable to cyclical factors (the shocks, or factors, during the recession), but that most of the slow recovery is attributable to a long-term slowdown in trend employment growth"

From these excerpts you would take away that Stock Watson's paper lend support to the Cochrane / Ohanian / Schlaes argument that the recession is not the result of the financial crisis but due to poor policy by the Obama administration.  You might think that if you had not read the paper and just took Cochrane's excerpts at face value...

What Stock and Watson actually say is "The main contributions to the decline in output and employment during the recession are estimated to come from financial and uncertainty shocks.  ....Taken at face value, this suggests an economy being hit in close succession by a sequence of unusually large shocks, all of which have been experienced before, but not in such magnitude or close succession: an initial oil shock, following by a financial crisis, financial market disruptions, and prolonged uncertainty due in part to policy uncertainty....given the value of the factors in 2009Q2, the DFM [Stock Watson's model] predicts nearly two years of sub-trend employment growth following the 2009Q2 trough.  In fact the DFM predicts a slower employment recovery from the 2009Q2 trough than actually occurred, that is, the current recovery in employment is actually faster than predicted; from the perspective of the DFM forecasts, the puzzle, if there is one, is why the recovery was a strong as it has been."

Their paper is more nuanced than the excerpts that I have pulled out here.  Here is the idea:  Stock and Watson look at a large number (198) of macroeconomic variables and posit that there are a small number of underlying factors which drive them all.  They first estimate how many underlying factors there are (six) and how much each of the six underlying factors contributes to explaining each of the 198 macroeconomic variables.  Some of the macroeconomic variables are predicted very well by the six driving factors and some less so. 

Next they ask if this recession is different from other recessions in terms of what underlying factors drove the recession.  They ask if there a seventh factor responsible for the most recent recession or do the same six factors which have been responsible for previous recessions do a good job of explaining the most recent recession as well.  They reject the existence of a seventh factor.  In other words this time is not different in terms of what the factors are that drove the recession - although the size of the shocks to those factors was unprecedented. 

Finally they try to distinguish what types of shocks actually drive their factors.  The six shocks they consider are: oil, monetary policy, productivity, uncertainty, liquidity / financial risk, and fiscal policy.  They find that the productivity, monetary, and fiscal shocks had small impact on the 2007-2009 recession.  Oil shocks - depending on how one defines them - may have contributed at the start of the slowdown.   The two shocks which seem to have most impact are liquidity / financial risk as represented by the TED spread and corporate bond spreads, and uncertainty as represented by the VIX and BBP economic policy uncertainty variable.  The TED spread represents the spread between bank borrowing rates and US Treasury.  During the 2007-2009 financial crisis the TED blew out as banks equity collapsed and fears of lending between banks took over.  That was the financial crisis.  Other recessions have seen a  widening of the TED spread, the corporate bond spread, and an increase in the VIX, but this most recent recession saw extreme moves in all three. 

Finally they note that part of the reason that the recovery has been so slow is that that trend component in labor force participation slowed greatly between 1965 and 2005.  The initial 2007-2009 decline was deeper then any previous downturn back to the Great Depression and given our slowed secular growth rate  in labor force participation it will take a while to get back to pre-recession levels.  That sounds about right to me.

Stock Watson conclude:  "Three main conclusions emerge from this work.  First the recession of 2007-2009 was the result of shocks that were larger versions of shocks previously experienced, to which the economy responded in a  historically predictable way.  Second, these shocks emanated primarily but not exclusively from financial shocks and heightened uncertainty.  Third while the slow nature of the subsequent recovery is partly due to the shocks of this recession most of the slow nature of the recovery in employment and nearly all of the the slow recovery in output is due to a secular slowdown in trend labor force growth.  This slowdown in labor force growth provides and simple explanation for the jobless recoveries of 2001 and 2007 recessions."