Risk Off

Andrew G Haldane, Executive Director, Financial Stability and Member of the Financial Policy Committee
18 August 2011

Four years on from the start of the Great Recession, the world economy is cloaked in uncertainty. The story so far is well understood. Over-extension of private sector balance sheets – in particular among banks – sowed the seeds of the crisis. Those private sector risks have since been socialised, either directly through support for the financial sector or indirectly through lower aggregate output in the economy at large.

That socialisation has caused balance sheet risk to migrate from the private to the public sectors. Today, these public sector balance sheets strains are most visible in Europe where a number of countries remain under the sovereign searchlight. But outside Europe, two of the world’s three largest economies - the United States and Japan – have been the subject of ratings action. And sovereign CDS spreads among advanced countries are at their highest-ever levels.
Four years on from the start of the Great Depression, the world economy was also cloaked in uncertainty. In his inaugural address in 1933, newly-elected President Roosevelt famously captured the mood of the moment: “the only thing we have to fear is fear itself”. That fear factor is once again pervasive today. But do we have nothing to fear? And what role might policy – in particular macro-prudential policy – play in allaying those fears?

Emerging from the Great Recession

The path out of recession is invariably a bumpy one. This time’s Great Recession is unlikely to be an exception. Chart 1 compares the recent path of UK GDP with that following previous GDP dips: the Great Depression of the 1930s and the UK recession of the early 1990s. To date, GDP has steered a middle path, somewhat stronger than in the 1930s but weaker than in the early 1990s recovery.

If past recessionary experience is any guide, the UK’s GDP trajectory might be expected to pick up pace from here. Most external forecasts remain broadly consistent with that view. But the risks around this path are considerable, as recent indicators of slowing global activity attest. This is not altogether surprising. Crisis-induced recessions are deeper and longer, on average taking up to three years to return to their pre-crisis peak.

Some take longer still. Following the Great Depression, UK GDP only recovered its pre-crisis level after 5 years. The US recovered its pre-crisis level after 7 years (Chart 3). Having reached this point, the US economy then lurched downwards again in 1937; it double-dipped. Roosevelt had been wrong in 1933. With hindsight, there had been plenty to fear.
As in 1933, the fear factor is rife in today’s financial markets. The prompt has been sovereign debt concerns in parts of Europe and the United States. This is but the latest – and most severe – in a series of waves in sentiment since the onset of the crisis. Risk appetite has yo-yoed. In the language of the market, it has alternated between periods of “risk on” and “risk off”. Having been indecisive, financial markets are now not so sure.

To read the entire speech with charts please click on the pdf.