The uncertainty shock from the debt disaster will cause a double-dip recession

"The potentially explosive combination of Eurozone debt contagion, vulnerable banking systems, and European and American political paralysis has pushed stock-market volatility to levels nearly as bad as the days following the 11 September 2001 terrorist attacks. Nobody knows what happens next. This column reviews research on 16 previous shocks and concludes that today’s uncertainty shock will create a short, sharp contraction in late 2011 of about 1% with a rebound coming in spring 2012.

Editor's Note: This is an UPDATE of the column first posted on 9 August 2011
In the ten days that have passed since posting my original warning, stock markets have swung wildly. Market makers are incredibly uncertain about the future.

• Will Democrats and Republicans in the US manage to agree on how to deal with US debts?
• Will Germany bail out the failing southern European governments?
• Are there banks in the US and Europe that are going bust?

When there is this much uncertainty even the smallest rumour generates wild market swings. Mundane news can generate hundred-point swings. Good news sends the markets soaring. Bad news sends the markets crashing.

Six more weeks of panic according to historical patterns

So how long will this stock-market panic last? On average the previous 16 uncertainty shocks have had a 1.9 month half-life – this means it takes almost two months for the peak level of uncertainty to fall back by 50%. Hence, within about six weeks the current panic should have subsided (since it is already about two weeks old).
As I discuss below, this panic is likely to cause a double-dip recession in late 2011. The uncertainty will lead firms to pause hiring and investing until probably early 2012.
But despite my short-run pessimism, I’m very positive on long-run US and European growth. Why?

• First, this disaster will help to push both continents to undertake long-needed reforms of retirement systems (particularly in Europe) and healthcare systems (particularly in the US).

Already countries like Greece are torching swathes of regulations, cutting back the public sector, and delaying retirement. In the US this disaster might be enough to initiate serious reforms to limit healthcare spending, to avoid this breaching 20% of GDP.

• Second, the growth of China and India will continue to drive global growth.

These countries have decades more of high growth, and as they grow they will represent a larger share of the world economy, accelerating global growth.
In fact I am sufficiently optimistic in the long-run that today I even invested my tax rebate in the S&P index. So I certainly hope for a rapid recovery!..."

at http://www.voxeu.org/index.php?q=node/6846