The US stock market has dropped over 6% in 2016. One question that keeps investors up at night is whether the economy is currently falling into a recession. A recent publication by Roger Farmer, economics professor at UCLA, suggests that the equity market crash caused the Great Recession and finds a stable connection between the real value of the stock market and the unemployment rate. (Click here to access this paper.) In light of these interesting findings, we would like to share some thoughts on this study.
First, this paper uses data from 1953 to 2011, but only finds significant result during sub-period 1979-2011. The author argues it’s due to the “Volcker disinflation”. When we replicate the test using an even more comprehensive dataset, the overall result became very weak. Therefore, the finding may be subject to sample selection and underlying economic condition, which could undermine the generalizability of this study.
The foundation of the paper is the Granger causality test, which statistically confirms the causal relationship between two events. In the sub-period between 1953 and 1979, Farmer finds that the stock market downturn causes the BAA spread to widen, which causes the unemployment rate to rise. This finding recalls a classic debate, which we can simplify this way: “If A causes B, and B causes C, does A cause C?” Maybe. However, Granger causality isn’t necessarily transitive, since econometric analysis relies heavily upon statistical significance, which may be weakened from A to C. Thus, without direct evidence of the causal relationship between the stock market and recession, Farmer’s thesis may only apply to a very limited period of history.
So, did the stock market actually cause the Great Recession? Sometimes the answer is right in front of our eyes. Let’s walk down memory lane and take a look at the financial crisis one more time.