Bad News in the Great Depression, the Great Recession, and Other U.S. Recessions: A Comparative Study Jean-Paul L'Huillier and Donghoon Yoo∗ February 2016 Abstract In economic recessions consumption usually drops in tandem with other aggregate quantities as output or employment. Following the permanent income hypothesis, these drops can be rationalized by the idea that con- sumers have pessimistic views about their long-run income. Using a stan- dard signal-extraction model, we show that this pessimism can be due either to a persistent fall of aggregate productivity before and during the reces- sion (signaling a future decline of income), or to other negative information unrelated to fundamentals, which we label \bad news". We classify U.S. recessions (from 1919 to 2015) according to a bad news index that reflects this negative information. We find that both the Great Depression and the Great Recession score highest in this index. The index is such that we can rule out that this is due merely to the length or the depth of these reces- sions. Instead, these two recessions are similar in that both were aggravated by a wave of pessimism about future income which cannot be related to contemporaneous fundamentals. Keywords: recessions; permanent income hypothesis; news and noise. ∗Einaudi Institute for Economics and Finance, Via Sallustiana, 62, 00187 Rome, Jean- [email protected]; and University of Lausanne, Quartier UNIL-Dorigny, 1015 Lausanne, [email protected]. We would like to thank Daniele Terlizzese, Robert Waldmann, and participants at the conference \Large-scale Crises: 1929 vs 2008" for helpful comments. 1 1 Introduction Aggregate consumption fluctuations not only depend on economic fundamentals but are also heavily affected by swings of consumers' perceptions of the current and future state of the economy. Originally advanced by Pigou (1927) and Keynes (1936), and later rejuvenated by Beaudry and Portier (2004), the expectation- driven business cycle hypothesis suggests that fluctuations could arise due to ex- pectations about future fundamentals. The purpose of this paper is to examine the role of consumers' perceptions about the state of the economy on the behavior of consumption in the Great Recession and in the Great Depression, the two large scale crises over the last century and to compare them with the experiences of other U.S. recessions. Following Blanchard, L'Huillier, and Lorenzoni (2013), we base our inference on the permanent income hypothesis, allowing for noisy signals about future in- come, which in the model is determined by productivity. Consumers and firms decide their current spending by solving a signal extraction problem. The signal extraction problem involves two types of information. First, there is productivity, composed of a permanent and transitory component. Second, there is a noisy sig- nal about the permanent component of productivity. A shock to the signal is able to influence beliefs about the future level of income and thereby distort agents' expectations. Our key point of departure from Blanchard et al. (2013) is the classification of the sample into periods of \bad" news and periods of \good" news beyond the information conveyed by fundamentals (that is productivity). This means, for a given period, we compute the behavior or consumption warranted by the observa- tion of productivity and compare it with the actual realized level of consumption. If the realized level of consumption is below (above) the one warranted by produc- tivity, this is evidence that consumers received bad (good) news about the future through the signal.1 Based on this simple idea, we study whether U.S. recessions are mostly driven by persistent falls in productivity (letting consumers infer that their income will fall in the future and thereby triggering a recession), or whether they are driven by other information that cannot be explained by looking at the 1Notice that this is different from just a negative (positive) signal (using the notation in Blanchard et al. 2013, st < 0 (st > 0)). 2 dynamics of productivity alone. We perform this exercise on each recession in isolation and compute a bad news index for each. This allows us to compare recessions on this dimension. Our investigation requires an initial technical step which is to show that our decomposition of Bayesian inference into the beliefs obtained by the observation of productivity alone, and beliefs obtained by the observation of the signal afterwards is equivalent to the inference obtained by the usual updating using both signals simultaneously. Our second step in the paper is to proceed to estimation. We estimate a simple permanent income consumption model on U.S. quarterly data from 1919 to 2015. Consistent with previous work (Blanchard et al. 2013; L'Huillier 2012; Yoo 2015), we find that consumers' belief updating and consumption spending respond more to noisy information than to observed productivity at high frequencies. We then estimate the shocks to productivity and to the signal using a Kalman smoother. This reveals that an overwhelming majority of the Great Depression and the Great Recession are associated with consumers receiving bad news about the state of the economy. Of the fourteen quarters of the Great Depression, only one period is associated with consumers receiving good news, and during the Great Recession, consumers always received bad news about the state of the economy. This implies that during these two episodes noisy information worsened the economic slowdown. Interestingly, not all recessions are so clearly related to consumers receiving bad news about the state of the economy. In fact, in some recessions consumers actually receive good news about future fundamentals. Our main finding in this paper is that the Great Depression and the Great Re- cession are the two recessions associated with the highest amount of bad news. We establish this result by constructing a bad news index based on a (standardized) sum of the bad news received in each recession. Table 1 shows U.S. recessions ranked according to this index. We find that the Great Depression and the Great Recession are have a similar score in our bad news index. Also, they are differ- ent from other U.S. recessions because all other recessions did not feature such a high amount of drops in consumption that one cannot explain with fundamental information. Several other works have claimed that the Great Depression and the Great Recession are similar in many dimensions. For instance, Gallegati, Gatti, Gaffeo, 3 Table 1: Standardized News Index for U.S. Recessions Recession Dates Duration Standardized News Great Recession 2007:Q4{2009:Q2 7 -0.0220 Great Depression 1929:Q3{1933:Q1 15 -0.0207 Early 1990s (Gulf War) 1990:Q3{1991:Q1 3 -0.0180 Double-dip Recession (Volcker) 1980:Q1{1982:Q4 12 -0.0154 1937{38 1937:Q2{1938:Q2 5 -0.0119 Oil Crisis 1973:Q4{1975:Q1 6 -0.0103 1920{21 1920:Q1{1921:Q3 7 -0.0087 1953{54 1953:Q2{1954:Q2 5 -0.0085 Monetary Recession of 1960{61 1960:Q2{1961:Q1 4 -0.0075 Recession of 1958 1957:Q3{1958:Q2 4 -0.0062 1926{27 1926:Q3{1927:Q4 6 -0.0012 Dot-com Bubble 2001:Q1{2001:Q4 4 0.0010 1948{49 1948:Q4{1949:Q4 5 0.0016 Recession of 1969{70 1969:Q4{1970:Q4 5 0.0025 1923{24 1923:Q2{1924:Q3 6 0.0048 1945 1945:Q1{1945:Q4 4 0.0292 Notes: Recessions start at the peak of a business cycle and end at the trough. The duration is in quarters. and Gallegati (2015) stress credit booms as a lead-variable for big crises, Cao and L'Huillier (2015) emphasize the technological booms preceding crises, Anderson, Bordo, and Duca (2015) suggest that sharp increases in risk premia and declines in M2's velocity were notable feature of the onset of the two large scale crises; Fratianni and Giri (2015) highlight the importance of tight money triggering the crises, of sudden arrest in capital flows inducing balance-of-payments crises, and of the impacts driven by a banking crisis among others; Bianchi (2015) documents similarities between these rare events by examining the behavior of financial mar- kets with a Markov-switching vector autoregression (MS-VAR). Our contribution to this body of work is to emphasize yet another dimension in which these two important U.S. recessions are similar, mainly that it is difficult to rationalize the associated drops in consumption by appealing to contemporaneous fundamentals, and this more than in other U.S. recessions. This paper closely follows a revival in macroeconomic models with imperfect in- formation initiated by Mankiw and Reis (2002), Woodford (2003), Hellwig (2005), 4 Bacchetta and van Wincoop (2006), among others. Within this literature, we follow a body of empirical papers using signal extraction in DSGE models, see Lorenzoni (2009), Boz, Daude, and Durdu (2011), Barsky and Sims (2012), and other papers cited above. Methodologically, we attempt to disentangle contribu- tions of multiple signals by sequential filtering, in order to more closely examine the respective role of each signal on consumption fluctuations. Rest of the paper is organized as follows. Section 2 discusses the information structure and the model. This is followed by the solution of the model in Section 3, discussing consumers' and the econometrician's filters. Section 4 estimates the model and studies the empirical implications. Section 5 concludes. 5 2 The Model 2.1 Productivity Processes and Information Structure Consider a \news and noise" information structure (Blanchard et al. 2013), where productivity at (in logs) is the sum of a permanent component xt and a transitory component zt: at = xt + zt Consumers do not observe these components separately. The permanent com- ponent follows a randomly changing trend due to a permanent shock: ∆xt = ρx∆xt−1 + "t (1) The transitory component follows the stationary process: zt = ρzzt−1 + ηt The coefficients ρx and ρz are in [0; 1), and "t and ηt are i.i.d.