Harbingers of Recessions

• Author: John C. Bluedorn, Jörg W. Decressin, and Marco E. Terrones
• Position: an Economist and is a Deputy Director in the IMF's European Department. is an Assistant to the Director in the IMF's Research Department.­

There are two views about the relationship between changes in asset prices and business cycles, particularly recessions. One view contends that asset price corrections often precede or coincide with a recession. The 1929 stock market crash and the Great Depression, the early 1990s asset price collapse and the ensuing recession in Japan, and the 2008 global crash in asset prices and the Great Recession are some of the most vivid cases of recessions foreshadowed by asset price corrections.Â

The other view argues that asset prices may fluctuate too widely to be useful predictors of recessions. The sharp collapse in the stock market in 1962 did little to unsettle the economic recovery in the United States. Likewise, the stock market crash of October 1987 did not significantly affect U.S. economic activity, despite predictions of a severe recession in 1988. Proponents of this view contend that asset price changes often reflect overly optimistic or pessimistic changes in investors’ expectations and are therefore poor indicators of the business cycle.Â

These two views raise some important questions about the relationship between asset prices and the business cycle. What does the theory say? Are these implications borne out by the data? Are asset price corrections useful in predicting the start of a recession? To shed light on these questions, we first describe economic theory’s predictions about the relationship between asset prices and the business cycle and examine whether they are supported by data for the Group of Seven (G7) advanced economies (Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States) over the past four decades. Next, we assess whether the prices of two key assets—equities and houses—are useful predictors of recession starts in these economies and explore the effect on the explanatory power of these prices when other variables commonly thought to be associated with the cycle are included in the analysis.Â

Asset prices and output fluctuations

In theory, there are many reasons why asset price movements could be associated with the business cycle. First, asset prices affect households’ net wealth and their ability to borrow, which can have important effects on households’ consumption plans. Second, according to standard Tobin’s q-theory, investment should move in the same direction as q, which is the ratio of the market value of capital to its replacement cost. Therefore investment should be high when...