9.2 The probability of a sudden stop (3.1)
The main concern with New Zealand's high NFL arises from the consequences of a sudden stop – an economic disaster. How likely is an economic disaster, and how large might it be?
These issues have received considerable attention in the literature over the past few years. Barro (2006) used a disaster model to explain the historically high average equity risk premium – the excess of equity returns over bond returns. This was a development of a model proposed earlier by Rietz (1988), but Barro calibrated his model by tabulating 60 disasters for 35 countries (including New Zealand) that resulted in a GDP contraction of 15% or more in the twentieth century.
Barro estimated the annual probability of such a disaster to be 1.7%, and the average GDP contraction to be 29%. The frequency distribution of the observed GDP contractions is shown in Figure 9.11 below.
In further research, Barro and Ursúa (2008), using a refined data set with 21 countries for which comprehensive data were available from before WWI to 2006, also obtained a probability estimate of 1.7% for a GDP contraction of greater than 15%. Barro and Jin (2009) used a power law method on the same data set and estimated a probability of 3.8% for GDP contractions of 10% or more with an average contraction of 20%.
In short, the probability of a sizeable economic disaster – a sudden stop – is appreciable, perhaps one in 25 to 50 years.
Further, research by Farhi and Gabaix (2008) and Farhi, Fraiberger et al (2009) suggests that countries with higher economic disaster probabilities will have higher interest rates and exchange rates than expected under uncovered interest parity. This is the case for New Zealand, so that the probability of a sudden stop here could be higher than the estimates obtained by Barro and his co-authors for developed countries on average.
To put these figures in perspective, the probability of a fire in a house or flat large enough to call out the Fire Service is about 0.4% per year, or about one fire in 250 years. This is about one tenth the likelihood of a sudden stop, but virtually every house and flat in New Zealand is insured against fire. What is more, fire strikes only 0.4% of residences in any one year, but when there is a sudden stop, everyone is affected at the same time.
Finally, we note that some of the measures recommended in this report will not only mitigate the consequences of a sudden stop, but are likely to reduce the probability of occurrence as well.
- Figure 9.11: Frequency distribution of economic disasters
- Source: Barro (2006). Based on 60 disasters with GDP contractions of 15% or greater for 35 countries in the 20th century.
