What's bad about recession?

What's so bad about recession? All those reports about stock markets falling "on fears of recession" give the impression  that recession is self-evidently a terrible thing.
But it's not. Robert Lucas once famously estimated (pdf) that the welfare cost of economic fluctuations were minute - a mere one-twentieth of one per cent of consumer spending. This is simply because such fluctuations are small - a fall in GDP of 2% is a deep recession - and the average person just isn't very risk averse  so wouldn't pay much to eliminate a small chance of a loss as small as 2%.
Stock markets, however - or at least market reports thereof - tell us Lucas was wrong.
But markets have always been telling us this. As John Quiggin pointed out here (pdf), the very fact that investors require high expected returns to compensate for holding equities suggests that people are somehow more averse to losses than Lucas-style calculations suggest.
But why? One possibility is that we're creatures of habit. Even small losses - on equities or from recession -  force us to change our way of life. And tiny changes - a smaller car, going to less fancy restaurants - can disturb us.
Another possibility lies in the fact that recessions don't hit equally. Recessions don't make us all 1% worse off. They make 2% of us 50% worse off as some people lose their jobs and businesses. And because we can't tell in advance who these 2% will  be, we all get scared.
What's more, we might think: "I don't want to risk losing money on shares at the same time I lose my job. So I'll stay of of the market."
This might explain why average long-term returns on shares are high; such people need high returns to tempt them to hold shares (though this is controversial - George Constantinides thinks it is significant, but Martin Lettau doesn't).
It might also explain why the stock market falls "on fears of recession" - it's because such thinking looms larger as the prospect of recession increases.
And here's the point. If we had better institutions to pool recession risk - Shiller-type macro markets - these fears would diminish. Share prices would be higher (as more people were willing to buy them) and less sensitive to recession.
In other words, the stock market is suffering this year because financial markets are so woefully incomplete. Shareholders are paying the price for not having adequate markets.
As an entity, society is very hypocritical in bellyaching about recession but doing so little to spread its risks better.
Wouldn't it be a nice idea if financial innovation were used to help ordinary people avoid risks, rather than help egomaniacs become rich?

Comments

[Jim]

"Wouldn't it be a nice idea if financial innovation were used to help ordinary people avoid risks, rather than help egomaniacs become rich?"

Yes it would. So why hasn't this happened?

[Chris]

Because egomaniacs are running the country, sadly

[Jim]

So it's a case of some required change in legislation or regulations, then, rather than market failure of some kind? Has this kind of thing been implemented in other countries? Genuine questions, I don't have any particular view on the subject.

[chrisc]

Long run returns for equities in the most successful democratic/capitalist economies have been high.
Not in those markets which disappeared!
Survivor bias I'm afraid.

[chris]

Chrisc - you're right that the equity premium for all markets including those that disappeared is low, as this paper shows:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=8156
But does this really explain the high premium in the US? Is this really a compensation for the risk of revolution or defeat in war?

[reason]

Chris,
the unequal distribution of the effects is more serious than you think. Think of young people entering the job market for instance. They will never catch up - they get no foot on the rung, get no on-the-job training and then have to compete with younger school leavers when the recovery starts. Think also of people unable to move because housing markets have become illiquid. Looking at averages can be very misleading (my favourite catchcry by the way).

[reason]

Also why do you think such markets would work.
1. How could we have confidence that the market would survive a downturn. Essentially you are asking for an art for catastrophe insurance (highly auto-correlated risks). But a private insurance market is likely to bid the price so low that bankrupcy in the event of a severe recession is almost certain. Even if it doesn't go bankrupt, the liquidity requirements of the re-insurer would almost certainly make the financial consequences of the recession even more severe. I can't see how you can avoid such systemic risks without considerable regulatory interference or having the re-insurance come from the central bank. If it is the latter, how is that different from standard anti-cyclical central banking?
1. The people most in need of that insurance (because their lack of financial assets makes them especially vulnerable to a downturn), can't afford it. This is the general problem of relying on markets to solve social insurance. Markets only serve those with resources.

[spencer]

Generally pre-recession periods are times of rising interest rates that reduces the present value of future earnings. So stock markets falling in a pre-recession period may not have anything to do with investors anticipating recessions, rather it is just a function of rising rates.

[reason]

Spencer...
I usually find your posts enlightening. In this case though, I don't believe you, please produce some evidence. Long term real rates (which surely what is relevant for discounting) are VERY low in the US. Or are you suggesting that the market is expecting deflation (surely TIPS would tell you that)?